正文
Saving, Asset-Price Inflation, and Debt-Induced Deflation
by Dr. Michael Hudson
Michael Hudson’s book Super Imperialism - New Edition: The Origin and Fundamentals of U.S. World Dominance is a critique of how the United States exploited foreign economies through IMF and World Bank. Other books by Dr. Hudson include The Myth of Aid (Orbis Books); Global Fracture: The New International Economic Order (Harper & Row)
As an advisor to the White House, State Dept. and Defense Department at the Hudson Institute, and subsequently to the United Nations Institute for Training and Research (UNITAR), he became one of the best known specialists in international finance. He also has consulted for the governments of Canada, Mexico and Russia. (Dr. Hudson's bio is continued at the end of this article.)
Summary
The exponential growth of savings and debt takes the form mainly of loans to finance the purchase of real estate, stocks and bonds. These loans extract interest and amortization charges that divert revenue away from being spent on goods and services. The payment of debt service by the economy’s non-financial sectors interrupts the circular flow that Say’s Law postulates to exist between producers and consumers.
Financial institutions re-lend their interest and other financial inflows as new loans to finance asset purchases. The result is that net savings do not increase for the economy as a whole. Meanwhile, lending out savings helps bid up asset prices, but does not necessarily promote new tangible investment and employment or increase real wages and commodity prices. In fact, new tangible investment and employment decline as investors find it easier to obtain price gains in stocks, bonds and real estate than to make profits by investing in factories and other tangible means of production. The effect is to divert savings and credit away from financing new direct investment, and hence from employing labor to produce more output.
...
The growth of net worth through capital gains
The cumulative volume of savings also grows through a dynamic that Keynes had little reason to analyze in the 1930s: capital gains. Property and financial securities tend to appreciate in price over time. The main cause of this price appreciation is that the physical volume of assets grows slowly, while the financial volume of loanable funds grows exponentially.
Let us return for a moment to Richard Price’s example of a penny saved at the time of Jesus being worth a sphere of gold extending from the sun out to Jupiter. Few investors buy gold, as it does not yield an income. The largest investment – and the most heavily debt-financed asset these days – is land. More credit does not expand the volume of land, which is fixed, but it does raise its market price. A rising volume of savings is channeled to buy a fixed supply of land. The financial system thus creates capital gains as the finite volume of property and supply of buildings and financial securities expands more slowly than the potentially infinite volume of loanable funds.
Keynes did not anticipate that savings would be channeled in a way that bid up asset prices for securities and property without funding tangible capital formation. In the 1930s net worth was built up mainly by saving, not by asset-price inflation such as is occurring today. In traditional Keynesian terms, revenue or credit spent on buying property in place represented hoarding, not investment.
Homeowners and investors imagine themselves growing richer as prices rise for their assets. Their net worth rises without their having to save. However, this rise tends to require more income set aside to pay debt service on the loans taken out to buy their property. Credit lent out in this way does not increase consumption and direct investment. It creates debts whose carrying charges shrink markets. Savings and debts rise together, so that there is no increase in net saving.
New saving does occur as financial institutions recycle the receipts of debt service into new loans, whose carrying charges absorb yet more future income. The result is that gross savings (and hence, indebtedness) rise relative to national income. Stated another way, saving for many homeowners takes the form of paying off their mortgages. This is not the same thing as hoarding (in Keynes’s sense), but it plays much the same function, as it is not available for spending on current output.
As savings rise and are lent out, debt service absorbs more income. But the net economic surplus available to service these savings – by paying interest and dividends on the debts and securities in which they are invested – tends not to keep pace with their stipulated debt service. This debt problem therefore plays the deflationary economic role that Keynes attributed to savings.
How asset-price inflation aggravates economic polarization
Keynes favored inflation as eroding the burden of debt. Calling for “euthanasia of the rentier,” he saw inflation as the line of least political resistance to wiping out the economy’s debt burden. His idea was that inflation would leave more income available for consumption and for new direct investment. But asset-price inflation works in a different way. Instead of eroding the purchasing power of wealth relative to commodities and labor, it increases property prices without increasing consumer prices or wages. At least this has been the pattern since 1980. Wealth disparities have increased even more than have disparities among income brackets. The net worth for the wealthiest 10 or 20 percent of the population has soared, while the rest of the economy has fallen more deeply into debt and many of its gains have turned out to be short-term.
Keynes recognized that rich and poor income and wealth brackets had differing marginal propensities to save. But today’s financial polarization has gone beyond anything he anticipated, or what anyone else anticipated back in the 1930s, or for that matter even in the 1950s.
Long before the General Theory, economists recognized that wealthy people did not expand their consumption in keeping with their income growth. The image of widows and orphans living off their interest was relevant only for a small part of the economy. Rentiers always have tended to save their income and reinvest it in the financial and property markets. This occurs also with savings deposits, which banks lend out or invest directly in financial securities. Most of the interest and dividends credited to savers thus is left to grow by being lent out or plowed back into indirect securities and property investment, increasing asset prices.
