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Is the Fever Finally Breaking? Is This the End of 'Financialization'?

Saturday, August 22, 2015

Anyone who has kids has been there.

You're standing by the bed with the thermometer to check on their temperature as you nurse them through a bout with the flu.  They are bundled up in blankets, shivering, yet sweating profusely. It is a moment of conflicting emotions because you have been there, too, and know how bad they feel.  But you also know - because you're the adult in the room - that these signals all say the fever is breaking.  You're thankful because you know they will soon be back to their normal self: playful at times - exasperating at others.

Yesterday (Friday) the Dow Jones Industrial dropped 530 points. And a good 100 of those points came in the final few minutes of trading.  And it happened on a Friday.  All of this is rather odd and does not portend well for Monday.  Usually on a sharp drop trading day, the markets gains back a little at the end of the day.  And this is especially true on Fridays.  But here we have the market - which we have to remember is made up of people with emotions - left to stew over the weekend.  Monday will probably not be pretty - unless the Fed does something dramatic over the weekend.

I am going to try to explain why the adults in the room - as opposed to the Fed and the government - should be thankful for the very real possibility that the 'fever' is breaking.  But before I start throwing up charts and their facts and figures, it is important to simplify the issues.

One of my favorite examples is the "better mousetrap."  I don't know if today's young people would immediately get the metaphor, but my generation (born in 1967) should easily understand it as coming up with an idea to improve something.  If you devise a "better mousetrap" you file a patent on your improvement so only you can bring it to the market.  If your mousetrap is a hit with the consumer, you might have to rent a building, buy equipment and hire workers to churn out your better mousetrap.  And to do that, you might need a loan.

Economic growth used to be about the better mousetrap, not the loan.  This is because the creation of wealth happens when things of use in the economy are improved - or made more useful.  The financial sector, on the other hand, does not create wealth.  It might help manage it and facilitate its exchange - but it does not create it.  I will show here that as the financial sector's share of Gross Domestic Product (GDP) increases, our economy gradually morphs into a wealth transfer economy instead of a wealth creating economy.

But as these charts show, profits in the financial sector as a share of  GDP has grown dramatically over the years.  Economists call this the 'financialization' of the economy.  It seems much easier, though, for the rest of us to simply call it a 'fever'.

A simple chart for this can be seen here.  The most important thing to notice is that the share of GDP for the financial sector is higher now than during the Great Recession.  In other words, we have done nothing to fix the real problem, which is an ever increasing dependence on the loan instead of the better mousetrap for economic growth.

But because loans are 'bought' at a price - the interest rate - there is a natural, mathematical limit called zero. In order to understand that, all you have to do is imagine how you would react if your bank started 'paying' you a negative interest rate.  This would be the same as charging you for the privilege of keeping your money with them (over and above all of the bogus fees they already charge).  Once that reality sets in, your 'mattress' becomes the logical place for your money.  It occurs to me that the 'mattress' is another metaphor the younger generation might not understand.  Their great-grand parents, though, would put their money 'under their mattress' during the Great Depression.

Before I finish up by getting into what the next financial crisis - which might have started this past week - will look like, another, even better chart will drive home what we have brought upon ourselves by allowing the financial sector to swallow up an ever increasing share of the economy.

This particular chart is helpful because it shows three important things all at once:

1) It shows the correlation between the share of overall income represented by those in the financial sector (the blue line) with the income share of the top 1%.  More on this in a moment.

2) It shows the share of overall income enjoyed by those in the top 1% of income earners (the black line).  This is the traditional indicator for income inequality.

3) It is fascinating to see where the lines cross.  The blue line (the share of overall income enjoyed by the financial sector) crosses ahead of the black line somewhere in the mid-1960's.  This matters because this is when we (in the United States) decided we could have "guns and butter."  As a result we were forced to take the dollar off the gold standard in 1971.

Traditionally, economists use the phrase "guns or butter" to describe the choice that an economy has to make between focusing on defense (guns) or social spending (butter). When my siblings and I buried our parents (seven months apart in 2010), we found our grandparents' food ration coupons from World War II.  Back then if we decided we needed to fight a war, commensurate sacrifices in terms of "butter" had to be made lest we saddle the next generation with an insurmountable debt.  There is a reason we call their generation the "Greatest Generation" that is about more than just the courage of those who defeated Adolf Hitler on the battlefield.

But in the sixties we decided not to make those sacrifices.  We were fighting the Vietnam War and building the Great Society at the same time: guns and butter.  The Greatest Generation refused to do this because they knew what it would produce - over 18 trillion dollars in debt, and with it a banking and monetary system that would come to depend on the value of that debt. That reliance on the value of debt then requires endless rounds of money printing for ever more frequent bailouts.

And the chart shows us that the people closest to all of that new money enjoy its rewards disproportionately to everyone else.  Ever since the sixties, financial sector salaries have been pulling up income inequality with them.  This makes it very easy to understand: Income inequality is salary inflation.  But only those in either the financial sector (by way of lending) and the political sector (by way of borrowing) are enjoying this salary inflation.  Everyone else (the 99%?) are being left behind...

...Until interest rates hit zero and there is nothing more central banks can do. And so here we are.

There are credible voices who believe the coming week will see a little rally starting Tuesday, after which the bottom will completely fall out.  The few whispers of Dow 5,000 are starting to increase in numbers, but are still just whispers.  Whether or not last week was the start of the next financial crisis, another crisis is mathematically inevitable - and soon. Here is why and what will then happen:

1) The more money is pushed into the system, the cheaper money itself becomes.  That 'price' is expressed in interest rates. But once you hit zero percent, there is no reason to keep money in the bank.  (In fact, even if inflation is 2% - which is nonsense and the product of gimmicked stats - then once interest rates go below inflation the rationale for keeping money in bank disappears.)  When people start taking money out of the banks, the banks will lose the 'capital' needed to offset their 'liabilities' and start getting into serious trouble.

2) The financial sector will then cry for another bailout and say they are 'deficient' in 'capital'.  This is also nonsense. They are looking for 'capital' to offset their 'liabilities'.  There are two ways of describing this problem: a lack of capital or an excess of bad debt.  It is this excess of bad debt (dot com investments using borrowed money is Exhibit A, sub-prime mortgages are Exhibit B, and now 'junk bonds' - which are just the corporate version of sub-prime mortgages - will be Exhibit C) that started us down this road of money printing bailouts.  It is the classic case of the drug addict going through withdrawal. Provide him drugs to alleviate the withdrawal (i.e. crisis) and all you have done is intensified the addiction - and the inevitable pain of subsequent withdrawal.

The question, though, is how the rest of us will respond. And by the 'rest of us' I expressly mean the adults in the room rather than the financial sector, the Federal Reserve, or our political so-called leaders.

If we are to wish the best for our kids, seeing the fever break is a relief, even though we know they will suffer a bit.  So, too, is it with the economy.  If we wish a prosperous future for our kids and grand-children, it is then on us to take the hit now as the fever breaks.  We actually do have the opportunity to change places with our kids.  We need to be adults and not let that opportunity pass us by.

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