The Financial Crisis: The Economy and Role of Government

The rapid removal of credit from the financial system was one catalyst that combined with many others led to our current situation. Businesses without access to credit find it difficult to maintain their previous position and impossible to expand.

Jamie Dimon’s letter to shareholders does a phenomenal job explaining how we got to this point. To summarize, changes in accounting gave large corporations an incentive to eliminate pensions in favor of 401(k) plans. Housing prices went up way too fast. People who were lending shouldn’t have been lending and the people borrowing shouldn’t have been borrowing. Securitization reduced lending standards and provided misunderstood securities. Money market funds grew as a consequence of 401(k) plans. Of the $2 trillion in money market funds, $700 billion was invested in commercial paper-a source of very short-term capital provided to businesses.

The housing market had to fall, and it did. The securitization of mortgages all but disappeared, which led to a few well-known Investment bank failures, which led (for example) to huge increases in Credit Default Swap spreads. This either required payment or collateral that even our largest institutions couldn’t handle. The government stepped in to help but by then it was too late. The stock market, which had already taken a hit, continued to take a further beating. The fear of bank failure caused a huge shift in capital allocation specifically out of money market accounts. Almost overnight the commercial paper markets disappeared as people moved their money out of money market and similar accounts. Businesses had to turn to the banks. But the banks had their own problems. As mortgage default rates substantially increased, the credit quality of securitized mortgages became increasingly questionable. The securitization market dried up and the banks were left with assets of rapidly declining values. Banks are required to have certain asset to liability ratios to remain solvent. The banks, struggling for survival, simply couldn’t support businesses in need of short-term loans.

As Jamie Dimon clearly puts it:

Individual Investors, corporations, pension plans, bond and loan funds, money market funds and others – all individually acted wisely. But collectively, they caused enormous flows out of the banking and credit system. Regardless of whether the funds came out of a bank, a money fund, or a bond or loan fund, the fact remains that the cumulative result was a severe shortage of necessary credit that was removed from the system.

The impact of such a shortfall may not be immediately obvious, but it’s not difficult to understand.

Credit is a form of capital. Generally, capital initially (and during times of stress) comes in two forms: Equity and Debt. As an entity establishes itself it may increase capital by generating income on total capital which often becomes a form of equity.

The Concept & Use of Money

Earlier this century currency e.g. money was “Gold Backed” that is the quantity in circulation and therefore its value was supported via gold collateral. But the amount of goods and services increased, outstripping the supply of currency that could be supported by the worlds gold. Over time, for this and for other reasons, governments left the "Gold Standard" for "paper money".

In the end however, money is nothing more than a means to trade. A gold backed currency made trading different products easier-A few gold bars had a set value in the eyes of business owners or trade partners relative to other tradable items. But what if one day enough gold mines were discovered and enough gold extracted and distributed throughout the world, such that gold was no longer a scarce resource? Naturally the value of gold among trade partners would substantially decrease and what once cost only a single gold bar would now cost many more. This is inflation. As money is printed it becomes less valuable. If business people know that money is being widely printed then they are likely to increase prices accordingly or require some other form of trade (assuming such an option exists). Global currencies are now more or less supported by each country’s relative Gross Domestic Product (GDP). GDP is in essence the production of goods and services both of which, like gold, are tangible.

The Role of Government with Respect to Money

Our government came to recognize that as unemployment increases the production of goods and services decreases and with it GDP. If unemployment is high domestically, then people are not getting paid and consumption of the country’s goods and services declines to the point where inventories build up and the wealth of business owners is tied up in idle assets. To convert this into cash, and/or to stay in business (e.g. meeting interest obligations on debt), business owners will begin to lower prices until individuals with cash savings are enticed to spend money. If this continues, businesses compete in reverse by lowering prices faster and faster. This of course contributes to increasing unemployment. Without large scale business and consumer cooperation (which often requires Government intervention) this eventually leads to depression. This is bad. To make matters worse individuals that would invest or lend under normal conditions, choose to keep their cash idle, which contributes to business and economic decline.

Deflation

If deflation is thought to pose a real threat, the best response by the government is to put people to work and thereby putting money back into their pockets, which is then spent on goods and services, which ends declining prices and increasing unemployment. The Government is the only institution capable of this. Private business owners in a capitalist society are, by definition looking out for their interests first. This is generally a good thing because it usually promotes the most sensible use of a country’s productive assets. But when capital becomes idle or if productive assets decline we embrace the negative compounding of everyone’s standard of living. I am of the opinion that this is not desirable for a rational person. Such is the apparent justification of the government intervening into private enterprise.