The ability to get an easy ride from the resulting asset-price inflation – coupled with an easy access to credit and favorable tax treatment – prompts investors to take their returns in the form of capital gains rather than current income. In real estate, the economy’s largest sector, property owners use their rental income to pay interest on the credit borrowed to buy properties, leaving no taxable earnings at all. The same phenomenon characterizes the corporate sector, where equity has been retired for bonds and bank loans since 1980. Ambitious CEOs, managers of privatized public enterprises and corporate raiders have bought entire companies with debt-financed leveraged buyouts. Interest charges have absorbed corporate earnings, leaving little remaining for new capital investment. The name of the game has become capital gains, which have been spurred more by downsizing and outsourcing than by new corporate hiring.
Prices for property, stock, and bonds have soared relative to wages, forcing home buyers to spend a rising multiple of their annual incomes to buy housing. Also rising has been the cost of acquiring companies relative to corporate profits as price/earnings ratios increase.
Capital gains make the inequality of wealth and property more extreme than income inequality. The wealthiest layer of the population derives its power from capital gains, while using its income to pay interest – as long as interest rates are less than the rate of asset-price inflation. The ratio of wealth and property has risen relative to the value of goods and services, wages and profits, while the debt overhead has grown proportionally.
Does asset-price inflation “crowd out” new direct investment?
The FIRE sector has been expanding at the expense of the “real” economy. It drains revenue in the form of interest, rental income and monopoly profits, which are paid out increasingly as interest and financial fees. This triggers a fresh cycle of saving and re-lending by the FIRE sector itself, not so much by the rest of the economy. The more interest accrues in the hands of creditors, the faster their supply of loanable funds increases, thanks to the “magic of compound interest.” This revenue is lent out and accrues new interest (“interest on interest”), which is recycled into yet new loans.
This growth of savings and loanable funds in the hands of financial institutions is lent out mainly to buy property in place and financial securities, not to fund tangible capital formation. This financial dynamic spurs asset-price inflation, which in turn reduces the incentive to invest directly in capital goods, because it is easier to make capital gains than to earn profits.
These developments have prompted investors to seek “total returns” – capital gains plus profits or earnings – rather than earnings alone. Under Federal Reserve Board Chairman Alan Greenspan as “Bubble Maestro” in the 1990s, stock prices for dot.com and internet companies soared without a foundation in earnings or dividend-paying ability. Balance-sheet maneuvering was decoupled from tangible investment in the “real” economy. Companies such as Enron prided themselves in not having any tangible assets at all, just a balance sheet of speculative contracts. People began to ask whether wealth could go on increasing in this way ad infinitum.
Keynes’s analysis implied that the income “multiplier” (Y/S, or 1/mps) would increase as prosperity increased and people consumed a smaller portion of their income. What was being multiplied, however, was not national income – wages, profits and other earned income – but the volume of credit and hence the pace of capital gains in the asset markets.
Tax policy and financial bubbles
Unlike the industrial sector, real estate does not report a profit – and hence, pays no income taxes. Property owners do pay state and local real estate taxes, to be sure, but they have been joined by the financial and insurance lobbies to shift local government budgets away from the land and onto the shoulders of labor, through income taxes, sales taxes and various user fees for municipal services hitherto provided as part of the basic economic needs and infrastructure.
Although land does not depreciate – that is, wear out and become obsolete – by far the bulk of depreciation tax credits are taken by the real estate sector. This is because the economic theory underlying tax obligations has become essentially fictitious. Each time a property is sold, the building is assumed to increase in value, rather than the land’s site value generating the gain.
Nothing like this could happen in industry. Machinery wears out and becomes obsolete. (Think of computers and word processors bought a decade ago, or even three years ago.) Technological progress reduces the value of physical capital in place. But the prosperity that progress brings increases the market price of land.
In calling for “euthanasia of the rentier” Keynes pointed to the desirability of preventing the diversion of income into the purchase of securities and property already in place. He hoped to restructure the stock market and financial system so as to direct savings and credit into tangible capital formation rather than speculation. He deplored the waste of human intelligence devoted merely to transferring property ownership rather than creating new means of production.
Today’s financial markets have evolved in just the opposite direction from that advocated by Keynes. New savings and credit are channeled into loans to satisfy the rush to buy real estate, stocks and bonds for speculative purposes rather than into the funding of new direct investment and employment. Matters are aggravated by the fact that financial gains are taxed at a lower rate, thanks to the growing power of the financial sector’s political lobbies. This prompts companies to use their revenue and go into debt to buy other companies (mergers and acquisitions) or real estate rather than to expand their means of production.
Going into debt to buy assets with borrowed funds experienced a quantum leap in the 1980s with the practice of financing leveraged buyouts with high-interest “junk” bonds. The process got underway when interest rates were still hovering near their all-time high of 20 percent in late 1980 and early 1981. Corporate raiding was led by the investment banking house of Drexel Burnham and its law firm, Skadden Arps. Their predatory activities required a loosening of America’s racketeering (RICO) laws to make it legal to borrow funds to take over companies and repay creditors by emptying out their corporate treasuries and “overfunded” pension plans. New York’s laws of fraudulent conveyance also had to be modified.
