What Crisis? a.k.a. Creative Destruction Is The Beating Heart of Capitalism (September 25, 2008)
The well-oiled propaganda machine that is the mainstream media would have you believe the world was mere moments away from complete financial Apocalypse last Friday. Yet here we are, a week later, and the world still exists. So we have to ask: what crisis?
It is instructive to remove ourselves from the breathless propaganda for a moment and refer back to the core of Capitalism with a Capital C: creative destruction. Yes, destruction, as in closing the doors, going bankrupt, folding, game over.
Let's be honest. This entire crisis is best summarized like this: players leveraged 30-to-1, bet big and lost. End of story. Nice try, pal, now clear out and let another player take your still-warm chair.
Let's turn to Joseph Schumpeter for an apt summation of creative destruction:
The process of Creative Destruction is the essential fact about capitalism. Every business strategy acquires its true significance only against the background of that process and within the situation created by it.This is a long entry but an important one, so let's dig in.
Let's be clear about four critical points:
1. Banking and lending are essentially low-profit commodity businesses. Banks accept deposits, and then lend out the cash to qualified borrowers at an interest rate above what they pay on deposits. There is no magic in that, and the qualifying process is basically automated now so transaction costs are low.
How did Wall Street generate huge profits off an essentially low-profit commodity business? With huge leverage and 2+2=5 legerdemain/trickery. If you leverage $1 into $30 (yes, they all went for 30-1 leverage) and make 10 cents on a deal, thanks to leverage you made $3 instead of 10 cents--300% rather than 10%.
To mask the inevitable risk, then you have to present the "financial instruments" with a veneer of low risk, which the ratings agencies were pleased to provide for a fat fee. You also need to re-package the vanilla mortgages into instruments which enable you to charge huge fees, so you slice the low-yield mortgages into tranches which can be sold with hefty premiums. Then you sell derivatives (CDOs) based on the tranched mortgage-back securities, and you've effectively turned a commodity into a high-value "family" of instruments, the selling of which generates stupendous fees.
Now that the game is over, leverage has been shut down and the business has been forced back to a low-profit commodity model. Wall Street will not "come back" any more than the $100,000 condo in Florida will suddenly jump back to fetching $400,000. The outsized profits are gone, and the share of U.S. corporate profits will fall back to a much more modest slice--say, 1% rather than 4%:
2. Creative Destruction can be likened to a forest fire which burns away the deadwood. The President, Federal Reserve, Treasury and alphabet-soup agencies under their control have tried for years to stamp out any "blazes" of creative destruction as soon as the smoke was visible. They succeeded, but now the "forest" of our financial system is piled so high with flammable deadwood it will take a huge conflagration to clear it out and let the "forest" regenerate in a healthy fashion.
The devastating fires that swept Yellowstone National Park in the early 90s were the result of just this sort of short-sighted "any creative destruction is bad" forest management, and now Paulson, Bernanke and their boss, President Bush, are all desperately trying to beat out the flames licking at the bottom of an entire vast forest piled high with dry deadwood.
It won't work. They've "backstopped" and "saved" the system for so long that only a massive conflagration will clear the financial deadwood. Nothing they can possibly do will change the fact that the U.S. economy is loaded with the deadwood of unprecedented easy (and thus high-risk) credit:
Bernanke keeps bleating about "we need to free up credit," but he ignores the inconvenient fact that nobody needs to borrow more; they're already maxed out.
Various pundits have gleefully noted evidence that Americans are now starting to spend less and save more, but this is like gathering a few twigs from 100-square mile 10-foot thick tangle of branches and claiming the forest is now clear.
As noted yesterday, the reality is not quite so rosy: Consumers are increasing their debt burden even as they pay less and less on their credit cards. Card payments fell 6.2% YOY (year over year) in July, for the 9th month even as consumer borrowing on credit cards grew at 4.8% YOY.
