LACK OF INVESTMENT OPPORTUNITIES, SPECULATIVE BUBBLES, AND THE RESULTING CRISIS

Central point: The global financial markets are flooded with huge amounts of capital to invest, the world also needs huge amount of new investments to change to a planet friendly way of life, but our interest based financial system won’t allow most of them to be viable because their rates of returns are low; therefore money is chasing existing assets resulting in the global asset bubble.

This chapter is divided into three sections. The first, Real Economy Section, will identify fundamental economic factors responsible for the current economic turmoil. The second, Monetary Section, will analyze the feature of our interest based financial system that is preventing us from adapting to the economic and environmental changes of this century. The third, Concluding Section, points the way forward.

REAL ECONOMY SECTION

We will start this section by first looking at factors causing demand to slow, particularly investment demand. In the second half of this section we will look at savings and the impact their growth had on asset prices.

Difficulty of achieving higher rates of growth in developed countries

In his book “The general theory of employment, interest and Money” The great economist John Maynard Keynes says:

“Not only is the marginal propensity to consume weaker in a wealthy community, but, owing to its accumulation of capital being already larger, the opportunities for further investment are less attractive unless the rate of interest falls at a sufficiently rapid rate; which brings us to the theory of the rate of interest and to the reasons why it does not automatically fall to the appropriate level, …”

It is increasingly difficult for developed countries to achieve high rates of growth because earlier growth leaves progressively fewer investment opportunities with attractive returns. Compounding the difficulty is the mathematical reality that a certain percentage growth, say 5%, is a much bigger quantity, for countries with a larger income or capital base. With sustained growth the same 5% growth keeps growing bigger in absolute size and the room for growth keeps getting smaller. Given the size of the planet and the current mix of products, achieving double digit growth for the US is unrealistic because of its long history of economic growth and the huge size of the US economy.

For the Indian and the Chinese economies double digit growth may be realistic targets, because of bigger room for growth available in those economies and also because of the smaller size of those economies. Long history of peaceful economic growth, a relatively stable and stale mix of products, and a stable population makes the problem of achieving high growth rates doubly difficult for the US.

Economies do expand to other countries through foreign investments and through exports and continue to grow. Foreign investments don’t contribute to Gross Domestic product, or to national employment. The major part of the growth through foreign investments takes place in the foreign country. Furthermore, under the competitive and sometimes unfavorable environment in the fast growing economies there are little chances of foreign investment becoming a major vehicle of growth for the U.S.

Growth achieved through exports is growth in the domestic economy and creates full benefits of economic growth including employment. Developed countries find export markets a convenient way to grow. Colonial Britain, the US for most of the 20th century, and Germany and Japan in the post world war era are all good examples of export driven growth.

Export led growth in developing countries

In addition to the difficulty of low propensity to consume, larger capital base, smaller room for growth etc. businesses in industrialized countries have their difficulties multiplied over the last two decades by aggressive competition from businesses in developing countries. Developing countries are driving their economic growth through exports of a large variety of goods and services. Instead of exports helping growth it is the imports that are growing in developed countries. Business and investment potentials in developed countries are getting squeezed from both sides: domestic and international.

The currency tussle going on between China and the United States is an indication of the export led squeeze that is being felt in developed countries. The international currency valuation row is discussed in detail in Chapter 7.

Migration of industries

The United States economy has lost many of its major industries to developing countries and it continues to lose its competitive edge in other industries as well. Because of their higher wage structure, the United States and many European countries have seen large number of manufacturing industries migrate to developing countries. Most of the industries migrating overseas are now becoming heavily crowded by developing countries and their low wage workforce.

It is now abundantly clear that the industries that have gone overseas are not going to come back; in fact, more will be lost, and for years to come, the trend in all conventional industries will be that of job migration to developing nations. Companies in a globalized environment are looking for the cheapest workers, who happen to be located in the developing countries.

We now have to face the fact that developing countries are catching up fast in producing most industrially produced goods and services, and they will offer tough competition in most standardized labor intensive goods and services that can be shipped.

Third world wages and increasing global competition have significantly reduced the potentials and profitability of many established industries in developed countries. It is not only that we are finding it difficult to build new factories but that we are finding it difficult to retain most of what we had previously built.

Downward pressure on prices

Former Federal Reserve Chairman Alan Greenspan in his book “The Age of Turbulence” writes the following:

“Inflation had been subdued virtually across the globe. Inflation expectations, reflected in long-term debt yields, plunged. The yields on developing nations’ debt shrank to unprecedented lows. Double- and sometimes triple-digit annual inflation rates, historically a hallmark of developing economies, had, with a few exceptions, disappeared. Episodes of hyper inflation became extremely rare. Developing countries averaged an annual increase of 50 percent in consumer prices between 1989 and 1998. By 2006, consumer price inflation had fallen to less than 5 percent.”

Products that can be produced and shipped from China and other developing countries will not see much rise in prices because of increasing production capacities, low wages, and other economies of scale being achieved in China.

The reduction in prices benefit consumers world wide but may not be as good for producers and businesses in developed countries, who don’t have the same low wage rates and lax environmental policies as that in most developing countries. The economies of scale and of markets are also in favor of producers in developing countries who happen to be sitting right in the middle of the mass markets of Asia.

Business in developed countries will have to find some competitive advantage or cost advantage to offset the advantage of low wages that developing countries have. Reducing capital costs, given that capital is abundant, may be the answer.

Diminishing return potentials from old fashioned industrialization

Over the last three decades massive amount of industrialization has taken place in many developing countries. Higher production capacities and increasing competition eventually lead to lower returns or profits. Profit potentials for most globalized labor intensive industries have gone down precipitously, in the U.S., after large scale industrialization reached populous countries like China and India. Most manufactured goods sold in the global mass markets can now be profitably produced only in developing countries. Returns in developing countries are relatively higher because they still have room for growth; and their low wages and lower environmental standards allows them to expand through exports.