Tax laws promoted this debt leveraging. Interest was allowed to be counted as a tax-deductible expense, encouraging leveraged buyouts rather than equity financing or funding out of retained earnings. Depreciation of buildings and other assets was permitted to occur repeatedly, whenever a property was sold. This favored the real estate sector by making absentee-owned buildings and other commercial properties virtually exempt from the income tax. To top matters off, capital gains tax rates were reduced below taxes on the profits earned by direct investment. This diverted savings to fuel asset-price inflation. By the 1990s the process had become a self-feeding dynamic. The more prices rose for stocks and real estate, the more mortgage borrowing rose for homes and other property, while corporate borrowing soared for mergers and acquisition.
Meanwhile, the more gains being made off the bubble, the more powerful its beneficiaries grew. They turned their economic power into political power to lower taxes and deregulate speculative finance – along with fraud, corrupt accounting practices and the use of offshore tax-avoidance enclaves – even further. This caused federal, state and local budget deficits while shifting the tax burden onto labor and industrial income. Markets shrank as a result of the fiscal drain as well as the financial debt overhead.
Abuses of arrogance and outright fraud occurred in what became a golden age for Enron, WorldCom and other “high flyers” akin to the S&L scandals of the mid-1980s. But free-market monetarism draws no distinction between tangible direct investment and purely financial gain-seeking. Opposing government regulation to favor any given way of recycling savings as compared to any other way, the value-free ethic of our times holds that making money is inherently productive regardless of how it is made. “Free-market fundamentalism” came to shape neoliberal tax policy in a way that favored finance, not industry or labor.
Can economies inflate their way out of debt?
Only a limited repertory of opportunities for profitable new direct investment exists at any given point in time. The exponential growth in savings tends to outstrip these opportunities, and hence is lent out. This lending – and its mirror image, borrowing – may become self-justifying at least for a time to the extent that it bids up asset prices. Homebuyers and investors feel that it pays them to go into debt to buy property, and this is viewed as “prosperity,” although it is primarily financial rather than industrial in character.
About 70 percent of bank loans in the United States and Britain take the form of real estate mortgages. Most new savings and credit creation thus enables borrowers to bid up the price of homes and office buildings. The effect is to increase the price that consumers must pay to obtain housing, as new construction loans account for only a small proportion of mortgage lending. Over-extended families become “house-poor” as rising financial charges for housing diverts income away from being spent on new goods and services, “crowding out” consumer spending and business investment.
Governments may try to mitigate the inflation of housing prices by raising interest rates. But this will increase the carrying charges for borrowers with floating-rate mortgages, as well as debtors throughout the economy. (Also, as Britain discovered in spring 2004, the increase in interest rates also raises the currency exchange rate, making its exporters less competitive in world markets.) For fixed-rate mortgages, higher interest rates may squeeze the banks, leading to losses in their portfolio values and prompting calls for the government to bail out losers (at least depositors, if not to rescue S&Ls and commercial banks).
Perception of this problem leads central bankers not to raise interest rates and take the blame for destroying financial prosperity by pricking the bubble. Instead, they try to keep it from bursting. This can be done only by inflating it all the more. So the process escalates.
Balance sheets improve as the pace of capital gains outstrips the rate of interest. Debt service can be paid out of rising asset values, either by selling off assets or by borrowing against the higher asset prices as collateral. The problem occurs when current income no longer can carry the interest charges. The financial sector absorbs more income as debt service than it supplies in the form of new credit. Asset prices turn down – but the debts remain on the books. This has been Japan’s condition since its bubble peaked in 1990. It may result in “negative equity” for the most highly leveraged mortgage borrowers in the real estate sector, followed by debt-ridden companies.
When interest charges exceed rental income, commercial borrowers hesitate to use their own money or other income to keep current on their debts. The limited liability laws let them walk away from their losses if markets are deflated, leaving banks, insurance companies, pension funds and other financial institutions to absorb the loss. Sell-offs of these properties to raise cash would accelerate the plunge in asset prices, leaving balance sheets “hollowed out.”
Savings do not appear as the villain in such periods. The zero net savings rate has concealed the fact that gross savings have been relent to create a corresponding growth in debt. America’s national debt quadrupled during the 12-year Reagan-Bush administration (1981-93). This increase in debt was facilitated by reducing interest rates by enough so that the unprecedented increase in credit rose without extracting more interest from many properties.
The natural limit to this process was reached in 2004 when the Federal Reserve reduced its discount rate to only 1 percent. Once rates hit this nadir, further growth in debt threatened to be reflected directly in draining amortization and interest payments away from spending on goods and services, slowing the economy accordingly. Further debt growth would require a rising proportion of disposable personal income to be spent on debt service.
How long can bubbles keep expanding?
The potential credit supply is limited only by the market price of all existing property and securities. The process is open-ended, as each new credit creation inflates the market value of assets that can be pledged as collateral for new loans.
Until bubbles burst, they benefit investors who borrow money to buy assets that are rising in price. Running into debt becomes the preferred way to make money, rather than the traditional first step toward losing the homestead. The motto of modern real estate investors is that “rent is for paying interest,” and this also applies to corporate raiders who use the earnings of companies bought on credit to repay their bankers and bondholders. What real estate investors and corporate financial officers are after is capital gains.