Nothing they do will change the fact that there are millions of existing dwellings without residents or buyers, or the fact that the housing bubble was enabled by "qualifying" millions of previously unqualified buyers. With those millions now once again excluded by tightening lending standards, there is literally nothing to prop up a housing market which clearly exceeded all previous extremes:
As is supposed to happen in free-market capitalism, excessive supply and plummeting demand has led to a free-fall in prices:
3. Creative destruction is like natural selection: the unlucky, the mismanaged, and the foolish get wiped out, clearing the market for faster, better, cheaper competitors. I know it's not polite, but the reality is a free market for goods and services is Darwinian: you mess up, you fail.
If you take huge risks and/or you're dumb, you typically are at a big disadvantage, as illustrated by the painfully amusing Darwin Award Winners "who improve our gene pool by removing themselves from it."
In a similar fashion, firms which are no longer competitive or solvent do the economy a favor by closing. Bailing out dying/badly-managed companies is a horrible misallocation of scarce capital, and that robs the economy and taxpayers: failing firms don't pay taxes, further burdening remaining taxpayers. Capital poured down the rathole of insolvent firms is capital that is no longer available to healthy firms seeking funds to grow.
The banks that gambled and lost deserve to die, and those who gambled in the Ponzi Scheme and lost should also suck their losses.
4. There is no "crisis" in banking: well-managed banks like Wells Fargo which did not indulge in leverage and gambling are in fine fettle, ready and able to lend to qualified borrowers. A great number of banks which were managed prudently are quite solvent and in no need of bailouts.
In Capitalism, they should be rewarded by the disappearance of insolvent competitors. With the losers cleared out like deadwood, then the healthy, prudent firms can expand by offering their competent, well-managed goods and services.
Hindering this process will destroy any economy, and that's precisely what Paulson and Bernanke are seeking to do in bailing out the losers and the fools who just happen to be their buddies and pals.
The moment I read that Warren Buffett said the Bailout should be passed, I lost all respect for the man, who sadly has sunk to being a Toadie and Propaganda mouthpiece for Paulson.
Correspondent Mike D., who has lived and worked in China for many years, raised a possibility that many have pondered: the bailout is fundamentally a bailout of non-U.S. investors, without whom our bond markets would cease to function:
I fully agree that Paulson's $700 billion bailout plan looks like a Fascist power grab, but I wonder whether you aren't looking far enough into this. Is this really a Wall Street inspired coup attempt or is the whole thing being forced on America by its creditors?Well-said, Mike, thank you. My view is: overseas holders of "agency" (Fannie and Freddie) debt and various derivatives are screwed regardless of the bailout. Look at how the market reacted to the bailout: the dollar immediately tanked. So if Chinese and Japanese banks are bailed out of their agency losses, then they will lose even more as the value of their Treasury holdings plummets along with the dollar.
You can look up the numbers via a web search, but as I recall China holds about $350 billion in mortgage-backed U.S. debt and about $1.2 trillion in Treasury bonds. The Japanese hold about $250 billion in mortgage-backed debt and about $500 billion in Treasuries. The key point is their Treasuries and thus their positions in the dollar dwarf their U.S. mortgage holdings.
I have a problem with the assumption that the Chinese and Japanese banks were too ill-informed and blind to know that bubble assets contained risk, regardless of ratings agency games. What sort of due diligence did these smart guys do?
Commentators such as myself were warning of extreme valuations in U.S. real estate in major media publications as early as 2003: Bay Area Real Estate: All Signs Point To A Top (S.F. Chronicle, 2003)
The charts were readily available, as was the history of financial bubbles; to say the Chinese and Japanese bankers had no access to evidence the bubble was dangerous and unsustainable is simply wrong. They bought the agency debt and dollars for their own self-interest, to wit, propping up the American consumer so he/she could continue to buy Chinese and Japanese exports.
So now that the bubble has burst, they're whining to U.S. officials, demanding they be made whole? Sorry, folks, you knew exactly what you were getting into, and it wasn't for charity purposes. You propped up the global shell-game for your own enrichment, and now that the bets have been lost you want a bailout? Sorry, Capitalism doesn't work like that.