In other words a huge proportion of old fashioned industrialization around the globe has reached a level where the marginal rates of return from such industrialization is sinking below the applicable threshold in most developed countries. Such industrialization continues to be attractive, for the most part, in developing countries, where wages and related costs are still low and the environment is still a low priority.

Globalization enables U.S. and other developed countries’ investors to invest in developing countries where returns and growth potentials are better. These international investment opportunities do help absorb some of our investment appetite but is not enough to compensate for lack of growth at home. International investments do raise our national income but don’t create employment at home.  International investments are not a good substitute for domestic investments, at least at the national level.

It is obvious that we need to reduce costs and to allow investments to take place both in conventional industries and in environment related industries. Eliminating interest may help.

Dwindling reserves of Fossil fuel, global warming and their impact on investments

By 2009, globally, we had consumed a total of 1.1 trillion barrels of oil and our remaining proven reserves stood at 1.3 trillion barrels. Oil takes hundreds of millions of years to form and, at the current rate of consumption we may have just 58 years of proven reserves of oil left. This is not only a challenge to global peace, but also adds to supply uncertainties which translate into higher business risks.

Inelasticity in demand for oil creates severe price shocks in case of supply shortfalls. Sky high oil prices in the recent past have shown us the precariousness of the demand-supply balance and its economic impact. Risks of future oil price hike therefore have to be factored in investment decisions.

Whether we agree with the science and reality of Global Warming or not, the impact of global warming on the economy is obvious. Investors are shying away from investments in fossil fuel driven industries. The uncertainty about carbon tax or other climate change regulation is increasing risks and cost estimates. The resulting slowdown in investments is leading us down a spiral of lower economic performances.

As we will discuss in detail in the following chapters; fossil fuel consumption at the present scale is not sustainable both due to its impact on the environment and due to depleting reserves of these minerals. The realization of the un-sustainability of this life style is introducing huge uncertainty in the prospects of a large number of business and other investments. This uncertainty is causing economic growth to slow down; particularly in developed economies, where these uncertainties have the biggest impact due to, amongst other reasons, the heavy dominance of fossil fuel in the production and consumption structures of these economies.

Companies with even a 30 years investment horizon will have to consider the effects of diminishing oil supply or increasing oil prices in their investment decisions. Since dwindling oil reserves are already part of calculations in investment decision and strategic planning; the negative impact of supply and price uncertainties can be felt on investments and businesses today.

Oil supply constraints and global warming are reinforcing each other to reduce investments, not only in fossil fuel industries, but also in a large number of other industries such as automobile, heavy industry etc. Fossil fuel is so much part of the fabric of our economic life that uncertainty about it makes everything else less certain and more risky. We have to figure a way to eliminate the dominant role of fossil fuel on our economy, particularly foreign oil.

Fossilizing product mix

If we look at the evolution of the mix of products all around the world it has followed the same path for centuries. The general product mix in the U.S. and abroad has evolved slowly towards higher use of energy and fossil fuel. When we buy things we pay for its fossil fuel component and when we consume those things we again pay for fossil fuel, in the form of energy or in some other form. In 2008 our trade deficit was $696 billion and our import of oil was $475 billion; in 2009 these figures were $381 billion and $265 billion respectively. The huge transfer of wealth from developed countries, particularly the U.S., to oil rich countries is gradually reducing actual buying power of our people.

The price of oil has increased more than ten fold in a decade.  Oil price went from a low of $9.48 a barrel in December of 1998 to a high of $137.11 in July of 2008 and has hovered around $75 a barrel in most of 2010. It will naturally have dampening effect on consumption and investment demand in countries dependent on imported fossil fuel. Sluggish demand, lower investments, and lower employment are all here to stay as long as we stick to the fossil fuel driven life style and product mix.

The obvious way to increase demand, both consumption and investment, is to change the product mix, including capital goods, to the one that has a significantly lower component of fossil fuel. How can a large country like the U.S. maintain one of the world’s highest living standards when so much of that standard is dependent upon an imported fuel, which is also driving economic growth everywhere else in the world? We have to get the oil out of our products. We have to de-fossilize our product mix.

Fossil fuel is also bad for our economy

Going forward fossil fuel based industrialization will be more profitable in developing countries than it will be in developed countries because of the reasons mentioned above: bigger room for growth, low wages, and lax environmental standards.

Increasing industrialization in developing countries will also raise fossil fuel prices. Rising fossil fuel prices hurts us in our production costs and also in our consumption costs. Rising fossil fuel prices will hurt us far more than it will hurt developing countries because their consumption structure has lower fossil fuel content.

We have hit the limit on fossil fuel and our economies are slowing down because of the twin effects of fossil fuel and global warming but developing countries are not as much affected by these problems, they have room for growth in fossil fuel usage. Besides their low wages and lower environmental and living standards, their low per capita consumption of fossil fuel also gives them the ability to absorb higher fossil fuel prices. We have to work hard to slow down growth in fossil fuel usage because it hurts the environment and makes us uncompetitive.

Evident lack of Investment opportunities in America

Former Federal Reserve Chairman Alan Greenspan in his book “The Age of Turbulence” says “In fact … intended investment in the United States has been lagging in recent years, judging from the larger share of internal corporate cash flow that has been returned to shareholders, presumably for lack of new investment opportunities. These data are consistent with the notion that this decade’s decline in long-term interest rates, both nominal and real, is mainly the effect of geopolitical forces rather than that of the normal play of market forces.”

The following excerpts, from a New York Times article by Graham Bowley published on October 3, 2010, and titled “Cheap Debt for Corporations Fails to Spur Economy,” present another picture of lack of investment opportunities.