There is no inherent link with making new direct investment. Indeed, the after-tax return from asset-price inflation exceeds that which can be made by investing to create profits. Retirees, widows and orphans do best by living off capital gains, selling part of their growing portfolios rather than seeking a flow of interest, dividends and rental income. The idea begins to spread that people can live off capital gains in an economy whose incomes are not growing.
Asset-price inflation would be a rational long-term policy if economies could inflate their way out of debt via capital gains. The solution to debt would be to create yet more debt to finance yet more asset-price inflation. This dynamic is more likely to create debt deflation than commodity-price inflation, however. It is true that a consumer “wealth effect” occurs when homeowners refinance their mortgages by taking new “home equity” loans to spend on living, or at least to pay down their credit-card debt so as to lower the monthly diversion of income for debt service. If this were to lead to a general inflation, interest rates would rise, prompting investors to shift out of stocks into bonds. Foreign investors and speculators bail out, accelerating the price decline. This threatens retirement funds, insurance companies and banks with capital losses that erode their ability to meet their commitments.
The more likely constraint comes from asset-price inflation itself as price/earnings ratios rise. Interest rates and other returns slow, making it difficult for pension plans and insurance companies to earn the projected returns needed to pay retirees. In any event, asset sales exceed purchases as the proportion of retirees to employees grows, causing stock and bond prices to decline. Pension funds must sell more stocks and bonds – or employers must set aside more of their revenue for this purpose, in which case their ability to pay dividends is reduced.
Asset-price inflation reaches its limit when interest charges absorb the entire flow of earnings. Debt-financed bubbles remove more purchasing power from the “bottom 90 percent” of the population than they supply. Debt spurs rising housing prices but reduces consumer demand as a result of the need to service mortgages. Likewise, financing for leveraged buyouts, mergers and acquisitions may increase stock prices, but the interest charges absorb corporate earnings and “crowd out” new direct investment and employment.
The drive for capital gains thus complicates the traditional macroeconomic Keynesian categories. Although these gains are not included in the national income statistics, they have become the key to analyzing how asset-price inflation leads to debt deflation of the “real” economy. One thus may ask what sphere of the economy is more “real” and powerful: that of tangible production and consumption, or the financial sector which is wrapped around it.
Can the debt and savings overhead be supported indefinitely?
Richard Price’s illustration of the seemingly magical powers of compound interest is a reminder that many people saved pennies (and much more) at the time of Jesus, and long before that, but nobody yet has obtained an expanding globe of gold. The reason is that savings have been wiped out repeatedly in waves of bankruptcy.
The reason is clear enough. When savings, lending and “indirect” financial investment grow by compound interest in the absence of new tangible investment, something must give. The superstructure of debt must be brought back into a relationship with the ability to pay.
Financial crashes occur much more quickly than the long buildup. This is what produces a ratchet pattern for business cycles – a gradual upsweep and sudden collapse of financial and property prices, leaving economies debt-ridden. Many debts are wiped out, to be sure, along with the savings that have been invested in bad loans – unless the government bails out savers at taxpayer expense.
Financial crises are not resolved simply by price adjustments. Almost all crises involve government intervention, solving matters politically. As the financial and property sectors gain political power relative to the increasingly indebted production and consumption sectors, their lobbies succeed in lowering tax rates on rentier income relative to taxes on wages and profits. Tax rates on capital gains have been slashed below those on “earned” wages and profits, whereas the two rates were equal when America’s income-tax laws first were introduced.
Financial lobbies also have gotten law-makers to adopt the “moral hazard” policy of guaranteeing savings. Debtors still may go bankrupt, but savings are to be kept intact by making taxpayers liable to the economy’s savers. Ever since the collapse of the Federal Savings and Loan Insurance Corporation (FSLIC) in the late 1980s a political fight has loomed over just whose savings are to be rescued. Unfortunately, the principle at work is that of “Big fish eat little fish.” Small savers are sacrificed to the wealthiest savers and institutional investors.
The mathematics of compound interest dictates that such public guarantees to preserve savings cannot succeed in the long run. Financial savings and debts tend to grow at exponential rates while economies grow only by S curves, causing strains that cannot be supported as credit is used to buy assets rather than to invest in capital goods or buildings.
Financial strains become further politicized as large institutions and the “upper 10 percent” of the population account for nearly all the net saving, which is lent out to the “bottom 90 percent” and to industry. The balance-sheet position of the wealthiest layer increases as long as capital gains exceed the buildup of debt. The bottom 90 percent also benefit for a while during the early and middle stages of the financial bubble. Workers are invited to think of themselves as finance-capitalists-in-miniature rather than as employees being downsized and outsourced. But much of what they may gain in the rising market value of their homes (for the two-thirds of the U.S. and British populations that are homeowners) is offset by the debt deflation that bleeds the production-and-consumption economy.
Throughout history societies that have polarized between creditors and debtors have not survived well. Rome ended in a convulsion of debt foreclosure, monopolization of the land and tax shifts that reduced most of the population to clientage. Third-world countries today are being stripped of their public domain and public enterprises by the international debt buildup, while industry and real estate in the creditor nations themselves are becoming debt-ridden.
