Chapter One: Why the Financialized Economy and State Are Unsustainable
The Status Quo actively promotes the premise that it is both sustainable and eternal. Yet the system’s demographic, financial and resource foundations are clearly unsustainable. The Status Quo’s basic argument is the rear view mirror offers an excellent view of what lies ahead; those outside the Power Elites have looked through the windshield and discovered that the Status Quo’s sustainability is illusory: past stability is no guarantee of future stability.
I have covered our systemic unsustainability in my books Survival+: Structuring Prosperity for Yourself and the Nation and An Unconventional Guide to Investing in Troubled Times, and many other authors have addressed the same issues in depth. Since there is no way to summarize entire books into a few lines, I will illustrate the unsustainability with a few examples.
The U.S. economy and Central State (in the U.S., the Federal government) both rely exclusively on creating vast quantities of money (i.e. increasing the money supply) and debt to sustain their operations. The Federal government borrows about 10% of the nation’s entire output (GDP) each and every year ($1.5 trillion), or about 40% of its budget, if you include off-balance sheet supplemental borrowing.
Since the consumer no longer has the housing bubble to generate phantom assets that can be leveraged into more borrowing, consumer spending is now restrained to actual disposable income. Due to the rapid expansion of mortgage, student and consumer debt, much of this income is devoted to debt service, i.e. paying principal and interest.
Expanding debt is not cost-free; not only does it require paying interest, but as interest payments rise there is less money for consumption and investment. As a result, real (adjusted for inflation) disposable household income has been declining significantly in all income levels since 2008.
The solution offered by the Federal Reserve is to lower interest rates to zero so insolvent banks, local governments and consumers can all borrow more or mask their insolvency by refinancing old debt at lower rates. The debt does not disappear, but it becomes manageable over the short-term at near-zero rates of interest.
Due to a dynamic known as marginal return, it now takes $10 of new debt to generate $1 of economic activity. This requires debt to expand at fantastic rates to keep the economy expanding even modestly. (Back in the early 1960s when debt levels were modest and investment opportunities more abundant, a mere $1.50 in additional debt added $1 to the GDP.)
By some accounts, adding $10 in new debt actually causes a $1 decline in GDP as the costs of servicing that debt outweigh whatever thin shred of economic activity was added.
Rising debt has a consequence: rising interest. This consequence can be masked for a time by lowering interest rates, but unfortunately for the Federal Reserve’s solution, interest rates cannot drop below zero.
The solution is for the Central Bank (the Federal Reserve) and Federal government to give banks and other insolvent enterprises hard cash to maintain the illusion of solvency. The Federal government borrows the money by selling Treasury bonds and then transfers it to its favored cartels via subsidies and bailouts. The Federal Reserve does so in a slightly less obvious fashion: it loans billions of dollars to banks at zero interest, then accepts this newly minted money back as deposits from the banks. It then pays interest to the banks on the free money they just received from the Federal Reserve. The banks receive interest on money that was given to them at zero interest.
Creating money out of thin air and borrowing immense sums have consequences. Once you expand the money supply at rates that far exceed the actual expansion of goods and services produced by the economy, then eventually money becomes so plentiful that it loses its value. When this dynamic reaches extremes, it is known as hyper-inflation.
If debt expands while the income that is leveraging the debt remains stagnant, eventually most of the income is diverted to servicing this debt, i.e. paying interest. That leaves little to no income for capital investment, and the economy starves itself to death. Only those collecting the interest, i.e. the financial sector, profit from this death spiral.
We can understand this death spiral by comparing a capital investment with debt. When an enterprise buys a machine tool or computer to increase productivity, that tool or computer eventually wears out or becomes obsolete. The productive life of the tool or computer is not only finite; it is relatively short—a few years at best. Debt, on the other hand, never expires. It is permanent and deathless until it is paid or renounced by default or bankruptcy.
Once the rising costs of servicing debt squeeze out new investment, the productivity from the aging equipment declines, as do profits (what I prefer to call surplus income). This sets up a positive feedback loop in which declining productivity lowers profits which means future investment is crimped, which further lowers productivity, and so on in a death spiral.
Once an entity has to borrow money to pay its expenses, then interest payments crowd out investment. Without new investment to replenish aging equipment, productivity and surpluses decline, reducing the pool of surplus available to pay the rising interest. When interest payments have crowded out all investment, then dwindling productivity can no longer generate the surplus needed to pay the interest, and the entity defaults on its debts.
Once this death spiral becomes undeniable, those with capital refuse to lend more money to the entity. Once it cannot borrow more, then it can no longer pay its expenses. This is scale-invariant, meaning that it holds true for households, companies and sovereign governments.