It is however obvious to anyone who has thought about the subject that the government is much better at creating and supporting a system than it is at allocating resources or running business. So there is a definite line that government has to be careful not to overstep. This line is never stationary and moves very slowly from year-to-year. People generally have a hard time recognizing subtle changes. Over longer periods the line can move a great distance without recognition and the location of the line with respect to the governments “step” is therefore unknown.

Spending and the Potential for Inflation

To support spending the government has two fundamental sources of capital: (i) taxes which are income, and (ii) the issuance of government securities which are debt. The government however has a third way to finance spending, that is, by printing more money.

Too much printing however leads to very high inflation-the extreme of which is hyperinflation. This happened in Germany after World War I. Hyperinflation basically occurs when faith is lost in the nation's currency and consequently their money loses its value altogether. During hyperinflation in Germany, a life savings barely bought a single loaf of bread. During periods of such desperation, people revert back to trading tangible goods like art, gold, jewelry, etc. But this quickly ends, because people don’t need these things, they need food, shelter, and clothing.

The likelihood of hyperinflation is remote, but it is almost certain that we will experience at least some (above average) inflation in the years to come. Inflation is a hard and painful thing to reduce. Paul Volcker was able to curtail inflation in the 1980’s before it got out of control, but received death threats for doing so. That’s because government has to reduce the amount of money in circulation. One way to do this is by increasing the interest rates which makes borrowing very expensive for businesses and individuals. All else equal, this leads to reduced capital investment, which is ok if a country’s production is well below its normal capacity-the result of over-expansion.

But I’m assuming that inflation is the problem. It may very well be, but we’re not there yet.

Avoiding Deflation

To entice people to transfer their wealth (typically liquid like cash) into productive assets (typically illiquid like a manufacturing facility) the individual/investor must have (i) confidence that people will have the desire and ability to consume (purchase) what he/she produces or sells, (ii) the means of trade must be widely accepted, and (iii) the amount of reasonably expected profit must be acceptable to the investor.

Over time, the government and business owners have come to a cooperative agreement-although they may not recognize it: (overly simplified)

Government to Business owners:

“Keep as many people employed as possible”

Business owners to Government:

“O.K., but only if you keep inflation and taxes as low as possible”

But with economic prosperity and growth, for reasons too lengthy to express here, there is always at least slight inflation and there is always at least slight unemployment.

Ultimately, some people possess valuable tangible assets, others possess valuable knowledge or a trade, and some possess nothing. To promote the betterment of society or to increase the standard of living, quality of life, etc., we developed a standard means for trading different types of products and services and combined people various assets in the production of such products. Money facilitates trade. Banks facilitate money. Without money there is no trade, without banks there is no money.

Government, Money, and Employment

One of the primary purposes of our government is to provide a set of rules to promote organized trade. Since they supply the currency (money) and they determine the rules, they can also initiate trade by sensibly employing a percentage of the population, which businesses need to ensure long-term sustainability. This requires spending to be focused on those areas that will ultimately benefit business and production. Money spent on a diamond is an expenditure unwisely allocated, unless that diamond produces income. On the other hand, money focused on areas that are certain to benefit business, be it smart energy grids or incentives to develop a vastly more efficient solar panel, both have the effect of significantly reducing costs in specific areas that almost always benefit the consumer. Individuals and businesses are both consumers of energy, which means that businesses would become more competitive as their costs of production decrease and individuals would reduce a significant annual expense.

People are paid money by the government or by private business for their labor. As a result, people buy goods and services from their businesses, who make profits, which the government taxes so they can continue to facilitate order and trade.

Credit

The wise use of credit has enormous benefits to individuals and society. Its benefits are so perfectly obvious that our society has come to rely on certain types of credit. Extending credit puts capital into productive use, restricting credit puts capital into idle use. No one benefits from the idle use of capital. However as capital is sensibly put into productive use, everyone benefits.

The underlying value of a country is represented by its purchasing power. Purchasing power is a function of the total production of society. The nominal amount of idle capital is worth nothing more than its paper value, and often less. However the purchasing power of some productive asset is worth a substantial excess over its carrying value not only to the individual who earns interest on his money lent or invested, but also provides the entire country with an excess unattainable had the money been idle.