Today’s bubble economy is seeing interest charges expand to absorb profits and rental income, leading to slower domestic direct investment and employment. Much as classical economists believed that rent would expand to absorb the entire economic surplus, it now appears that interest-bearing debt will play this role.
by Dr. Michael Hudson
Michael Hudson’s book Super Imperialism - New Edition: The Origin and Fundamentals of U.S. World Dominance is a critique of how the United States exploited foreign economies through IMF and World Bank. Other books by Dr. Hudson include The Myth of Aid (Orbis Books); Global Fracture: The New International Economic Order (Harper & Row)
As an advisor to the White House, State Dept. and Defense Department at the Hudson Institute, and subsequently to the United Nations Institute for Training and Research (UNITAR), he became one of the best known specialists in international finance. He also has consulted for the governments of Canada, Mexico and Russia. (Dr. Hudson's bio is continued at the end of this article.)
Summary
The exponential growth of savings and debt takes the form mainly of loans to finance the purchase of real estate, stocks and bonds. These loans extract interest and amortization charges that divert revenue away from being spent on goods and services. The payment of debt service by the economy’s non-financial sectors interrupts the circular flow that Say’s Law postulates to exist between producers and consumers.
Financial institutions re-lend their interest and other financial inflows as new loans to finance asset purchases. The result is that net savings do not increase for the economy as a whole. Meanwhile, lending out savings helps bid up asset prices, but does not necessarily promote new tangible investment and employment or increase real wages and commodity prices. In fact, new tangible investment and employment decline as investors find it easier to obtain price gains in stocks, bonds and real estate than to make profits by investing in factories and other tangible means of production. The effect is to divert savings and credit away from financing new direct investment, and hence from employing labor to produce more output.
...
The growth of net worth through capital gains
The cumulative volume of savings also grows through a dynamic that Keynes had little reason to analyze in the 1930s: capital gains. Property and financial securities tend to appreciate in price over time. The main cause of this price appreciation is that the physical volume of assets grows slowly, while the financial volume of loanable funds grows exponentially.
Let us return for a moment to Richard Price’s example of a penny saved at the time of Jesus being worth a sphere of gold extending from the sun out to Jupiter. Few investors buy gold, as it does not yield an income. The largest investment – and the most heavily debt-financed asset these days – is land. More credit does not expand the volume of land, which is fixed, but it does raise its market price. A rising volume of savings is channeled to buy a fixed supply of land. The financial system thus creates capital gains as the finite volume of property and supply of buildings and financial securities expands more slowly than the potentially infinite volume of loanable funds.
Keynes did not anticipate that savings would be channeled in a way that bid up asset prices for securities and property without funding tangible capital formation. In the 1930s net worth was built up mainly by saving, not by asset-price inflation such as is occurring today. In traditional Keynesian terms, revenue or credit spent on buying property in place represented hoarding, not investment.
Homeowners and investors imagine themselves growing richer as prices rise for their assets. Their net worth rises without their having to save. However, this rise tends to require more income set aside to pay debt service on the loans taken out to buy their property. Credit lent out in this way does not increase consumption and direct investment. It creates debts whose carrying charges shrink markets. Savings and debts rise together, so that there is no increase in net saving.
New saving does occur as financial institutions recycle the receipts of debt service into new loans, whose carrying charges absorb yet more future income. The result is that gross savings (and hence, indebtedness) rise relative to national income. Stated another way, saving for many homeowners takes the form of paying off their mortgages. This is not the same thing as hoarding (in Keynes’s sense), but it plays much the same function, as it is not available for spending on current output.
As savings rise and are lent out, debt service absorbs more income. But the net economic surplus available to service these savings – by paying interest and dividends on the debts and securities in which they are invested – tends not to keep pace with their stipulated debt service. This debt problem therefore plays the deflationary economic role that Keynes attributed to savings.
How asset-price inflation aggravates economic polarization
Keynes favored inflation as eroding the burden of debt. Calling for “euthanasia of the rentier,” he saw inflation as the line of least political resistance to wiping out the economy’s debt burden. His idea was that inflation would leave more income available for consumption and for new direct investment. But asset-price inflation works in a different way. Instead of eroding the purchasing power of wealth relative to commodities and labor, it increases property prices without increasing consumer prices or wages. At least this has been the pattern since 1980. Wealth disparities have increased even more than have disparities among income brackets. The net worth for the wealthiest 10 or 20 percent of the population has soared, while the rest of the economy has fallen more deeply into debt and many of its gains have turned out to be short-term.
Keynes recognized that rich and poor income and wealth brackets had differing marginal propensities to save. But today’s financial polarization has gone beyond anything he anticipated, or what anyone else anticipated back in the 1930s, or for that matter even in the 1950s.
Long before the General Theory, economists recognized that wealthy people did not expand their consumption in keeping with their income growth. The image of widows and orphans living off their interest was relevant only for a small part of the economy. Rentiers always have tended to save their income and reinvest it in the financial and property markets. This occurs also with savings deposits, which banks lend out or invest directly in financial securities. Most of the interest and dividends credited to savers thus is left to grow by being lent out or plowed back into indirect securities and property investment, increasing asset prices.
