Friday, October 24, 2008

Understanding The Meltdown

The more I read about explanations for why we are in a financial crisis, the more I realize Occam was right. But in this case the simplest explanation is not how do we understand the problem, but rather where are we looking. We blame bankers for making illogical loans and gambling trillions of dollars. We blame middle America for wanting to own a home. We blame deregulation for allowing financial institutions to put the national economy at risk. Finally, we blame the overseers for not overseeing. All of those explanations are only symptoms of a very simple and fundamental flaw in our economy and, indeed, our entire national understanding of economics.

Let me walk through a simple thought experiment:

Imagine there are ten people and each has $100. This creates a society with $1000 worth of currency. One is given the exclusive privilege to lend money at a fraction of what he actually has. So, five of the people decide to borrow $1000 each in order to build a home. We now have $6000 in our society. The borrowers agree to pay back $1200 at the end of the year, but since they are not banks they must return the money in real dollars, not as bank credits. All five cannot repay the loans because it would require there to be more money in existence than actually exists. Even if, through the “invisible hand” of the market each of the five could get back all the credits outstanding and pay them back to the bank, the return would be short $500. These five must somehow get the remaining $500 that society has and turn that over to the bank as well.

But! I can already hear the objection. The bank would be issuing other loans and so there would be more currency out there than just the $6000. The five would have built something of value and so could borrow again with that newly built value.

In our world, in order to pay the original loan, the first five sell the houses to the other five for $1100 who take loans from the bank. Since the bank now has a supposed $5000 in loans it can cover these loans and even buy a house itself without any money. They make enough profit to borrow again and build themselves a home. Now the original five borrow $1000 to build homes. We now have $10400 in circulation. But, it must all be paid back to the bank. In fact more has to be repaid than exists in the world and so can never be repaid. So, the bank starts taking homes and can't sell them because either someone has a home or cannot borrow to get a home. 

This is the scenario we find ourselves in. But really, this just goes back to who is wrong? Is it the system? The borrower? The Bank?

Well, here is where we start looking elsewhere for the problem. As long as the system keeps expanding and the amount of money keeps increasing, we have no problem. As long as the population increases and technology increases we have no problem. And, as long we always have demand for that new production, we have no problem.

But, we have a problem. In our world there is a pretty straight connection between the money borrowed and the value of the product now owned. In other words, there is no profit takers. The bank makes money by its unique ability to create new currency and to hold dominance over that currency. Each builder makes a profit, but it largely goes back to the bank for more loans. And as long as this cycle continues, the system works fine.

Now before I am accused of being anti-profit, the point here is not pro or anti, rather it is to be considered.

In this world of ours, one of the ten becomes an entrepreneur Through some mechanism he ends up with a little more money or credit than his other citizens and he builds a factory with borrowed money and the other eight work for him. They get paid for building value and he gets profit for his (and here you will have to insert your own justification as I have not yet concluded in my own mind what he is exactly contributing. So insert any economics 101 regurgitation here as that will suffice for these purposes). The entrepreneur issues stocks and the workers buy some and the owner gets the rest and his factory is worth $10000 based on his workers buying shares with money they borrow based on loans from the increased value of their house and generous contributions in the form of 401k and option plans. The system actually continues to function. The workers work, and repay loans. The factory owner gets his profits, and repays his loans. Everything stays in balance.

Now I have really taxed the patience of the reader. I promised a simple explanation for what has happened and all I have done is given a long winded thought experiment justifying the status quo. I am almost to the point and I apologize it takes this long. I want to cover as many initial objections as possible before revealing the point. I hope that I have created a world that all can agree is a reasonable simplification of our economy at work. True, we have only one bank, one factory, and everybody works at the same place and we haven't even discussed the issues of monopolies, unionizing, taxes, government enforcement, oversight, banking regulations, pollution, raw materials, etc. All these are extraneous to the conversation and if we simply agree those issues are balanced by other forces in a larger, more complicated market, then we can continue the experiment.

For some reason, whether it be the forces we have not included or some unforeseen new opportunity such as expanded trading opportunities, our Entrepreneur begins accumulating wealth at a higher rate than he had before. This upsets the societal balance. The money must come from somewhere. Let's say he discovers he can make due with one less worker because he has optimized his operation. There is now an unemployed worker who is skilled at the job required. So, our entrepreneur cuts wages. After all, if they don't like it, the out of work worker will gladly take the job for less money. Unemployed or under-employed, the workers begin defaulting on loans. The entrepreneur and the banker begins accumulating the wealth in our fictitious village. The workers attempt to offer solutions to the two powerful men such as renegotiated loans and the banker and entrepreneur agree. The wages are cut further and the loans extended longer. At each stage, the workers ask for new terms and they are given. At each stage the accumulation of wealth increases deepening the already difficult economic situation. Finally, the two own all the real cash and there is none left to repay outstanding loans. The fictitious money collapses under its own devaluation. The banker finds himself once worth $10400 now worth only $500. The entrepreneur is in a similar situation. He has only $500 left and nobody will buy his products. The economy has collapsed and the two can only think back to when they were so rich.

The problem we face today is nothing more or less than proof trickle down economics does not work. All it does is concentrate the currency into the hands of a few people who leverage that currency into larger quantities of fictitious money whether they be stocks or mortgages. This money then, as Gresham's Law points out, drives out the good money where it is horded or moved overseas to purchase oil or finance federal debt. Since these institutions are not bound to take this fictitious money as legal currency, and in fact are forbidden, the bad money must be converted to good money in order to pay off another instrument of bad money, the mortgage. This transaction debases the bad money further and begins a downward spiral. Though the value of the fictitious money held by the bank is diminishing through this policy, the obligation of the borrower remains the same. His increasingly valuable real currency must be exchanged for a decreasingly valuable debt. The result is hording by the banks of the valuable real currency and an expulsion of the bad and decreasingly valuable fictitious money.

How can I make a statement as bold as this is proof trickle down economics does not work? Because we have seen an increasing accumulation of wealth and an increasing burden of debt to everyone but the wealthy. If money truly did trickle down, we would see the distribution of wealth remain relatively consistent and the economy rising evenly across all income levels. What we have seen instead is a greater and greater concentration of wealth resulting in a Gini coefficient at its highest since the great depression. This wealth is then leveraged into fictitious money and is considered to be at parity with real currency. And indeed, if one were to sell 100 shares of Microsoft, you would get parity. You would get what the market says it is worth. However, if Bill Gates sold all of his shares in Microsoft, he would not get parity, but rather some fraction of the current assumed worth. If everybody tried to sell Microsoft, the stock would be worthless and the parity percent would be zero.

Our assumptions that fictitious money and real currency have equal parity misdirects our economic efforts. For example, we point to the GDP and say, “Look at our prosperity!” But, this prosperity is largely fictitious money. As we pass legislation increasing the dominance of fictitious money through low capital gains taxes and IRA plans, we in turn devalue the fictitious money. Our parity percent becomes lower and lower with each increase of fictitious valuation. When we turn our economy from real goods and services to the management and creation of fictitious money, we balance our economy delicately on the pinnacle of a house of cards. Each move in this direction decreases the parity percent and the difference between our true worth and our perceived worth becomes increasingly larger until it can no longer be sustained and it all comes crashing down.

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