Lowering interest rates only masks this death spiral temporarily. It is much easier to create credit than it is to actually increase the production of goods and services in the real world. Debt can be added effortlessly even as the production of actual goods and services stagnates.
When an economy creates money and debt at rates far above the rate of expansion of its goods and services, then eventually the cost of servicing debt crimps investment, which then lowers productivity to the point that the economy starves itself to death as all surplus is devoted to paying interest on ballooning debt.
If a household’s income is stagnant but its expenses rise by 6% a year, eventually the household will be unable to pay its expenses. If the household increases its debt 10% a year to pay its expenses, then eventually the principal and interest of the rising debt will crowd out all other expenses, and the household will no longer be able to meet its obligations.
Any nation that relies on expanding debt to pay its expenses, including the United States of America, is financially equivalent to that household.
Here is the primary point: creating debt and printing money do not create wealth. All they can create is a temporary illusion of wealth.
Nations have one trick they can use to extend the illusion of solvency: they can devalue their currency by creating vast quantities of it. In the short-run, this creates phantom “growth.” Here is a real-world example: when a U.S.-based corporation earned 1 euro in profit in 2002, when it converted that profit into U.S. dollars it equaled $1. When the company earned 1 euro in 2008, after the Federal Reserve’s relentless devaluation of America’s currency, then that 1 euro magically became $1.60 in profit when converted to dollars.
The foul magic of currency devaluation created an illusory 60% rise in profits, which then boosted the stock market and tax revenues. Yet no more goods and services were created; the value of the item sold for 1 euro in profit was unchanged.
That illusory 60% rise in profits could then be leveraged into more debt: since income in dollars rose, then that income stream could support more debt. Yet the company did not create any more goods or services; the rise in profits was financial slight-of-hand, not an increase in efficiency or production.
Phantom assets created by devaluation or bubbles (in housing, stocks or tulip bulbs) can leverage new debt for only so long, and debt can expand faster than the real economy for only so long. The proverbial straw being loaded on the camel’s back offers an excellent analogy: debt, like straw, appears light in small quantities, but in large enough quantities it will break the back of any economy, no matter how large.
Many people have boundless faith in technological solutions to all of humanity’s troubles. Since current policies will lead to either the destruction of the purchasing power of money or the diversion of most surplus income generated by the economy to paying interest, then where will all the money come from to fund technological transformation? Private capital is not immune from these forces; indeed, corporate debt has skyrocketed right alongside consumer and public debt.
The Status Quo policies are intended to produce the same solution that has worked for the past 300 years: economic expansion. Rising debt and interest payments both become lighter if the entire economy expands faster than the debt and interest. Thus in what we might call “the good old days” of high growth, $1 in capital is leveraged into $10 of new credit, which is then lent out and invested in fast-growing industries. This infusion of capital investment fuels rapid expansion of output, employment and profits large enough to handily pay the interest on the borrowed money and still fund further investment.
The past 300 years could be described as technology and capital moving from one tree’s low hanging fruit to the next, all powered by higher energy-density fuels becoming cheaper and more widely available. Recently, the digital technology revolution has enabled dramatic increases in productivity and efficiency, creating more value with less energy, thus freeing up energy for recreational consumption.
We can understand the Status Quo’s faith in this model of “growth conquers all problems, including indebtedness”—the model has shown remarkable resilience, making fools of all who doubted the notion that creating credit out of thin air was a dangerous way to fund growth.
There is a basic problem that these advances in energy and productivity have masked: it is much easier to create credit/money than it is to actually increase the production of goods and services in the real world. Put another way, the supply of trees bearing low-hanging fruit is not infinite. But since the creation of credit and loaning out money is so immensely profitable and low-cost, then borrowed capital is far more abundant than productive investment opportunities.
This is how mal-investment occurs: easily borrowed money seeks a high return, and the very abundance of such credit leads to investments being made in risky low-return investments. These mal-investments do not just fail to deliver returns, they collapse into stupendous losses.
A recent example is expensive luxury homes being built in the middle of nowhere during the housing bubble. At the time, it seemed as if any house built anywhere could be sold for a handsome profit, and so borrowed capital gushed like a mighty river into building homes far from jobs and other essentials.
This is one example of the financialization of the global economy: the process of creating credit from thin air and leveraging it into debt-based financial instruments is far more profitable than actually attempting to produce more goods and services in the real world. If all goes according to the “growth conquers all problems, including indebtedness” model, then there is no risk of losses ever becoming large enough to dent the pyramiding of debt and financial profits.