The ability to get an easy ride from the resulting asset-price inflation – coupled with an easy access to credit and favorable tax treatment – prompts investors to take their returns in the form of capital gains rather than current income. In real estate, the economy’s largest sector, property owners use their rental income to pay interest on the credit borrowed to buy properties, leaving no taxable earnings at all. The same phenomenon characterizes the corporate sector, where equity has been retired for bonds and bank loans since 1980. Ambitious CEOs, managers of privatized public enterprises and corporate raiders have bought entire companies with debt-financed leveraged buyouts. Interest charges have absorbed corporate earnings, leaving little remaining for new capital investment. The name of the game has become capital gains, which have been spurred more by downsizing and outsourcing than by new corporate hiring.
Prices for property, stock, and bonds have soared relative to wages, forcing home buyers to spend a rising multiple of their annual incomes to buy housing. Also rising has been the cost of acquiring companies relative to corporate profits as price/earnings ratios increase.
Capital gains make the inequality of wealth and property more extreme than income inequality. The wealthiest layer of the population derives its power from capital gains, while using its income to pay interest – as long as interest rates are less than the rate of asset-price inflation. The ratio of wealth and property has risen relative to the value of goods and services, wages and profits, while the debt overhead has grown proportionally.
Does asset-price inflation “crowd out” new direct investment?
The FIRE sector has been expanding at the expense of the “real” economy. It drains revenue in the form of interest, rental income and monopoly profits, which are paid out increasingly as interest and financial fees. This triggers a fresh cycle of saving and re-lending by the FIRE sector itself, not so much by the rest of the economy. The more interest accrues in the hands of creditors, the faster their supply of loanable funds increases, thanks to the “magic of compound interest.” This revenue is lent out and accrues new interest (“interest on interest”), which is recycled into yet new loans.
This growth of savings and loanable funds in the hands of financial institutions is lent out mainly to buy property in place and financial securities, not to fund tangible capital formation. This financial dynamic spurs asset-price inflation, which in turn reduces the incentive to invest directly in capital goods, because it is easier to make capital gains than to earn profits.
These developments have prompted investors to seek “total returns” – capital gains plus profits or earnings – rather than earnings alone. Under Federal Reserve Board Chairman Alan Greenspan as “Bubble Maestro” in the 1990s, stock prices for dot.com and internet companies soared without a foundation in earnings or dividend-paying ability. Balance-sheet maneuvering was decoupled from tangible investment in the “real” economy. Companies such as Enron prided themselves in not having any tangible assets at all, just a balance sheet of speculative contracts. People began to ask whether wealth could go on increasing in this way ad infinitum.
Keynes’s analysis implied that the income “multiplier” (Y/S, or 1/mps) would increase as prosperity increased and people consumed a smaller portion of their income. What was being multiplied, however, was not national income – wages, profits and other earned income – but the volume of credit and hence the pace of capital gains in the asset markets.
Tax policy and financial bubbles
Unlike the industrial sector, real estate does not report a profit – and hence, pays no income taxes. Property owners do pay state and local real estate taxes, to be sure, but they have been joined by the financial and insurance lobbies to shift local government budgets away from the land and onto the shoulders of labor, through income taxes, sales taxes and various user fees for municipal services hitherto provided as part of the basic economic needs and infrastructure.
Although land does not depreciate – that is, wear out and become obsolete – by far the bulk of depreciation tax credits are taken by the real estate sector. This is because the economic theory underlying tax obligations has become essentially fictitious. Each time a property is sold, the building is assumed to increase in value, rather than the land’s site value generating the gain.
Nothing like this could happen in industry. Machinery wears out and becomes obsolete. (Think of computers and word processors bought a decade ago, or even three years ago.) Technological progress reduces the value of physical capital in place. But the prosperity that progress brings increases the market price of land.
In calling for “euthanasia of the rentier” Keynes pointed to the desirability of preventing the diversion of income into the purchase of securities and property already in place. He hoped to restructure the stock market and financial system so as to direct savings and credit into tangible capital formation rather than speculation. He deplored the waste of human intelligence devoted merely to transferring property ownership rather than creating new means of production.
Today’s financial markets have evolved in just the opposite direction from that advocated by Keynes. New savings and credit are channeled into loans to satisfy the rush to buy real estate, stocks and bonds for speculative purposes rather than into the funding of new direct investment and employment. Matters are aggravated by the fact that financial gains are taxed at a lower rate, thanks to the growing power of the financial sector’s political lobbies. This prompts companies to use their revenue and go into debt to buy other companies (mergers and acquisitions) or real estate rather than to expand their means of production.
Going into debt to buy assets with borrowed funds experienced a quantum leap in the 1980s with the practice of financing leveraged buyouts with high-interest “junk” bonds. The process got underway when interest rates were still hovering near their all-time high of 20 percent in late 1980 and early 1981. Corporate raiding was led by the investment banking house of Drexel Burnham and its law firm, Skadden Arps. Their predatory activities required a loosening of America’s racketeering (RICO) laws to make it legal to borrow funds to take over companies and repay creditors by emptying out their corporate treasuries and “overfunded” pension plans. New York’s laws of fraudulent conveyance also had to be modified.