So as Mike D. noted, the threat is the Chinese and Japanese central banks will no longer prop up the U.S. bond markets by buying T-bills and other dollar-denominated debt. Well, as the global recession deepens, they won't have as many dollars anyway, so that decline is inevitable.
And if Congress is spineless enough to pass the bailout, then the dollar falling will wipe out hundreds of billions of value from the $1 trillion+ Chinese and Japanese hoards of T-Bills and other debt.
As the street saying goes: "They get you coming and going." The non-U.S. holders of dollar-denominated debt have already lost, and nothing Congress or the Treasury can do will change that. If the bailout hands them $200 billion, then the dollar decline the bailout will trigger will take away the $200 billion (or even more) from the value of their Treasury holdings.
Non-U.S. players would be better off demanding "no bailout" and seeking a fundamental "clearing out" of bad debt which would eventually strengthen the dollar.
The proposed bailout makes no sense for other reasons. Longtime correspondent Nurse Dorothy points out one glaring one the MSM completely ignored/missed:
I'm firmly against the 700 Billion dollar bailout for two reasons. One, it will not work and two, I do not trust Henry Paulson or the Federal Reserve. Paulson was quoted as saying that if there are too many conditions to the bailout he is afraid that financial institutions will not participate. If that's the case, then how bad off are we really? If you are a bank and about to fold and this is your last resort, why would you not participate? Paulson will have you belive that we are days from a meltdown but yet he's afraid Wall Street won't participate! Somehow that just doesn't make sense. (CHS: emphasis added)
Well-said, Dorothy, thank you. Next up, correspondent L.D. who files this report based on his experience within the bowels of the credit/housing bubble:
Sorry to contribute to a world of hype, but I feel I must say something. In addition to being the only Californian who refused buy an oversized mortgage to get into a wildly overpriced house during the past six years, I witnessed some part of the insanity when I worked at Countrywide for three years at the peak of the mortgage finance insanity. At that time I decided to rent and not buy another home because houses were wildly overpriced. I still rent and pay taxes. Lots of taxes. Really.That raises one last key point: you cannot eliminate risk from free-market capitalism, as that is the very essence of creative destruction. This has been illustrated in great depth by mathematician Benoit Mandelbrot in his seminal book The Misbehavior of Markets
Frequent contributor Harun I. made these cogent points about the impossibility of ridding the market of risk, as the bailout proposes to do:
bloomberg.comAnd just for a refresher, here is the chart of the Dow Jones, which looks poised to break support at 10,700 and head lower--much lower. It's called creative destruction, and it is the beating heart of Capitalism.
The Black Swan: The Impact of the Highly Improbable
by Nassim Nicholas Taleb
Manias, Panics, and Crashes: A History of Financial Crises
by Charles Kindleberger
According to several sources the market for so-called “credit default swaps” last year alone was nearly equal to the total global GDP, around 70 trillion dollars by some estimates. Yet these derivatives have no discernible “origin” or value.
The MacRib is Back!
(Chris Sullins, Septmber 23, 2008)
I want to assure you this is not a viral ad campaign. There is going to be a point to the title because it contains a small story within a much larger one. Also, the title contains a unique spelling for a reason.
CHS--my latest letter to my senators:
"This guy is THE leading visionary on reality.
He routinely discusses things which no one else has talked about, yet,
turn out to be quite relevant months later."
NOTE: contributions are acknowledged in the order received. Your name and email remain confidential and will not be given to any other individual, company or agency.
Thank you, William S. ($15), for sixth generous donation
to this site. I am greatly honored by your ongoing support and readership.
Your readership is greatly appreciated with or without a donation.
For more on this subject and a wide array of other topics, please visit my weblog.
All content, HTML coding, format design, design elements and images copyright © 2008 Charles Hugh Smith, All rights reserved in all media, unless otherwise credited or noted.
I would be honored if you linked this wEssay to your site, or printed a copy for your own use.
|consulting||blog fiction/novels articles my hidden history books/films what's for dinner||home email me|