In other words, when the low-hanging fruit of investment opportunities become scarce, then the creation of debt and leverage become the dominant generators of profit. Thus financial profits have come to dominate the returns of the Standard & Poor’s 500 corporations (the S&P 500).
Unfortunately, the growth model finally failed in 2007 because most of the capital being borrowed and invested was being invested in projects that did not yield an actual increase in goods or services. Building a luxury home in the middle of a field added to the nation’s gross domestic product, but it didn’t create any new goods or services; it was simply another form of consumption. Once the market discovered its real value was lower than its initial cost, then the illusion that building it created “growth” and “wealth” was shattered.
On the surface, the Internet boom of the 1990s and the housing bubble of the 2000s both generated strong increases in gross domestic product (GDP), employment and profits. But there were three fundamental differences between the two periods of growth.
In the Internet boom, capital flowed into companies that grew at spectacular rates building the infrastructure, both hardware and software, of the global Internet. It also flowed into companies that didn’t grow and thus failed. Though some companies did borrow vast sums via corporate bonds, in general the money invested in technology companies was cash—what we call capital. If the company failed, that capital was lost. There was no debt to pay off.
The housing bubble, on the other hand, was fundamentally a credit bubble: vast sums of money were created out of thin air and invested in housing. Banks leveraged $1 in capital (cash) into $25 in new loans. When the bubble popped, the “wealth” vanished but the debt remained.
The second difference is that the Internet boom created an immensely productive technology that continues to lower costs via increasing efficiency in every sector of the global economy.
The housing bubble created no infrastructure or productive technologies; it was purely consumption. Once the homes were built then the increase in GDP, jobs and profits vanished, but the immense debts taken on remained to be paid. Mortgage debt roughly doubled in the bubble from $5 trillion to $10 trillion, and has barely declined in the five years since the 2007 bubble top.
This is the difference between productive investment and mal-investment: productive investment is based mostly on cash capital, and it creates assets that generate real value for years to come. Mal-investment is based on credit (borrowed money) and generates no productive technologies. It is essentially a financial event that briefly generates financial gains for banks from an explosive expansion of credit and speculation.
These mal-investments failed, and since the borrowed money was leveraged by phantom assets, then that failure led to the near-collapse of the global credit-creation machine. This is not difficult to understand: if we create a $10 loan with $1 of actual cash, then the moment the asset the borrower bought with the $10 is only worth $8.90, then the lender is bankrupt since the $1 of actual cash has been lost. The lender has a negative value and can no longer issue more credit.
Which type of growth generated the most profits for the financial sector, productive or mal-investment? The speculative, credit-bubble frenzy of the housing bubble was far more profitable, as it created more debt for the financialization machine to package and enabled a broader spectrum of “financial innovations” to sell for hefty upfront premiums.
There is another deeply pernicious dynamic in this financialization. As financial profits come to dominate an economy, then the economy (and the Central State that lives off tax revenues) becomes increasingly dependent on the creation of new leverage, new debt and new financial instruments to sell for its growth and profits. This need to issue new debt and debt instruments creates irresistible incentives for lenders to push newly borrowed money into increasingly risky and marginal investments; whether the investments fail or not no longer matters, because the profits are made by the origination and selling of the leveraged debt.
The interests of the financial sector and the Central State that depends on financial profits thus diverge from those of real-world, non-financial enterprises: the real-world enterprise is still constrained by the physical world of equipment and plant, by the costs of debt and the marketplace for goods and services. The financial sector makes money by creating debt and debt-based instruments from thin air and selling them for an immediate profit. When the debt goes bad, i.e. the borrower stops paying interest and principal, then the Central State steps in and transfers the losses from the private financial sector to the public. These enormous losses then burden the taxpayers for decades to come.
Put another way: financialization richly rewards all who originate vast quantities of debt and out-of-thin-air financial instruments that end up burdening the real-world economy. Financialization is thus a subtle but very real feedback loop of self-destruction.
Financialization did not unfold in a vacuum: Central State and central bank policies either enable or discourage leverage and mal-investment. At this point we might wonder why the Central State continues pursuing and enabling such visibly risky and ultimately destructive policies. The answer is profoundly obvious and thus profoundly dangerous: the rise of financialization created gargantuan concentrations of wealth, and since the political class requires huge sums of money to win re-election, these concentrations of wealth essentially bought control of the machinery of governance via unprecedented levels of campaign contributions and lobbying.