Tax laws promoted this debt leveraging. Interest was allowed to be counted as a tax-deductible expense, encouraging leveraged buyouts rather than equity financing or funding out of retained earnings. Depreciation of buildings and other assets was permitted to occur repeatedly, whenever a property was sold. This favored the real estate sector by making absentee-owned buildings and other commercial properties virtually exempt from the income tax. To top matters off, capital gains tax rates were reduced below taxes on the profits earned by direct investment. This diverted savings to fuel asset-price inflation. By the 1990s the process had become a self-feeding dynamic. The more prices rose for stocks and real estate, the more mortgage borrowing rose for homes and other property, while corporate borrowing soared for mergers and acquisition.
Meanwhile, the more gains being made off the bubble, the more powerful its beneficiaries grew. They turned their economic power into political power to lower taxes and deregulate speculative finance – along with fraud, corrupt accounting practices and the use of offshore tax-avoidance enclaves – even further. This caused federal, state and local budget deficits while shifting the tax burden onto labor and industrial income. Markets shrank as a result of the fiscal drain as well as the financial debt overhead.
Abuses of arrogance and outright fraud occurred in what became a golden age for Enron, WorldCom and other “high flyers” akin to the S&L scandals of the mid-1980s. But free-market monetarism draws no distinction between tangible direct investment and purely financial gain-seeking. Opposing government regulation to favor any given way of recycling savings as compared to any other way, the value-free ethic of our times holds that making money is inherently productive regardless of how it is made. “Free-market fundamentalism” came to shape neoliberal tax policy in a way that favored finance, not industry or labor.
Can economies inflate their way out of debt?
Only a limited repertory of opportunities for profitable new direct investment exists at any given point in time. The exponential growth in savings tends to outstrip these opportunities, and hence is lent out. This lending – and its mirror image, borrowing – may become self-justifying at least for a time to the extent that it bids up asset prices. Homebuyers and investors feel that it pays them to go into debt to buy property, and this is viewed as “prosperity,” although it is primarily financial rather than industrial in character.
About 70 percent of bank loans in the United States and Britain take the form of real estate mortgages. Most new savings and credit creation thus enables borrowers to bid up the price of homes and office buildings. The effect is to increase the price that consumers must pay to obtain housing, as new construction loans account for only a small proportion of mortgage lending. Over-extended families become “house-poor” as rising financial charges for housing diverts income away from being spent on new goods and services, “crowding out” consumer spending and business investment.
Governments may try to mitigate the inflation of housing prices by raising interest rates. But this will increase the carrying charges for borrowers with floating-rate mortgages, as well as debtors throughout the economy. (Also, as Britain discovered in spring 2004, the increase in interest rates also raises the currency exchange rate, making its exporters less competitive in world markets.) For fixed-rate mortgages, higher interest rates may squeeze the banks, leading to losses in their portfolio values and prompting calls for the government to bail out losers (at least depositors, if not to rescue S&Ls and commercial banks).
Perception of this problem leads central bankers not to raise interest rates and take the blame for destroying financial prosperity by pricking the bubble. Instead, they try to keep it from bursting. This can be done only by inflating it all the more. So the process escalates.
Balance sheets improve as the pace of capital gains outstrips the rate of interest. Debt service can be paid out of rising asset values, either by selling off assets or by borrowing against the higher asset prices as collateral. The problem occurs when current income no longer can carry the interest charges. The financial sector absorbs more income as debt service than it supplies in the form of new credit. Asset prices turn down – but the debts remain on the books. This has been Japan’s condition since its bubble peaked in 1990. It may result in “negative equity” for the most highly leveraged mortgage borrowers in the real estate sector, followed by debt-ridden companies.
When interest charges exceed rental income, commercial borrowers hesitate to use their own money or other income to keep current on their debts. The limited liability laws let them walk away from their losses if markets are deflated, leaving banks, insurance companies, pension funds and other financial institutions to absorb the loss. Sell-offs of these properties to raise cash would accelerate the plunge in asset prices, leaving balance sheets “hollowed out.”
Savings do not appear as the villain in such periods. The zero net savings rate has concealed the fact that gross savings have been relent to create a corresponding growth in debt. America’s national debt quadrupled during the 12-year Reagan-Bush administration (1981-93). This increase in debt was facilitated by reducing interest rates by enough so that the unprecedented increase in credit rose without extracting more interest from many properties.
The natural limit to this process was reached in 2004 when the Federal Reserve reduced its discount rate to only 1 percent. Once rates hit this nadir, further growth in debt threatened to be reflected directly in draining amortization and interest payments away from spending on goods and services, slowing the economy accordingly. Further debt growth would require a rising proportion of disposable personal income to be spent on debt service.
How long can bubbles keep expanding?
The potential credit supply is limited only by the market price of all existing property and securities. The process is open-ended, as each new credit creation inflates the market value of assets that can be pledged as collateral for new loans.
Until bubbles burst, they benefit investors who borrow money to buy assets that are rising in price. Running into debt becomes the preferred way to make money, rather than the traditional first step toward losing the homestead. The motto of modern real estate investors is that “rent is for paying interest,” and this also applies to corporate raiders who use the earnings of companies bought on credit to repay their bankers and bondholders. What real estate investors and corporate financial officers are after is capital gains.
There is no inherent link with making new direct investment. Indeed, the after-tax return from asset-price inflation exceeds that which can be made by investing to create profits. Retirees, widows and orphans do best by living off capital gains, selling part of their growing portfolios rather than seeking a flow of interest, dividends and rental income. The idea begins to spread that people can live off capital gains in an economy whose incomes are not growing.
