A few weeks ago, in a speech at the Brookings Institution, Lawrence Summers, head of the President’s National Economic Council, rattled off a list of the major crises that have beset the American economy in recent years: the stock market crash of 1987, the savings and loan scandals, the decline of the real estate market, the Mexican crisis, the Asian crisis, the Enron affair. "That works out to one big crisis every two and a half years," he said. "We can and must do better." But we're unlikely to do better until we understand the dynamic that produces these crises. Lax regulation? Greedy bankers? Crooked Ponzi schemers? Creditors taking on unrealistic debt?
Sure, all of those play a role. But they are superficial phenomena. We're unlikely to "do better" until we understand the fundamental origin of the economy's need for periodic crises. Each and every one of the crises Summers names was, at heart, a crisis of debt repudiation. We're unlikely to avoid their reoccurrence until we control their source: a system that allows debt--a claim on future income--to grow faster than income can grow.
"A problem well put," the American philosopher John Dewey wrote, "is well on its way to being solved." As Summers and Geitner and others on the President's economic team look to solve the financial crisis that led to the largest economic downturn since the Great Depression, they would do well to think carefully about the fundamental cause of the crisis. What definition of the problem are they working from?
David Brooks laid out two general categories of diagnosis in the New York Times ("Greed and Stupidity" April 3): the global economic meltdown was caused by the greedy overreaching of an oligarchy of banking and finance types, brandishing the economic power given them by that sector’s exponential growth in recent years; or it resulted from the failure of bankers and investors to estimate accurately (or even simply understand) the risks and drawbacks offered by complex new instruments of finance. Brooks allowed that he was inclined toward crediting the latter story: "arrogant traders around the world were playing a high stakes game they didn’t understand."
There are a few problems with that diagnosis. It ignores the fact that both overvaluation of assets and failure to be diligent in assessing risk are systematically encouraged in a market system. By their nature, markets select the most optimistic evaluations of whatever is offered for sale. If I’m ready to spend $10,000 on a used car because I think it won’t give me much trouble, your more cautious offer of $8000 is not going to be the valuation that the market settles on. Perhaps there were bankers that had reservations about credit default swaps and the other complex instruments of debt monetarization that were invented in the past decade; wherever those bankers are, they chose out of the market, and the market spun merrily along without them.
But the problem isn’t simply that debt instruments were overvalued, or that banks leveraged themselves too deeply in such overvalued, toxic loans. There is a systematic flaw in how our economy finances itself. To put it simply: we allow debt--a claim on the future real production of the economy--to grow much faster than that real wealth can grow.
(I covered this in some detail in an op-ed in the New York Times Sunday, April 12.)
An economy can grow in only two ways: either it sucks up more matter and energy from its environment or it makes better, more efficient use of the stream of matter and energy it currently sucks up. The first route increases the economy's ecological footprint, which has already exceeded a sustainable size. The second route--as long as it is limited to a sustainable flow of material input--gives us the opportunity to have modest increases in economic wealth indefinitely. But modest improvement in the creation of wealth through technical tinkering is very different from expanding the rate of uptake of resources, and deserves a different name. Ecological economists Herman Daly and Joshua Farley call this second kind of increase "development" to distinguish it from unsustainable growth.
Increasing the economy's throughput destroys ecosystems--the very ecosystems on which civilization depends. (Technological improvements in efficiency make that increase smaller than it would have been otherwise, but it's still increasing.) Given the many ways that the economy has hammered on ecological limits (falling fish catches, increasing desertification, global decline in human access to clean water--not to mention our overuse of the planet's capacity to absorb CO2), it seems unwise to count on growth continuing.
Parenthetical aside: There are those who believe that we can have infinite economic growth on a finite planet, because they believe that technology can solve any material choke-point that we will ever face. Their paradigm case: thirty years ago copper was in short supply. But as the price of copper rose, innovation made that choke point irrelevant: fiber optic cable made the use of copper wire for telecommunications unnecessary. Economists call this "factor substitution," and mainstream economics has abandoned the Myth of Infinite Factor Resources (the world is obviously finite) only to regroup behind the Myth of Infinite Factor Susbstitution. Yes, technology can help us do more with less--that's the whole point of Daly and Farley's notion of sustainable development--but it cannot ever let us do more with nothing. We can improve the fuel efficiency of automobiles, but we can never invent an internal combustion engine that will run on no fuel. (If electric vehicles are sourced to solar energy, they would be sustainable; but note that they don't run on no energy.) Economic life has a physical root, and is subject to the laws of thermodynamics: "you can't make something from nothing, and you can't make nothing from something," says the first. And "Nor can you recycle energy," says the second. Together, these two laws tell us: there's a limit to the amount of valuable matter and energy we can sustainably take from the environment, and a limit to the amount of degraded matter and energy that the planet can sustainably absorb from us.
As long as growth in debt outstrips the capacity of the economy to generate the wealth that will pay that debt, the economy has a structural need for debt repudiation. As morally repugnant as they were, Ponzi schemers like Bernie Madoff, and the perfectly law abiding but unscrupulous gang of bankers who invented novel instruments of debt leveraging (like subprime mortgage derivatives)
were filling a niche that the economy created for them. Ponzi schemes are illegal; inventing new instruments of leveraged debt is not. (It ought to be.)
Now, the really bad news: how much debt is out there? Well, a lot of debt has been repudiated in this financial crisis: bankruptcies, defaults, foreclosures, and the disappearance of all kinds of claims on future income through the fall in stock prices and the consquent shrinking of retirement plans and pensions. But if David Beim at Columbia Business School is right (check this out), we're still in trouble. Here's a bit of an interview done by NPR's Alex Blumberg with Beim:
Alex Blumberg: We’re in his office, and we’re looking at a graph, and it's, basically, a measure of how much debt we the citizens of America, are in. How much we all owe--on our mortgages and credit cards and auto loans--compared to the economy as a whole, the GDP. And for most of history, the amount we owed was a lot smaller than the economy as a whole.
This ratio, household debt to GDP bounces along around between 30 and 50 percent, for most of the '30s and '40s 50s, 60s, and 70s, right into the 80s. Then it breaks through 50 % in the 80s, starts heading up in the 1990s. And then ...
David Beim: From 2000 to 2008, it just goes, almost a hockey stick, it goes dramatically upward.
Alex Blumberg: Like a rocket.
David Beim: It hits 100% of GDP. That is to say, currently, consumers owe 13 trillion dollars when the GDP is $13 trillion. That’s a $100 trillion owed by individuals
Like a hockey stick. Like a rocket. There's the source of the bubble that burst: the huge run-up in the debt load being carried by the economy. Economics 101 will tell you that saving from current consumption and lending it to someone else creates debt--the opportunity to claim future income. This saving, lent out at interest, can be used to make investments (I don't mean the monetary kind but the real, physical investment that increases future productivity: new factories, better production processes).
Investment produces growth in productivity. Real productivity growth has been on the order of a few percent a year. The rest of our nominal growth has been funded by increasing the economy's ecological footprint--a process that can't continue--or it has been wholly speculative bubble.
It is extremely unlikely, to put it mildly, that we can double the economy's throughput of scarce matter and energy--but that's what would need to happen to pay off that debt load.
Too much debt standing as a claim on an amount of income that is already at an ecologically unsustainable level: that's the source of this crisis.