Such is their influence—or shall we be direct and call it a partnership of wealth and political power—that the Central Bank (the Federal Reserve) prints and distributes cash to the banking sector via the mechanism described above, and the Central State has injected trillions of dollars of direct cash subsidies and bailouts to the financial sector.
The self-serving apologists for this looting of the public coffers claim that this was necessary to maintain the “engine of growth that conquers all problems, including indebtedness.” But this rationalization has failed to mask the reality that the Central State and bank’s partnerships with extreme concentrations of financial wealth have broken the engine of growth by institutionalizing extremes of debt, leverage, fraud, misrepresentation of risk, mal-investment and devaluation of the nation’s money.
As noted above, the expansive Central State requires an expanding economy and an expanding surplus that it can tax. It also requires a robust market for its own debt, Treasury bonds, so it can borrow virtually unlimited sums to fund its expansion.
Once the low-hanging fruit was all harvested, financial profits from the issuance of debt became the dominant source of growth and taxes. This is a key point: financialization serves the interests of the Central State even as it works against the interests of the citizenry. In other words, once a State becomes dependent on financialization for its own growth, the interests of the State diverge radically from those of its citizenry.
These financialization policies do not serve the interests of the citizens and taxpayers who now stagger under titanic burdens of public debt, but they do serve the interests of the political class devoted to maintaining their grasp on power and the financial sectors which have profited so immensely from the policies of the Central State they now control.
The Status Quo propaganda machine ceaselessly claims that the policies of the Central State and bank are aimed at restarting the “engine of growth conquers all problems, including indebtedness;” but the reality is the policies of the Central State and bank have crippled the engine of growth and put the nation into an economic death spiral.
As noted above, there are real-world limitations on the growth paradigm; there are not an infinite number of trees bearing low-hanging fruit awaiting capital investment to reap a windfall of productivity and profits. Indeed, the increasing visibility of marginal return suggests that windfalls have become few and far between, and that input costs are rising while output surplus is declining. In other words, more and more capital must be invested to reap less profit, and since surplus is declining, then the only way to get capital is to borrow money, which then increases the interest that must be paid out of the surplus. Once again we have a death spiral based on rising debt.
Surplus is simply what’s left over after we subtract the total costs of the production from the value of the output. If all the investment capital was borrowed, then interest payments will make up a substantial portion of the production costs. If the surplus declines, then the cost of servicing the debt will eventually exceed the profit, and the enterprise will spend more than it takes in. Once its cash is devoured by losses, it becomes insolvent.
In other words, the financialization of the economy works admirably when the surpluses created by investing borrowed money grow faster than the interest payments. But once the surpluses decline, then the cost of servicing the monumental debt devours the enterprise from the inside.
Another way of describing this death spiral is depreciation outstrips new investment and rising interest outstrips increases in income.
There are two other reasons surpluses diminish in eras of concentrated financial and political power: Elites (aristocracy, oligarchy, theocracy, etc.) are fundamentally parasitical, contributing little if any productive value to the economy while absorbing a significant share of the surplus being generated. In our era, the parasitical classes include the financiers benefitting from financialization and the political class which feeds off the financial Elite’s wealth.
In other eras, these parasitical classes might have been religious aristocracies constructing grandiose monuments to their order’s glory or warlords bent on conquest. The nature of the parasitical Elite matters less than its size and burden on the economy. The more concentrated the wealth and power held by the Elite, the larger its consumption of the surplus. When the surplus shrinks below a critical threshold, the entire predatory, top-heavy social order collapses in a heap.
The second drain on surpluses in eras of self-serving financial and political power is what the Romans called “bread and circuses,” the bribes offered to potentially restive classes of citizenry whose loyalty to the Status Quo is conditional. In the latter stages of Roman decline, some 40% of the population of Rome received free bread, and lavish, distracting entertainments (once held only on special occasions) were hosted by the Central State on a year-round basis. Both the free bread and free circus extravaganzas were horrendously costly, yet as the interests of the Elite diverged from those of the dwindling, overtaxed productive classes, these bribes to the lower classes were considered as vital to the survival of the Status Quo as the military legions—both of which eventually bankrupted an Empire ruled by an Elite obsessed with its own self-preservation.
Combine the heavy costs of supporting parasitical Elites with the ever-rising costs of bribing the non-Elite classes into sullen complicity and you soon have a deadly reduction of surplus to zero and the State implodes under its own weight.
The Elites ruling the Central State are left with only two ways to finance their dominance: devalue the currency, that is, steal purchasing power from every holder of the currency by creating new currency from thin air (i.e. the theft we know by the carefully benign term “inflation”) or they borrow money from those with capital, and hope the lenders remain blind to the fact that their loan will never be paid back at full value.