As many households and small businesses are being turned away by bank loan officers, large corporations are borrowing vast sums of money for next to nothing — simply because they can. Companies like Microsoft are raising billions of dollars by issuing bonds at ultra-low interest rates, but few of them are actually spending the money on new factories, equipment or jobs. Instead, they are stockpiling the cash until the economy improves.

According to the financial data provider Dealogic, United States companies have borrowed $488 billion on the American high-yield and investment grade bond markets so far this year, 7 percent more than businesses borrowed during all of 2009, and on track to at least match the $589 billion borrowed in the boom year in 2007, which was the highest on record.

Smaller companies continue to have trouble borrowing, and most of the new financing is limited to bigger corporations.

Profitable companies found it better to pay dividends or return money to stockholders than to make new investments in the bubble era. They are now hoarding huge sums of cash but not investing in new plant or facilities. If these profitable companies can’t find ways to invest cheap money, then cheap money may not be the answer to our economic problems, or it may not be all we need. We need far more than cheap money to address the current crisis.

Speculative bubbles and real investments

We have seen so far that there is a shortage of good investment opportunities in the U.S., but since savings always equal investments a certain amount of investment has to take place. All savings have to be in the form of an asset. Sometimes there are plentiful investment opportunities, and investments pull savings to equality; interest rates tend to rise as a result. At other times savings are plentiful and have to push investments to equality; interest rates tend to fall as a result.

The role of interest and the financial markets is to facilitate allocation of savings or financial capital to the best or most productive use. Interest rate is a hurdle mechanism i.e. each investment proposal has to cross the hurdle to become actual investment. Interest rate hurdle mechanism works well when there are plentiful investment opportunities. But when there isn’t enough investment opportunities, even at low rates, and savings need to push investments the hurdle mechanism itself becomes an obstacle against discovering or developing new investment opportunities. The reasons for failure of savings to adequately push interest rates down are discussed in the monetary section of this chapter.

The position of this book is that our interest based system works fine when there are plentiful investment opportunities and interest helps us eliminate the least productive of those but when there are not enough investment opportunities the elimination mechanism is not that useful. We are currently in the latter situation. The system fails when savings have to push investments to equality. Speculative bubbles are the result of that failure because speculation, particularly in real estate, has an easy investment process and also provides good collateral. Speculation catches up fast in real estate because of the obvious upper limits on its supply. Let us look at savings and see how they are powering speculative bubbles.

Growth in savings abroad

Having discussed the trend of declining investment in America, let us look at the other factor that drives investment: savings. Since money travels fast all around the globe, international savings also have to be looked at to get the whole picture.

One of the commonly attributed causes for the current economic conditions is that Americans saved too little. Though Americans can be blamed for saving too little the fact remains that our low rate of saving did not cause the financial crisis. The lack of savings in the US in fact helped to alleviate the severity of the crisis. If we had saved more the asset bubble would probably be bigger and the economic crisis deeper. Low interest rates during all of this century are a clear indication that we were never short of savings to fund investments during those years. Our lower rate of saving also prevented other social and political global crises from developing. Let’s see how.

Geopolitical aspects of our low savings

By saving too little we have made China, Korea, India, Brazil and others economic powers. By providing them our markets and buying large quantities of their goods we have given them the economic means to thrive. If we had not provided them the economic opportunities the world could be in a different kind of crisis. It could have easily been a global political crisis and could have provided an incentive for war to the emerging powers.

If the productive capacity of the emerging powers was not used for commercial purposes it could have been directed towards militaristic purposes. At this point they are happy to hold US government bonds but if that was not the case they would probably be eyeing some territorial assets somewhere. Our high consumption in fact allowed many countries to increase their incomes and also increase their stake in global peace.

Inflationary aspects of globalization of savings

Since income levels have gone up in China and elsewhere a correspondingly higher amount of saving is also taking place. Generally as income increase savings increase a little more than proportionally; but in developing countries with high incentives for savings and a savings culture, savings are going up far more than proportionally. Former Federal Reserve Chairman Alan Greenspan’s use of the term “geopolitical forces” in the statement cited in one of the preceding paragraphs was probably used to mean the extraordinary savings of fast developing countries.

There is a peculiarity with the US dollar savings of countries like China. China’s $2 trillion of US dollar reserves create two kinds of inflation at two different places. First when the Chinese government takes the dollars away from its businesses it exchanges them for the local currency Yuan. The local economy gets flooded with Yuan and that tends to cause inflation because the corresponding goods have been exported. However because of the huge potentials for growth and tremendous increase in production in China this did not cause much inflation; it probably helped increase investment and growth. Such is the ease of achieving growth in some developing countries.

When the Chinese government, including its citizens, invests those dollars in the US market it lends to sound financial institutions that try to lend it against collateral and other security. If there were enough real investment opportunities this injection of saving into the financial system would not be a problem but lack of good quality investment opportunities makes those savings chase existing assets, particularly real estate. Prices of assets go up; in other words we have asset price inflation.

Global savings becoming American consumption

Lending and borrowing obscured the fact that Chinese savings were ending up as American consumption. Let us take a hypothetical example of a saving of a Chinese company of one million dollars which found its way to the international financial markets. Those million dollars ended up in the hands of a mortgage financier who lent it to a person who bought a million dollar house. The buyer owns the house and owes the million dollars. The person who sold the house made a two hundred thousand dollar profit on the sale and decided to use the profit for consumption purposes. He bought boats, cars, and other toys for himself. This process was probably repeated several times to cause most of the million dollars to become profit through asset price increases.