Take $1 million and put it under your mattress. At the end of the year this capital commands $1 million of purchasing power, no less, no more, and your standard of living is similarly, no less, no more. Now take this $1 million and lend it out at interest to some enterprising individual. At the end of the year your purchasing power will have increased, and your standard of living will also be on the rise. By holding the capital idle, you employ no one. By extending credit you benefit twofold: Your purchasing power increases from interest earned on capital employed which also, in effect, pays an additional dividend that comes in the form of increased standard of living-not only for you but for society on the whole. That is, one dollar lent is worth much more than one dollar held idle. Many people come to understand this in terms of compound interest, but there is another way to think about this which is much more intuitive and relevant to our current financial crisis.

The million-dollar loan was put into circulation via the enterprising individual who used the money to expand the workforce of his profitable manufacturing facility. The $1 million then is transferred from the lender to the manufacturer or borrower and then from manufacturer to laborers. The laborers in turn use their wages to purchase the necessities of life, spending their income at (for example) the general store. The general store receives the laborers wages, which from the store's perspective are sales. The store’s sales are used to replace products sold in the normal course of business and to pay wages to its employees. Naturally the stores suppliers earn revenues as the laborers buy their products from the store.

However, remove the $1 million from circulation, and you reduce the manufacturing facilities workforce, which reduces output, which decreases the general stores inventory turnover, which reduces the supplier sales, which reduces the employment and production of the supplier, which on the whole reduces the population's purchasing power and wealth. Since we were expanding, not shrinking, this trickle-down effect played a positive role in the progress of this country over the last 100-150 years. That's partly because we had low levels of unemployment and modest growth in per capita GDP. Things would have turned out much differently had our government failed to address the depression appropriately.

What’s the Best Policy Going Forward?

I don’t know, but I’ll offer one suggestion that may help us avoid an undue amount of pain. I have heard many valid arguments against government spending, however we must realize that not all spending is considered equal. One of the roles of our government should be to help keep US internationally competitive. We are slowly losing this battle largely due to our much higher labor costs and trade imbalances. This isn’t likely to even out any time soon. One of the major costs to American businesses and individuals is the cost of energy. These costs are certain to rise in an inflationary environment. If we can focus our energy on developing a real long term solution to our energy needs, we will effectively avoid prolonged high interest rates and the subsequent decline that would likely follow.

A solution does not entail supplementing gasoline with ethanol or other biofuels. A solution would be one that provides us with a net benefit. That is the energy produced must exceed the energy expended. The most obvious of such source is the sun, since we wouldn’t have to expend any energy at all. The only argument against this is not a good one. We need only an efficient solar panel and a lens to focus the sun’s energy. (Boeing currently has the most efficient panel-40% efficient without the interference of the earths atmosphere.)

There is a three-fold benefit to such a solution. Energy costs will decline for both individuals and businesses. Individuals will have additional discretionary capital or savings and businesses will have reduced costs of production, which would make us internationally more competitive in many respects. We would also find our trade imbalance greatly reduced, for reasons I think are obvious. America possesses a great deal of the world’s intellectual power. Due to the current financial crisis, many find themselves unemployed. I think we’d all be better off if engineers spent their time trying to construct a much needed efficient solar panel instead of engineering financial instruments that we certainly do not need.

The Benefits of Slight Inflation:

Inflation benefits borrowers of long term duration since the borrower is paying back principal with cheaper dollars. If the money being lent is largely held by or lent by wealthier individuals, then it may be said that the wealthier individuals suffer more during inflationary times. But this is not entirely true since they may also have equity interests that take advantage of increasing prices and the increased production and high employment tends also to enhance everyone’s standard of living. During deflation however, everyone suffers as productive assets and otherwise liquid capital turn idle, people lose jobs, consumption declines, and with it a countries wealth both absolute and relatively. The benefits of reasonably increasing production over time are indisputable. It is in everyone’s interest: rich and poor, private and public, domestic and foreign to cooperate and to put and keep people employed.

Comments

[whidbey:]

Hardly worth the trip since it is trivial at best and questionable in key parts. What was the goal?

Jul 09 10:23 AM

[Pat C:]

This is very well written - the President needs this to inform the rest of us in plain english. On the energy front, I truly believe we need to explore the issuance of stock rather than debt (which we are running out of) to finance this worthwhile economic and social goal. I can hear the conservative's going wild over such an idea but, we need to explore all the financial alternatives just as we would if we were running a business.

Jul 09 10:25 AM

[biomedlives:]

"I think we’d all be better off if engineers spent their time trying to construct a much needed efficient solar panel instead of engineering financial instruments that we certainly do not need."

I agree, and therefore I don't worry about the possibility that stiffer regulations will slow down "financial innnovation."

Jul 10 09:42 AM