Neither of these strategies works for long; rather, they hasten the collapse of an increasingly unsustainable social order dominated by predatory, parasitical self-serving Elites.
Creating credit only sparks productivity when the borrowed money is invested in high-value, high-profit enterprise so that the economy expands at a faster rate than the debt. Once credit is diverted to low-return mal-investments and debt skyrockets while the real economy stagnates, a financialized economy is revealed for what it truly is, a machine of self-destruction.
The Central State and bank have masked this self-destruction with three policies: zero interest rates that lower the short-term burden of monumental debts, bailouts of the politically protected financial sector, and perhaps most perniciously, the transfer of private financial-sector debts to the public via massive public borrowing. Rather than put an end to destructive leverage, indebtedness and financialization, the Federal government has embraced them as its core solution: borrow stupendous sums of money to prop up the Status Quo, all leveraged off future tax revenues, and hope future growth will somehow outrun the runaway debt train.
I have described the “magic solution” the Status Quo is relying on, “the engine of growth conquers all problems, including indebtedness,” and explained why debt-based financialization necessarily leads to a death spiral of declining productivity, investment and profits. There is one other “magic solution” that many are counting on to erase the burdens of overleverage and over-indebtedness: inflation, i.e. the destruction of the currency.
This can be explained by a simple example. If there is $100 in the money supply, and $100 of goods and services to trade, then $1 will be exchanged for $1 of goods and services. If the money supply suddenly increases by $100, then the value of the existing $100 declines by half, as the money supply is now $200 and the supply of goods and services remains unchanged. Thus it now takes $2 to buy $1 in goods and services.
Holders of the currency have had half the value of their currency (what we call purchasing power) stolen by the central bank that issued the additional $100 in money supply.
The “magic” to this “solution” is that a $10 debt has effectively been reduced to $5: the debt can be repaid in full with the newly inflated currency, and the lender can only buy $5 worth of goods and services with the $10 he received in payment of the debt.
This is a very bad deal for holders of the currency, who have lost 50% of the value of their money, and for lenders, who also lost half the value of their loan. It is a good deal for borrowers, as their debt effectively declined by 50%.
The reason why this “magic solution” cannot possible work is equally simple. The interest rate charged on debt is sensitive to the devaluation of currency (i.e. inflation). If the currency is being devalued at 10% a year, then those with capital to lend will requires 13% interest in order to earn a real return of 3%, that is, they will add 3% to the rate of inflation/devaluation. This means the cost of new debt will always exceed the rate of inflation. This raises the cost of servicing debt and severely limits the issuance of new debt. Economies and households alike that depend on borrowing money to pay their expenses are quickly bankrupted by spiraling interest payments.
As interest costs rise, the surplus left for new investment is reduced, and once again we are back in a death spiral of rising interest payments and declining capital investment which leads to lower productivity and lower surpluses, and so on to the point of insolvency.
The Federal Reserve can manipulate the interest rate it charges banks, but it cannot set the interest rate private lenders demand. It can manipulate these rates by buying bonds, that is, artificially reducing the supply of debt, but its own balance sheet quickly explodes higher—by $2 trillion in the past few years. Ultimately, the Fed can only control interest rates by becoming the buyer of last resort. That will only succeed if the Fed’s balance sheet expands to infinity and private lending ceases.
This is in effect what has happened in the home mortgage market: between the Fed buying $1 trillion of existing mortgages and the Federal government guaranteeing new mortgages, private mortgage lending has fallen to a mere 1% of the market. In other words, mortgage rates are only low because the entire mortgage market has been socialized by the Fed and the Central State. The “free market” in mortgages has ceased to exist, and all the stupendous risks of keeping the real estate bubble inflated have been transferred to the taxpayers.
There are two fundamental characteristics of capitalism: capital (cash savings) is put at risk in an investment to earn a return, and a transparent market discovers the price of debt, assets and risk. Once the market is no longer free to price the cost of money, assets and risk—i.e. when the State and central bank socialize the entire mortgage market—then we no longer have capitalism.
The term “moral hazard” describes the separation of risk and return, and the Federal Reserve and the Federal government have institutionalized moral hazard by guaranteeing all mortgage loans issued by private lenders, no matter how defective or risky they might be. This creates perverse incentives to further financialization, as banks and lenders know the State will transfer their losses to the public, while letting the banks and lenders keep the profits.