The consumption that did not take place in China took place in America; the result is that we end up owing that money to China. From the 1950s to the 1980s American consumption was between 60% and 65% of GDP; after which it started rising steadily and reached 70% of GDP in 2001. It has stayed around that level ever since. If we have been saving more than 30% of our GDP why are we in such economic trouble? The answer may lie in phantom GDP, the GDP that was a result of asset price inflation. A significant part of GDP during the asset price inflation era was not GDP at all; it was just the result of inflation in asset prices. No wonder we are in such a deep crisis; we not only consumed more of our income we also consumed incomes that was not there.

The 30% saving that we were making, in addition to the foreign savings, was accumulating as asset in the financial system. The asset was the debt that was being accumulated by American household and government. The household debt which was around $680 billion in 1974 increased to $14 trillion in 2008. According to Dr. Paul Krugman “Twenty years ago, the average American household’s debt was 83 percent of its income; by a decade ago, that had crept up to 92 percent; but by late 2007, debts were 130 percent of income.” The increase in U.S. federal government debt was no less dramatic: it increased from 381 billion in 1970 to $14.5 trillion in 2010.

The tendency of debt to grow exponentially through interest, the money creation undertaken by the Central Bank and the financial system, foreign savings, and phantom GDP all combined together contributed to the phenomenal explosion of debt in our economy. In September 2008 bank liabilities had reached 100 percent of gross domestic product – double the ratio of a few decades earlier (NY Times of January 20, 2010). These gigantic increases in debt were the driver of the consumption economy that we saw during all of this century and earlier.

We have an economic system that won’t let us invest in low yielding industries and for the future, but instead helped us to consume what we didn’t earn. Since our economic system did not allow us to make the investments that we needed to make, it made us consume more to keep the economy growing. That was the consumption driven economy that we had for so long. Asset price inflation was the major intervening illusion through which all this debt and consumption materialized.

Briefly, asset price inflation did the following:

  1. It created consumption where investment should have taken place. We basically consumed an income that was just due to inflationary price increases. That will reduce our ability to consume and invest later and contribute to continued economic slowdown.
  2. It excessively inflated the prices of assets making them relatively illiquid and creating hurdles against future business, investments and economic growth.
  3. It increased our debt, contributing to its un-sustainability. The profits created through asset price inflation made some people and institutions very rich; they lent that money to other people who now own the overpriced assets and the accompanying debt.
  4. It created huge amounts of bad quality debt. It worsened the chances of the getting back the moneys loaned to the new owners and therefore contributed to the credit crisis

In the global economy savings and investment have to equal, as they do in the national economy. There is some difference in the way savings and investments are accounted for in the national accounts and in the global accounts but the substance is the same. In the Chinese account the dollars they own in US bonds and other assets are an investment but they are not so in the global account. In the global account a huge amount of Chinese saving is not saving because they became American consumption. The same applies to a huge amount of other, including American, savings which became consumption through a borrowing but are still showing up as an asset for the lender because the borrower, or the guarantor, has not defaulted yet.

If our economic system had been performing its functions we would not have asset price inflation, at least at the scale we did, and most of these savings would be invested in building new assets. Our economic system is basically making us eat our capital. If huge amount of savings are becoming consumption on a regular basis through lending, the stage is being set for loan defaults and a credit crisis.

Rising international savings causing asset price inflation in the US

There is high demand in the global financial markets for US assets. It is not just the Chinese but also oil exporting and other countries that are looking for ways to invest their savings in the US and other developed markets. Savings of our aging population and that of other developed countries as well as large number of super rich people are all adding to the growing demand for investment assets.

If the world does not offer good investment opportunities for those savings; those savings will tend to cause asset price bubbles and speculative investments. Asset price bubbles are the new inflationary phenomenon. The recent increases in stock prices, real estate prices, and prices of stockpiles of commodities are all examples of asset price inflation. Too many saving dollars are chasing few investment assets.

The classical economics’ answer to the current problem of savings not finding appropriate investment avenues is that interest rates will fall down to bring about higher investments. As already shown by Lord Keynes, interest rates don’t fall appropriately for many reasons including liquidity preference. Even if interest rates are forced down by the Central Bank, as we seen recently, it did not increase investments but fuelled speculation. As stated earlier temporary reduction in interest rates is no panacea for the current state of our economy. We need elimination of interest.

The huge amount of debt that was and is being piled up by the private and public sector in the U.S. has driven demand upwards for consumer goods and investment assets. The consumer goods demand is helping China and other developing countries. They save a high proportion of their income from selling consumer items and try to invest it in capital markets. Capital markets are flush with cash and they try to lend or invest it. Since investment opportunities, given interest rates, are not plentiful in developed countries the money is ending up fueling speculation in investment assets.

Most ordinary investors when they try to find or even imagine good investment opportunity only find speculative asset bubbles to be the way to make money. Dr. Paul Krugman, the New York Times economist, recently referred to an article titled “Recession-Plagued Nation Demands New Bubble to Invest In” as one cynical answer to the current crisis.

Asset price inflation: the new and relevant inflation to watch

As stated earlier a significant portion of the dollars that we are spending on import driven consumption, including government expenditures, are ending up as savings for the developing countries. These dollar savings are ending up in the US financial markets as investments or as asset backed lending, which in turn is driving up the prices of assets. We have been having high inflation, in asset prices, for more than a decade. This is the new kind of inflation that we need to measure and control. We need to measure inflation in asset prices to get a better view of the inflationary trends.

High level of inflation has showed up in asset prices. Inflation has showed up in asset prices because enough real assets are not being produced to accommodate growing savings. Housing and other build up in real estate being a response to asset price inflation, has mostly served to cater to speculative demand.

Real demand and speculative demand

Real demand has its origins in the real dynamics and forces driving the economy or in other words in the real sectors of the economy. There may be more demand for houses because there are more people with incomes demanding housing; that is real demand. Real investments, in response to real demand, create new assets that tend to lower asset prices. Real investments by enhancing productive capacities also tend to lower prices of goods and services. If demand goes up because easier loans are available; it fuels speculation. Speculative investments tend to raise prices because the driver is speculative fervor. Rising prices fuel speculation and speculation in turn further pushes prices up; this cycle continues for as long as it can. Speculative investments continue only as long as prices are rising. Rising prices show up as profits for earlier investors. Speculative investments are like Ponzi schemes in the sense that they benefit earlier players at the cost of later players.

