The subprime mess is no accident.
Thu Mar 06, 2008 at 11:38:18 AM PDT
I thought I would expand a bit on my diary from a few days ago, and make more explicit something it contained. (A friend told me I buried the lede.)
The subprime mess is generally treated as a crisis, a catastrophe, one of those unpredictable pathologies that happen in our economy because the ingenuity of corporate and financial types outpaces regulatory understanding and control. Sure, it's some of that, but what it isn't is unpredictable or pathological.
When you understand the thermodynamic roots of economic life, and when you understand how our financial system flouts thermodynamic law, you can see that regular crises like these are a structural requirement of our system.
Current econmic wisdom treats phenomena like inflation, bankruptcy, and the failure of bond issuers to meet their obligations as economic pathologies: wouldn't it be nice to see an end to these things? Maybe with good management we can cruise along without them.
But inflation, bankruptcy, and the failure of bond issuers to meet their obligations are all forms of debt repudiation, and our system has a built-in requirement for some form of debt repudiation, because it lets debt (which is a claim on future real wealth) grow faster than real wealth.
Debt grows through the charging of interest. In the neoclassical economic paradigm, charging interest is normal, but bankruptcy, bond failures, and inflation are not. Paradox, huh?
Here's how the charging of compound interest leads to a need for debt repudiation.
A loan at interest is made in the expectation that the borrower will be able to pay back the loan out of increased income in the future. If we scale that expectation up to the whole system--the economy as a whole--we can see that the obligation to pay back more than you borrowed can be met only if the economy as a whole grows by a percentage equal to the (average) interest rate.
An example? I'll use the one from my diary Tuesday. Say I borrow the price of a gallon of milk and promise to pay you the price of a gallon and a pint next year. (Multiply by billions, and apply this to lots of things besides milk: cars, houses, food, clothing, whatever you might borrow money to buy. Which is, basically, all goods and services.) The deal works out fine, if the economy grows enough so that where there was a gallon of milk this year there will be a gallon and a pint next year.
What if there's insufficient growth?
I could repudiate the debt--simply fail to pay it. (If I do this systematically, I'm declaring bankruptcy.) But I can stay out of trouble if there's inflation: if prices go up--if a gallon of milk next year costs the same as a gallon and a pint this year--I can pay you back the price of this year's gallon and a pint in inflated dollars, which lets you buy only a gallon. I've met my monetary obligation to you but haven't paid you the real gallon and a pint, the increased claim on real stuff that you thought the deal was going to bring you.
Debt is a claim on future wealth--a claim on real wealth, actual things, not "monetary wealth," which Frederick Soddy (a guy I mentioned Tuesday) calls "virtual wealth." (There's no good website that I can find that explains his ideas. If you have access to online academic journals, check out Herman Daly's article on him in the Journal of the History of Political Economy.) A system that lets debt grow faster than real wealth grows is a system that needs periodic bouts of debt repudiation: bankruptcy, inflation, or failed bonds.
Within the limit implied by the rate at which real wealth can grow from year to year, this holds true: anybody who "makes money" in investments at a larger rate than that has to be offset by someone in the system who loses out--who holds debt that is repudiated by inflation, bankruptcy, or other failure of investment instruments. If we hold inflation in check then the system needs more bankruptcies and bond failures.
So the subprime crisis is no surprise to me. It stands in a series of crises over the past few decades--the Savings and Loan crisis, the Enron affair--in which vast quantities of debt were "repudiated." That's a technical term for something that is very ugly: people invested savings and saw those savings disappear.
One implication of this theoretical perspective is that there is a quantifiable and discoverable relationship between several variables:
Debt Repudiation = growth in debt minus real economic growth
Thus, other things being equal, we'd expect to see more bankruptcies in eras when inflation is low, and vice versa.
Unfortunately, I haven't been able to find good data or the time to play with them in order to tease this out and demonstrate it. It's probably a Ph.D thesis amount of work, or at least a Master's degree. Anyone want to tackle it?