All that this socialization of risk accomplishes is that it transfers the death spiral of rising interest, declining surplus and marginal return to the Central State, i.e. the taxpayers. As the Central State attempts to collect enough tax revenues to fund its rising interest and other expenses, then it further squeezes private funds available for investment. This lowers the productivity of the private economy, which then generates fewer surpluses for the State to tax, and so on in another positive feedback death spiral.
The risk of ballooning debt cannot be extinguished, it can only be transferred; even the apparently all-powerful Federal Reserve and Federal government cannot rescind the consequences of runaway debt and financialization.
I have carefully described the dynamics of financialization, political corruption and moral hazard, and explained why financialization and reliance on debt for growth leads inevitably to a death spiral. There is no way out of this death spiral; there is no “magic.” Either the currency is devalued to near-zero, wiping out the wealth of the citizens holding the currency, or the costs of servicing the ballooning debt bankrupt the nation by choking productivity and investment.
Debt cannot sustainably rise faster than the production of real goods and services. If your expenses rise by 6% a year and your income rises by 2% a year, then within a very few years your expenses will exceed your income and you will go broke: your debts will be repudiated and your other expenses will not be paid.
A third “magic solution” presents itself: taxing the Elites who own most of the nation’s wealth and garner much of the national income. This is indeed a tempting solution, but it fails to grasp the point made above: it really doesn’t matter who owns the economy if expenses expand by 6% a year and net income only rises by 2% a year; the system is in a death spiral of inevitable insolvency and bankruptcy. The Central State could expropriate the entire wealth of the financial Elite and absolutely nothing would change in the final outcome.
Indeed, many governments have tried this “magic” and found their economies implode anyway: if expenses and debt are rising while the actual surplus generated by the real economy is stagnant, then eventually the costs of servicing debt exceed the economy’s net income. At that point, the debt is repudiated (default) and the expenses—State wages, pensions, entitlements, etc. —go unpaid.
The two options at the end of the death spiral, hyper-inflation or default, are not identical. If the Central State and bank choose to “solve” the problem of exponentially expanding debt by printing money to create inflation, then that inflation destroys all money. Everyone holding money (dollars) is wiped out.
Defaulting on debt, on the other hand, only wipes out debt-based assets. There is a key difference: destroying the value all money via high inflation wipes out people and enterprises who did not participate in the explosion of speculative debt—they held cash and cash assets. Since high inflation destroys all money, cash assets are wiped out and the innocent—those with cash capital—are wiped out even though they did not participate in the financialization.
Here is an example of how high inflation works. If inflation has been boosted to 30% a year to rid the Central State of its debts and obligations, then by year four, inflation has eroded $1 to a mere 24 cents. Any debt paying a fixed rate of low interest must be heavily discounted because no one wants a bond paying 5% when inflation is running 30% a year, so owners of debt-based assets have seen the value of their asset eroded just like cash. By year nine the value of the initial $1 has fallen to 4 cents, meaning that the debtor can pay off $1 in debt with 4 cents of purchasing power. Both cash and debt-based assets have been depreciated to near-zero.
This is excellent news for the Central State, which can then redeem fixed-rate bonds purchased for $1 with a mere 4 cents, even as its citizens’ wealth is destroyed. This is why so many observers expect the State to pursue the path of high inflation, as it enables the central State to pay its debts for pennies on the dollar.
This works well if the Central State has ceased borrowing, but if its borrowing increases due to the death spiral described above, it must pay 33% interest on all new debt (3% real return plus the 30% inflation rate). Since inflation destroys capital and any incentive to invest over the long term, then high inflation causes productivity and investment to falter, leading to the same death spiral of lower productivity and higher interest payments.
Alternatively, if $1 in debt is written down to 4 cents in one fell swoop via default, then cash money retains its value and the incentives to invest capital for long-term gains in productivity remain in place. Those who hold cash are not punished for the sins of the debtor Central State, and those who bought debt-based assets ( that is, they believed that extremes of leverage and debt posed no risk) suffered the loss when the risk was finally recognized. In other words, with default, risk and gain/loss are causally connected; in high inflation, everyone’s wealth is destroyed to maintain the illusion of Central State solvency.
Wiping out debt strengthens the positive incentives of holding cash while exacting a cost for over-borrowing and speculating in debt-based financial “innovations.” Wiping out debt via high inflation reinforces the incentives to borrow excessively and punishes anyone holding cash or investing capital in the real economy.
Default would wipe out those who depend on debt-based speculation, i.e. the “too big to fail” financial sector. This would be the equivalent of a vast swarm of crippling parasites suddenly dropping dead; the long-suffering organism (in this case, the real economy) would suddenly regain its vigor.