Real demand translates through the monetary sector into actual demand. Since both real and speculative demands go through their monetary translation, it is very difficult to distinguish one from the other. Speculative demand for producers and suppliers is every bit the same as real demand.

Real, sustainable, demand is not just an economic phenomenon; it has roots in every aspect of human existence. Real demand is influenced by real aspects of life; environment and resource depletion have become a real aspect of life in this century. People, including investors and entrepreneurs, see, experience, and are influenced by the environment and resource related problems in the course of their activities and respond in their life and business decisions.

People think that high level of savings in Asia is due to cultural reasons, it may be, but we also know that the factors that influence consumption or saving decisions are the prevailing economic and other conditions and expectations about those conditions. The economic conditions that most Asians experience and the expectations they have about their future conditions require them to save. They don’t see fountains of wealth around them; they see tough economic competition and deteriorating resource and environmental conditions. Those conditions are the drivers of real demand, or the lack of consumption demand in developing countries.

Economics cannot ignore the environmental and the resource challenge and expect demand and other variables of economic growth to follow the same pattern it did when these real life conditions were not present. It is extremely short sighted on the part of developed countries to demand that developing countries increase their consumption. We live on a small planet; when the billions of people in India and China significantly increase their consumption, particularly given the current product mix, even the Americans will feel squeezed by their appetite.   

As we can see drivers of real demand are not having the right impacts on demand. Constraints too visible to common experience are being ignored by the economic system. Our economic system is still working as if it was in the 19th century. Speculative demand, which is primarily driven by financial considerations and market sentiments, fills the void left by failure of real drivers of demand to positively influence demand. Widespread speculative demand is a result of the failure of the economic system to channel capital to most “economically productive” activities.

Even the term economically productive changes meaning if we remove interest from the equation. Under the current circumstances economically productive should include long term sustainability but does not, because of the limited time horizon of our financial system.  If the financial system was working right it would have channeled money into new low yielding areas and industries e.g. clean energy, instead of pushing higher amounts of money into old assets and industries and allowing prices to rise so far beyond sustainable or productive values of respective assets. The result is that speculative bubbles and credit crises have become a way of life in this system. Creating value illusions is currently the main product of our financial system.

Current speculative demand is the result of our outdated financial system

Our economic system takes only monetary inputs to value assets or economic activities. Our monetary system assumes that monetary value contains all information, publicly known or otherwise. Prices are supposed to reflect all relevant information. That may be true; but the interpretation of that information is subject to the perceptions and sentiments of the players in the market. The change in oil prices from $9.48 a barrel in 1998 to $137.11 in 2008 probably was not due to new information. The power of big players and their motives have also started to affect the markets. The volatility that we see in asset prices these days reflects the erratic assimilation of information in prices and the accompanying public nervousness about it.

Since this is not a book on economic theory, we cannot get into a discussion of different efficient market hypotheses. We are not disagreeing with the basic premises of efficient markets, but we know that at this point the markets are not correctly interpreting information related to the environmental and resource challenge that we face in this century. For instance, prices are failing to translate sustainability, or lack thereof, into monetary values. The interest based system by maintaining an irrelevant hurdle in the investment process has reduced the efficiency of prices to reflect value. There is not much point in interpreting the information correctly if it can’t be translated correctly into economic activities. Prices and their role in the emerging economic conditions are further discussed in Chapter 7.

Rampant speculation worldwide is a clear sign of the failure of our economic system rather than an aberration. It is a failure of the economic system to go behind the monetary veil to appropriately value economic productivity, sustainability and long term viability. Market prices alone are not enough to transition us into a sustainable economy. If we keep relying on market prices to deliver us to the new economy we will be disappointed. No man made system can be expected to correctly translate changes that are the first of its kind in human history. Speculative bubbles will become frequent. Asset tax being proposed here is a means through which the economic system will get input from outside the monetary system in valuing assets and economic activities.

Meeting investment demand in a non-speculative manner

The huge amounts of global savings need to be profitably invested. Currently a significant portion is being invested in speculative activities. Asset price inflation is one outcome of such investing and credit crisis is another. If savings are well invested the chances of any financial crisis is minimal. Most financial or credit crises have their origins in savings being not well invested.

Governmental efforts to create demand will end up creating speculative demand and resulting economic crises. Investments made in response to speculative and other non-sustainable demand is discussed in one of the following sub-sections titled “Mal-investment.” One of the greatest economic problems of our time is that we are not recognizing the new driver of real demand of our time. If we do not recognize the demand for environment friendly products and services and continue with our fossil fuel based model there will never be enough sustainable demand.

We need to create more productive assets to fulfill investment demand and to prevent asset price inflation from ruining our economy and our financial institutions. Growth can be achieved by changes in the product mix. When new and advanced technologies come into use a new range of products are created that increase economic value and efficiency. A large number of old products are replaced by better ones. New products have been a major driver of growth and development both here in the U.S. and abroad. We all remember the economic growth brought about by the advent of internet, in the U.S. and all around the world.

If we adopt an environment friendly economic model, the product mix will change so substantially that it will drive new investments and economic growth for a long time. The opportunities for growth that came along with the challenges of the environment and globalization are not materializing due to the hurdle presented by interest based financial system. The financial rate of return model will translate the economic benefits of the environment friendly industries into financial benefits only when fossil fuel becomes extremely expensive.