Asset-price inflation would be a rational long-term policy if economies could inflate their way out of debt via capital gains. The solution to debt would be to create yet more debt to finance yet more asset-price inflation. This dynamic is more likely to create debt deflation than commodity-price inflation, however. It is true that a consumer “wealth effect” occurs when homeowners refinance their mortgages by taking new “home equity” loans to spend on living, or at least to pay down their credit-card debt so as to lower the monthly diversion of income for debt service. If this were to lead to a general inflation, interest rates would rise, prompting investors to shift out of stocks into bonds. Foreign investors and speculators bail out, accelerating the price decline. This threatens retirement funds, insurance companies and banks with capital losses that erode their ability to meet their commitments.
The more likely constraint comes from asset-price inflation itself as price/earnings ratios rise. Interest rates and other returns slow, making it difficult for pension plans and insurance companies to earn the projected returns needed to pay retirees. In any event, asset sales exceed purchases as the proportion of retirees to employees grows, causing stock and bond prices to decline. Pension funds must sell more stocks and bonds – or employers must set aside more of their revenue for this purpose, in which case their ability to pay dividends is reduced.
Asset-price inflation reaches its limit when interest charges absorb the entire flow of earnings. Debt-financed bubbles remove more purchasing power from the “bottom 90 percent” of the population than they supply. Debt spurs rising housing prices but reduces consumer demand as a result of the need to service mortgages. Likewise, financing for leveraged buyouts, mergers and acquisitions may increase stock prices, but the interest charges absorb corporate earnings and “crowd out” new direct investment and employment.
The drive for capital gains thus complicates the traditional macroeconomic Keynesian categories. Although these gains are not included in the national income statistics, they have become the key to analyzing how asset-price inflation leads to debt deflation of the “real” economy. One thus may ask what sphere of the economy is more “real” and powerful: that of tangible production and consumption, or the financial sector which is wrapped around it.
Can the debt and savings overhead be supported indefinitely?
Richard Price’s illustration of the seemingly magical powers of compound interest is a reminder that many people saved pennies (and much more) at the time of Jesus, and long before that, but nobody yet has obtained an expanding globe of gold. The reason is that savings have been wiped out repeatedly in waves of bankruptcy.
The reason is clear enough. When savings, lending and “indirect” financial investment grow by compound interest in the absence of new tangible investment, something must give. The superstructure of debt must be brought back into a relationship with the ability to pay.
Financial crashes occur much more quickly than the long buildup. This is what produces a ratchet pattern for business cycles – a gradual upsweep and sudden collapse of financial and property prices, leaving economies debt-ridden. Many debts are wiped out, to be sure, along with the savings that have been invested in bad loans – unless the government bails out savers at taxpayer expense.
Financial crises are not resolved simply by price adjustments. Almost all crises involve government intervention, solving matters politically. As the financial and property sectors gain political power relative to the increasingly indebted production and consumption sectors, their lobbies succeed in lowering tax rates on rentier income relative to taxes on wages and profits. Tax rates on capital gains have been slashed below those on “earned” wages and profits, whereas the two rates were equal when America’s income-tax laws first were introduced.
Financial lobbies also have gotten law-makers to adopt the “moral hazard” policy of guaranteeing savings. Debtors still may go bankrupt, but savings are to be kept intact by making taxpayers liable to the economy’s savers. Ever since the collapse of the Federal Savings and Loan Insurance Corporation (FSLIC) in the late 1980s a political fight has loomed over just whose savings are to be rescued. Unfortunately, the principle at work is that of “Big fish eat little fish.” Small savers are sacrificed to the wealthiest savers and institutional investors.
The mathematics of compound interest dictates that such public guarantees to preserve savings cannot succeed in the long run. Financial savings and debts tend to grow at exponential rates while economies grow only by S curves, causing strains that cannot be supported as credit is used to buy assets rather than to invest in capital goods or buildings.
Financial strains become further politicized as large institutions and the “upper 10 percent” of the population account for nearly all the net saving, which is lent out to the “bottom 90 percent” and to industry. The balance-sheet position of the wealthiest layer increases as long as capital gains exceed the buildup of debt. The bottom 90 percent also benefit for a while during the early and middle stages of the financial bubble. Workers are invited to think of themselves as finance-capitalists-in-miniature rather than as employees being downsized and outsourced. But much of what they may gain in the rising market value of their homes (for the two-thirds of the U.S. and British populations that are homeowners) is offset by the debt deflation that bleeds the production-and-consumption economy.
Throughout history societies that have polarized between creditors and debtors have not survived well. Rome ended in a convulsion of debt foreclosure, monopolization of the land and tax shifts that reduced most of the population to clientage. Third-world countries today are being stripped of their public domain and public enterprises by the international debt buildup, while industry and real estate in the creditor nations themselves are becoming debt-ridden.
Today’s bubble economy is seeing interest charges expand to absorb profits and rental income, leading to slower domestic direct investment and employment. Much as classical economists believed that rent would expand to absorb the entire economic surplus, it now appears that interest-bearing debt will play this role.
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