If we grasp even half the implications of the financialization death spirals described in this chapter, then our rational minds understand the Status Quo is unsustainable, and its various magic tricks to escape the death spiral are only actively speeding our approach to the cliff of insolvency.
Yet few of us are willing to entertain an exit from the belief system that supports the Status Quo.
I liken this to the state of mind on the “unsinkable” ocean liner, Titanic, moments after the ship’s brief encounter with an iceberg on the night of April 14, 1912. In those first few moments, the ship seemed undamaged, and the possibility that the glancing collision with the iceberg had fatally wounded the great ship seemed not just remote but impossible.
Unbeknownst to everyone on board, the ship had fatal material and design flaws. The steel plates of the hull were brittle and did not deform when struck by the ice, they fractured much like shattered china. The ship was designed to survive four of its 16 watertight compartments being flooded, but the iceberg damaged six, dooming the great liner.
Shortly after the collision, simple calculations revealed that the ship would inevitably sink: as the first five watertight compartments flooded, water would eventually cascade over the top of the adjacent bulkheads in a domino-like effect.
The officers, though knowledgeable and experienced, had trouble grasping this fact, and this helps explain the confusing mix of reassurances given to passengers and half-measures to goad them into lifeboats when the ship’s bow had only begun to settle slowly into the cold water of the Atlantic.
How many people would have acted on this knowledge had they been present at the briefing? We would like to think we would have acted appropriately by either boarding a lifeboat or if that was not possible, by lashing together deck chairs to form a makeshift raft, or some other method of remaining afloat after the great liner met its inevitable doom.
But few people acted on the inevitable until it became undeniable. By then, it was too late.
The financial system of the United States of America is like the Titanic. Hubris leads many to declare it financially unsinkable even as its fundamental design is riddled with fatal flaws and the human pilots in charge are running it straight into the ice field at top speed.
I have just explained in some detail how these flaws doom the financial system and government finances alike to either default or destruction of the nation’s currency. There are no other end-points.
We could insist on changes to these policies, but we do not; why?
Some of our reluctance can be attributed to disbelief, as the gap between what we know is inevitable—the ship will sink beneath the waves—and what we currently see—a proud, mighty ship, apparently undamaged—is so wide.
But if we delve deeper, we discern how calculations of risk and gain yield faulty assessments of self-interest. While the ship appears undamaged, it seems risky to clamber into an open lifeboat and drift away into the freezing night, while the supposed gain (saving our life) is questionable: from the warm deck of the ship, it seems that clambering onto a lifeboat would place our life far more at risk than staying on board the mighty ship.
This assessment of self-interest was tragically flawed, and by the time the impossible (sinking) had become the inevitable, it was too late to change the fate we’d selected back when all seemed permanent and secure.
The point of this exercise is to reveal just how illusory our assessment of self-interest and security can be, and how prone we are to making decisions based on the present even when our rational minds are well aware that it is unsustainable.
The Central State offers us plentiful reasons—incentives, promises and threats —to believe it is in our self-interests to accept the Central State and bank policies, even though it is obvious they will lead to moral, political and financial bankruptcy.
This dynamic can be illustrated by an examination of the Medicare system that promises us with lifetime medical care after we reach 65 years of age. This is unsurprisingly an extremely popular program, and thus politically untouchable except for minor policy adjustments.
Yet it is also visibly unsustainable: program costs rise by 6% or more annually, while the underlying economy that must fund it grows by 2% at best. Demographics render the program unsustainable, too; 60 million Baby Boomers are beginning to enter the system even as people live longer and the range of possible treatments expands every year. Anyone who looks into the costs and demographics concludes that Medicare alone will inevitably bankrupt the nation. The only way to paper over the reality is to assume rapid growth of the entire economy will suddenly outrace the costs of Medicare—in other words, the same old hope that’s supposed to solve every problem: future growth that is so rapid it outraces debt, demographics and an ever-expanding Central State.
All of this should make us question our political devotion to the program, but that’s not even the worst of it. Numerous studies have found that 40% or more of Medicare expenses are fraudulent, and another significant percentage is wasted on needless or even counterproductive tests, care, medications and procedures.
We know all this but we refuse to renounce our share of the illusory promise: if everyone else is going to get their share, then I deserve mine, too. The fact that no one can possibly receive what has been promised simply doesn’t register in our calculation of self-interest.
In effect, the Central State has bribed us into complicity with a modern-day version of bread and circuses: don’t dare question the system, because you’ll be placing your share of the goodies at risk.