Economies function through financial inputs; asset tax will provide the input needed to translate economic benefits into financial benefits; there will be no need for making fossil fuel extremely expensive. Asset tax will achieve part of the economic effect by making clean energy cheap and at the same time making fossil fuel use expensive.

We need our financial system to allow build up of assets so that these savings can find a new home; and don’t overbid for old assets. New, productive, and sustainable assets in the environment friendly economy are waiting to be built; only if we removed the hurdles.

MONETARY SECTION

Unresponsiveness of interest rates to high levels of savings

Our interest based financial system is not allowing creation of new assets. New businesses and production facilities are the kind of assets that not only satisfy demand for new investments but also for returns on those investments. They would provide income and employment to replace those jobs migrating overseas, and also provide goods and services to keep general inflation under control.

The planet and our economy need new investments but our financial system is not allowing them primarily because interest rates do not appropriately respond to changes in savings and investment needs. That is the point being made in the following statement by the economist John Maynard Keynes, which was quoted in the opening paragraph of this chapter, “which brings us to the theory of the rate of interest and to the reasons why it does not automatically fall to the appropriate level.”

As we will show in the later parts of this book that interest is more responsive to liquidity preferences, at lower interest rates, than it is to savings and investments. If interest rates go below a certain point lenders’ preference for liquidity override interest income considerations and therefore result in unavailability of further credit; or hoarding of cash by those who have it or can borrow it. This extreme situation is usually referred to as the “liquidity trap.”

The Zero bound

The basic problem with interest is that it can’t go below zero, which it should if it is to allocate capital under all economic conditions and bring savings and real investments into equilibrium. If it did go below zero, conditions for liquidity trap would never exist. Interest would always remain responsive to savings and investment needs no matter where the rates were. The asymmetrical behavior of interest rates around zero brings into play the laws of physical sciences and mathematics to create the anomalous behavior of financial markets around that point. As long as this asymmetry remains interest rates would remain a flawed and occasionally counter productive tool for allocating capital and regulating financial flows.

The following are a few excerpts from a blog written by Dr. Paul Krugman; they connect the problem of the zero bound with real economic observations.

Consider the Fed, which under Bernanke is more adventurous than it would have been under anyone else. Even so, it has gone nowhere near engaging in enough unconventional expansion to offset the limitations created by the zero lower bound.

A while back Goldman estimated that if it weren’t for the lower bound, the current Fed funds rate would be minus 5 percent, and that to achieve the same effect as a further 5 points of Fed funds cuts the Fed would have to expand its balance sheet to $10 trillion; I wouldn’t stake my life on those estimates, but they seem in the right ballpark. Obviously, the Fed isn’t doing that.

—–

The point is that while you can think of things the Fed can do even at the zero lower bound, that lower bound is in practice a major constraint on policy. —–

And by that criterion, how much of the world is currently in a liquidity trap? Almost all advanced countries.

While Dr. Krugman, the Wall Street Journal, Forbes and others can argue about the finer points of liquidity trap and as to what it really means; the point being made here is that the zero bound of interest rate presents a major problem in allocating capital when the available investment opportunities offer returns that are nearing zero. The system starts to fail because of its zero bound.

The fact that the zero bound limitation of interest seriously effects the emerging non-fossil-based economic environment adds to the certainty of the failure and the magnitude of its consequences. We need subzero interest rates to counter global warming. Even though this may sound like an attempt on being poetic it nevertheless is based on economic reasoning. Environment related industries need the existence of the possibility of negative interest rates.

If interest rate, or something similar, has to handle allocation of capital in the emerging economic environment it needs the ability to go below zero. Asset tax being proposed here is an effort to effectively achieve subzero interest.

Buoyancy level of interest rates

Compounding the zero-bound problem is interest rates’ buoyancy level, the rate at which it tends to stay. Interest rates have for centuries hovered around 5%. That 5% is the buoyancy level of interest rates, i.e. average interest rate over a long period of time.

We have entered an economic era in which even a 2% buoyancy level, may not be sustainable. This is the era of wind energy not fossil energy. Our financial system would rather have savings wasted in speculation and asset price inflation than allow investments to take place in assets that yield less than 5% or so.

The interest rate mechanism works fine when interest rates are in the stratosphere or at least above 5%; the failure starts near the ground levels.

Low interest rates increase mismatch in available and desired loan terms

Since interest rates can’t go below zero; the closer they get to zero, the more the chance of interest rates going up and therefore the greater the chance for the lender to lose money. The greater the amount of the loss the longer the money is lent for. Therefore the incentive to lend for a significant length of time is very low when interest rates are significantly below 5%.

Potential losses due to changes in interest rates are measured in interest rate risk or duration risk. A duration risk is a composite measure of the term (time length) of the loans and the timing of interest payments. It may be defined as: the percentage change in the value of an existing loan or a portfolio of loans that will result from a 1% change in interest rate. The longer out the cash-flows coming from the bond the higher the duration risk or the percentage loss if interest rates go up.

Matching savings and investment should be much more than matching available lending with borrowing; it should also involve matching the term or the time periods of desired borrowings and lending. Though interest rates do help with matching dollar borrowing with dollar lending; but when rates are below 5% they worsen the mismatch between the desired terms (time period) of the lending and that of desired borrowings. When interest rates fall lenders prefer short term lending and shy away from long term lending; loan availability tends to shrink on the long end, which is partially reflected in a steeper yield curve. Higher expectation that interest rates would rise make long term loans, which have higher duration risks, really unattractive for lenders.

Low interest rates tend to exacerbate long-short mismatch in financial institutions

The money supply-demand part of interest rate determination in low interest rate environment typically does most of the matching at the short end of the term structure of interest rates. The long end moves based more on expectations, targeted Central Bank intervention, and other macro economic and “geopolitical” factors.

Since the short end of the term structure absorbs most of the dollar flows because of the preference for short duration lending during low interest rates; it becomes relatively extra attractive for borrowers as well. A steep yield curve reflects the preference of the lenders for the short end of the curve. Banks and other financial institutions tend to take advantage of the cheap short end and borrow heavily at the short end and lend for longer periods. Steeper the yield curve, higher the profits that banks make in short-long trades.

The Savings and Loan crisis of the late 1980s was a classic case of long-short mismatch. The institutions lent for long durations and borrowed from savers for short durations; when interest rates, including short term rates, went up these institutions were faced with solvency crisis. The long-short mismatch did not prominently figure in the current crisis primarily because banks were hit first by the credit crisis, and also because interest rates didn’t go up. However the urgency and rapid spread of the crisis indicates long-short mismatch. If Bear Stearns had borrowed long for long term investments we would not have to rescue it in such a hurry. The same may be true of Fannie Mae and Freddie Mac.

Government guarantees distort the markets

Since the government assumes the credit risk in mortgages and similar loans the lenders overall risk is reduced, which increases the incentives for lenders to make mortgages and similarly guaranteed or packaged loans available. Government guarantees make the most tedious part of the credit process very simple. Lenders therefore find ways to make long term loans available through mortgages and other eligible asset backed transactions. The government guarantees for mortgage and other loans increases the pressure for long term lending, further reinforcing the long-short mismatch in the financial system.

Government guarantees, loan packaging, teaser rates, adjustable rate mortgage contracts, and similar other instruments contributed to the high growth in the mortgage market even though mortgages are primarily long term loan contracts. High international savings and monetary policies also added to the pressure for growth, which led to the ballooning of global mortgage portfolio. Government guarantees drown market signals and consequently distort the markets. Government guarantees are not a good and sustainable way to support the market, or any significant segment of it.

Our financial system requires so much government support for functioning that it has become normal for governments to intervene in the financial markets. Government intervention in markets should not be the norm if we want to benefit from the efficiency and the powers of the free markets. Taxation is a function of the government. Asset tax is a tax.

Low interest rates tend to fuel speculation

Extra low short-term interest rates generally find use in speculative activities. Low interest rates translate into low speculation costs. The $4 trillion of daily volume in global foreign exchange trades may be a good example of low speculation costs and a result of extra active short end of the yield.

Speculation comes into the mortgage market picture because the institutionally supported lending, e.g. mortgages and other collateral backed lending, are for certain kinds of assets; demand for those assets go up consequently fueling speculation. Government guarantees very substantially expand the size of the credit market and therefore tend to support prices of the assets or economic activity being promoted. It also simplifies the credit issuance process. No wonder we had so many mortgage finance companies in the boom years. Even though most of the risky ones were operating in the non-guaranteed market they nevertheless benefited from the asset price support provided by the guarantees.

Rapid increase in real estate and other asset prices brings in borrowers who borrow long term with low front end rates with the intention of liquidating it in the short term. Lenders follow the same reasoning of increasing prices and assume their teaser and adjustable rate loans would be honored even when the rate increases. Speculation in other assets goes up simply because more money is chasing fewer investment assets. Money will always find a use if not in productive assets then in consumption and speculation.

The Central Bank’s lowering of interest rates to spur demand or to increase the demand for loans usually just increases demand for existing assets, which after a certain point tend to create asset bubbles and other speculative outcomes. Asset tax as proposed in this book will create a direct disincentive against speculation because asset tax will be a cost of speculation which can be increased if there is inflation in asset prices. Asset tax can be targeted to particular assets like real estate, stocks, and commodity inventories, if speculation in these assets heats up.

Government intervention does far more damage than the long-short mismatch

Government interventions like the one in the mortgage market tend to achieve one outcome, e.g. popularize homeownership, but create a host of risks and problems. The mortgage program was basically a program to subsidize credit risk. Subsidizing credit risk at such a massive scale distorts the dynamics of the markets. Strong buying over extended periods of time in those assets created a false sense of stability and growth in prices which in turn reduced the perception of risk in these markets. The false sense of ever rising real estate prices, along with many other factors mentioned above created the global speculative bubble that triggered the global economic crisis. It has exposed the distortions that patchworks, like subsidies, create in markets. The mortgage related distortion is particularly important for its size.

Government intervention in markets on such massive scale is also dangerous because of the open ended costs. Since these interventions don’t require outright cash outflow we don’t know their costs till the actually hit us. With globalization the financial markets have become too big and integrated; the chances are therefore high that the cost of such intervention will keep growing till it becomes too big, for the guarantor. In fact becoming too big for the guarantor is in itself a trigger for such costs to actually hit the guarantor. Government intervention is not an effective way to deal with the flaws of the system that is so huge and so global.

The flaws of the system have to be addressed through reforming the system, as is being proposed here. If interest rates could go below zero it would automatically incentivize the needed volume of investments. If it was not for the flaws of this system our government would never have had the need to intervene in the mortgage market through subsidizing credit risk on such a massive scale. A flawed economic system almost guarantees government intervention in the markets.

Low interest rates not a panacea for establishment of new industries

Long terms loans are more important for establishment of new low yielding industries. But our financial system tends to shrinks the supply of long term loans when it has more loans to give. The steep yield curve is the main indication of this preference, other preferences are borrower specific. It makes short term loans more available and long term less available when rates are below 5% which is the rate range most likely to work for new low yielding industries. Therefore our financial system is never likely, in itself, to help establishment of new low yielding industries; even when there is plenty of money to lend.

Adding to the lack of availability of long term loans during periods of low interest rates is the temporariness of interest rates. Temporarily low interest rates will not help establishment of new environment friendly industries because their returns are permanently low. Interest rates, particularly long term, need to stay very low over a long period of time to enable establishment of significant number of new, environment friendly, industries.