This is an interesting phenomenon, for our perception of self-interest is clearly delusional: there is no way that Medicare can fulfill what has been promised, yet we cling to the promise because it seems to serve our self-interest. Like the passengers in the warm interior of the Titanic gazing out at the cold sea, we cling to our belief in the mighty ship’s invulnerability until it’s too late and we’re sliding down the tilting deck into the very sea we feared.
But this is only the leading edge of what’s interesting about self-interest: even when told the program will bankrupt the nation, we still want our share. In other words, what’s real and immediate to us is going to the hospital and paying almost nothing for treatment; the destruction of the nation’s finances is abstract and apparently disconnected from our windfall of nearly-free visits to the hospital.
We will not believe the program is unsustainable until it fails.
This self-delusion has a great cost: rather than face reality when the situation could be salvaged, we refuse to believe our perception of self-interest is misplaced until it’s too late.
This delusion has been institutionalized within the sprawling, expansionary Central State. The Central Intelligence Agency (CIA), for example, appears to be keenly aware of the risks to national security posed by America’s dependence on unstable or unfriendly nations for its oil supply, by extremes of weather, geopolitical tensions, etc. Yet it appears, at least publicly, to be completely blind to the threat posed by the domestic death spiral of financialization.
As I write in March 2012, the Federal Reserve and the Federal government’s policies of masking the inevitable outcome of exponentially expanding debt appear to be intact; but these policies have done nothing but buy time even as they hasten the eventual reckoning.
To many, it seems impossible that such a powerful nation could be brought to its knees by mere debt, in effect digital zeroes and ones. But debt is now the lifeblood of the nation and its global empire, and if that debt machine shakes to pieces then the nation will be unable to pay its mounting expenses by issuing more debt.
I liken the present to the final days of the mighty Ming dynasty in China. In 1640, the dynasty’s power and stability were unquestioned; four short years later, the dynasty collapsed in a tangled heap of shattered stability and illusory strength.
The Chinese have an apt saying: when you’re thirsty, it’s too late to dig a well. We’re not yet thirsty in America, so we have no interest in digging a well. When we do suddenly feel thirst, it will be too late.
This delusional faith in the Status Quo is not entirely self-directed; the Status Quo actively markets the illusion that it serves our self-interest as a way of promoting its self-preservation and masking the great divergence of our real interests from those of the Elites atop the Status Quo.
But it is merely another iteration of self-delusion to think that our delusion is only political and financial; its roots extend deep into human nature and our basic insecurities that are exploited so effectively by the Status Quo’s marketing machine.
Stripped of illusion, we can now understand the Status Quo is unsustainable, that the interests of its Elites and the citizenry have radically diverged, and that the dominance of these parasitical, financialized Elites is ruinous to the nation.
The renunciation of the Elite’s heavily promoted version of our self-interest is the first step in liberation. The second step is to recognize that the citizenry do not need the approval or permission of the Elite or the Central State they rule to pursue their own positive transformation.
Why do we accept a Status Quo that will inevitably fail to fulfill its promises? Why do we continue to believe that the Status Quo serves our self-interests? Why do we submit to a framework of beliefs that render us powerless to change our circumstances?
Our faulty assessment of self-interest has several deep causes that range across the social, political and economic spectrum. Balancing risk and gain is the foundation of our self-interest, and only by exploring risk can we understand how our calculations of risk and gain can be so spectacularly self-destructive.
Control of beliefs, myths, worldviews, contexts and agendas is also political control, and so we must understand how the media-marketing complex shapes our perception of the world and our own definition of self-interest. Control of the financial system ultimately translates into political power, too, and so we must understand these mechanisms as well.
To fully understand all these interconnected forces, we must examine human nature, marketing and the nature of groups, societies and economies. Though this may appear to have little to do with resistance, revolution and liberation in either a political or spiritual sense, this integrated understanding is essential to our synthesis of these two modes of positive change.
Revolutions, peaceful and non-peaceful alike, occur when two conditions are met:
1. The Status Quo is no longer able to serve the interests of its non-Elites as promised.
2. The non-Elites finally recognize that the Status Quo is designed to serve the interests of Elites and thus it has lost the capacity to serve their interests.
These may seem to be restatements of the same condition but they are quite different. The first condition has already been met, though it is not yet apparent because the financial Titanic still appears mighty. The second condition will only occur when the ship is finally sinking beneath the waves.
This is the basic credo of liberation:
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Copyright 2008-2012 Charles Hugh Smith all rights reserved in all media. No reproduction in any media in any format (text, audio, video/film, web) without written permission of the author.