Central Banks, however, can and sometimes do influence long term interest rates by buying long term bonds and through other measures. Bringing long terms rates down for a short period is not the kind of solution our economy will respond to under the current lack of good investment opportunities.

Investors won’t invest in an industry that yields low even when interest rates are favorable because they are likely to go up later. As long as there are good chances of interest rates going above the normal yield of the industry that industry will not attract investment, particularly if it is capital intensive. Let me make a crude statement, obviously not for its accuracy but for the point it helps to make: The current financial system will never, in itself, allow investments to be made in any industry that normally yields less than 5% financial rate of return.

As long as we don’t either raise the returns on planet related and other socially important industries or we significantly and permanently (40 years minimum) lower our return requirements from new industries we are going to be stuck with low level of good quality investments in America.  As long as the fundamental reason for this crisis remains in place the crisis will remain in one form or another.

Time value of money limits investments

As stated earlier “A dollar today is worth more than a dollar tomorrow” does not hold true any more than does the opposite, “A dollar tomorrow is worth more than a dollar today.”

Currently cash flow from most investments becomes too small for consideration after discounting for 30 years’ interest. A $100 cash-flow due 30 years hence discounted at 10% annual interest (quarterly compounded) rate will become $5.16 in present value. The approximately thirty year time horizon for most investments is basically a result of the time value of money, which itself is determined by the rate of interest.

Elimination of interest will eliminate “time value of money” as we know it today. Elimination of time value will in turn greatly increase the time horizon for most investments. After the elimination of interest time horizon will become more in tuned with the life cycle needs of the investors. There are many valid reasons, besides asset tax, as to why an investor may value cash flow in later years more than the same in earlier years. The yield curve, or any other manifestation of it, will not be an upward sloping line the way it is under the current system; it will take all slopes at all points.

Increasing the time horizon for investments automatically increases the universe of economically viable investments. In a fiat money monetary system there is really no need for “time value of money.” Time value of money is discussed in detail in the Chapter on interest and also in the chapter on space.

Investment in assets and industries that are likely to become more relevant with passage of time are accordingly likely to gain or maintain value. Since the interest based financial system values nearer values higher than the distant ones, because of discounting, it is structured to under read changing tides of time or under value assets that gain value with changing times. Interest based system is likely to take us in the wrong direction in the changing times we face in this century. It will take us against the tide till the tides overpower us.

Monetary Policy solution

We are so short of real investment opportunities that additional money supply only contributes to speculation and asset bubbles. Monetary easing, that is reduction in interest rates through increase in money supply, is not going to solve the problem of low rate of investment because additional money or temporarily low interest rates don’t create new or additional investment opportunities. They can only help capitalize on opportunities that are already established.

Low interest rates are a temporary phenomenon. Since we need low long term interest rates over a long duration to enable establishment of new (environment friendly) industries, temporary low interest rates will tend to increase speculative activities (asset bubbles) or cash hoarding rather than increase investment in new low yielding industries.

Increasing money supply will not solve the investment problem. It will only cause speculation and asset bubbles. Expanding money supply increases debt or leverage which in turn is causing the credit crisis we are facing. Increasing money supply in the absence of abundant investment opportunities will create or aggravate the credit crisis.

The Austrian School of Economics position vis-à-vis monetary easing or increasing money supply is that it will create mal-investment. Mal-investment as the name suggests happens when investments are misdirected, or excessive. They won’t deliver their promise and consequently cause credit and economic crisis. Currently in America due to shortage of investment opportunities monetary easing is causing mal-investment. However the same cannot be said with the same certainty about China.

The Federal Reserve purchased $1.5 trillion of long dated Treasury bonds and housing agency securities in less than a year (NY Times of January 20, 2010). The Federal Reserve currently holds $2.3 trillion of government and corporate securities (total assets). The $600 billion quantitative easing program announced by the Federal Reserve in November 2010 will further add to long term debts held by the Central Bank. It will further increase money supply in an effort to boost the sluggish economic recovery.

Monetary policy solutions being tried to the extreme are now part of the problem. If we keep trying the low interest rate solution for long, low interest rates would fail to even increase short term lending, assuming inflation is under control. We may call it the liquidity trap or something else; the basic reason will be sheer lack of profitable investment opportunities, lack of momentum in speculative activities, and lack of good credits to borrow for consumption.

CONCLUDING SECTION

Current financial system and environmental energy

We use the term environmental energy to mean energy that is freely flowing in the environment, which is part of the environment e.g. wind, sunshine, waves, tides, river current, etc. It does not include energy from agricultural and other products that directly compete with food production for land and other resources. If we need to protect the environment we need environmental energy. Environmental energy is free, it is part of the natural environment, and it is least likely to hurt the environment; if it does, the damage will be minimum, and be localized.

New, environment friendly businesses and industries are not taking root due to their low rates of return. Their rates of return are low because they use very dilute sources of energy like wind and sunshine as compared to fossil fuel, which is very concentrated energy. Fossil fuel-based industries consume resources that have been stored in the earth over millions of years, whereas renewable energy industries use only the natural flow of energy in the environment. Their rates of return are low also because a major part of the benefits of clean industries accrue to the environment, to the planet, and to mankind.

Our economic system will only promote massive amounts of environmental energy investments after fossil fuel becomes extremely expensive (perhaps $500 a barrel) but that would be too late, because the widespread suffering resulting from higher prices of almost all goods would be devastating. The current system may find the answer in the long run, but as we all know, “In the long run we are all dead.” The current economic system will find the answer through death and destruction.

The great investment opportunities that had naturally arisen in environment friendly industries are being blocked by our financial system therefore the savings resulting from the huge increase in incomes around the world are being wasted in speculative investments and credit crises. In the next chapter we talk about ways to make environmental energy competitive and to increase investment opportunities so that all savings are productively employed.

 

Chapter 6

Table of Contents