The problems of compound interest
Mike Lewis and Pat Conaty:
"Compound interest rates have a huge impact on our lives, socially, economically, and environmentally.Yet this issue is seldom discussed let alone analyzed.The sheer mathematical facts reveal what the compounding of interest over short intervals does to governments, small businesses, and households for the benefit of global banks. In ordinary circumstances, a debt at 3% compound interest will double in 24 years; at 6% will double in 12 years; and at 12% will double in 6 years.Thus with a variable rate interest on a 25-year mortgage, homeowners frequently pay three to four times the sum they borrowed in the first place. If payments are missed, penalty charges, default fees, and interest charged on interest can escalate costs higher still.'
The Latin origin of the word“mortgage” –“grip of death” – spells out the dangers that the debt treadmill involves.The more people owe creditors, the more they have to work to pay it off. Forty years ago, mortgages were mainly paid by one wage-earner.Now it takes two earners to keep pace with the treadmill.
Additionally, over the past three decades deregulation of credit has led to a free market in high-risk borrowing and lending.Mortgages, once limited to three times the household income of the borrower, catapulted to 5-6 times income.
In the U.S. even these multiples were disregarded in the run up to the credit crunch of 2006.“Ninja lending” practices were rife, advancing mortgages to households with“no income, no job and no assets.”
Just as disturbing has been the increase in the average working week over the past 20 years.Not coincidentally, this rise has coincided with a rise in the debt-to-income ratio of British households to the highest in the world and in history (about 180%). The evidence in Britain indicates that shopping and convenience foods serve as a relief from debt-related overwork. Insidiously, debt drives people to work longer and consume more, and thereby generate even more debt and less time.
For such reasons, religious laws have proscribed usury making money out of money for over 4,000 years.The legalization of usury has been comparatively recent.Until 1977 the maximum legal interest rate in Britain was 48%.
Now payday lenders on commercial strips in London and Manchester legally quote annual charges of 1500-2000%. The past 40 years of globalization has been described as the era of “financialization” because of the colossal growth in the influence of global banking on the world’s economy. From the 1960s to 2005, a period of growing government and household indebtedness in the U.S.A. and Britain, also witnessed an increase in the share of the financial services industry in total corporate profits from about 10% to 35%.
Debt-driven growth is unsustainable not just from a micro-economic perspective; it is undermining the real economy.
Debt, manufactured by banks without the backing of real assets, and inflated over time through the“magic of compound interest,” redirects the wealth created by people working in the productive economy to creditors in the form of interest payments.
Margrit Kennedy’s research in the 1980s confirms how the cost of compound interest is embedded in the cost of living throughout the German economy.
Her analysis suggests that up to 50% of the costs of essential goods could be traced to compound interest: 12% of the cost for rubbish collection and 70% in the case of public housing, two of many examples she cites.The result is a significant inflation of the cost of living and increasing income disparity.
Researcher Helmut Creutz affirms that interest payments in 2000 represented at least a third of the expenditures of every German household (over three times what they paid in value-added tax), constituting a massive daily transfer of wealth to the 10% of households that own most of the nation’s interest-bearing assets.This mechanism is also responsible for the fact that the growth rates of Germany’s GDP (600%) and net incomes (300%) between 1950 and 2000 were completely outdistanced by that of its money supply (2600%).
The steadily rising ceiling on permissible lending rates (or in the case of the U.K., the lack of any ceiling whatsoever) accelerates this process. In the U.S., more than one in four low-income households spends over 40% of its income to service debts. The deregulation of the credit markets in the U.K. and the U.S. has led to a proliferation of fringe banks that can legally charge fees ranging from 80% for secured pawnbroker loans to as much as 2000% for payday loans. Sub-prime mortgage lenders charge fees that for centuries would have been regarded as extortion.
The social costs of compound interest continue to mount. In the U.K. housing foreclosures were over 40,000 in 2008 and are projected to rise to over 100,000 in 2011. In the first quarter of 2009 bankruptcies and personal insolvencies reached an all time record in the U.K. Are there interest-free financing mechanisms that can enable households and communities to return a measure of sanity to the financing of basic needs? Might credit unions and social banks internationally learn from such an approach?" (makingwaves volume 20, number 3 52)
Compound Interest and the 2008 Meltdown
"The political fight in nearly every economy for thousands of years has been over whose interests must be sacrificed in the face of the incompatibility between financial and economic expansion paths. Something has to give, and until quite recently creditors have lost. This is the point that modern economists and futurists fail to appreciate. Financial claims run ahead of the economy’s ability to produce and pay. Expectations that interest payments can keep on mounting up are “fictitious,” as Marx and other 19th-century critics put it. When indebted economies and their governments cannot pay, bankers and investors call in their loans and foreclose.
Why isn’t this the starting point of modern economics? As Herbert Stein famously quipped: “Things that can’t go on forever, don’t.” The accrual of savings (that is, debts) is constrained by the economy’s inability to carry these debts. Recognizing that no society’s productive powers could long support interest-bearing debt growing at compound rates, Marx poked fun at Richard Price’s calculations in his Grundrisse notebooks (1973:842f.) incorporated into Capital (III:xxiv). “The good Price was simply dazzled by the enormous quantities resulting from geometrical progression of numbers. … he regards capital as a self‑acting thing, without any regard to the conditions of reproduction of labour, as a mere self‑increasing number,” subject to the growth formula: Surplus = Capital (1 + interest rate)n
Individuals found it difficult to make use of the compound interest principle in practice. Peter Thelluson, a wealthy Swiss merchant and banker who settled in London around 1750, set up a trust fund that was to reinvest its income for a hundred years and then be divided among his descendants. His £600,000 estate was estimated to yield £4500 per year at 7½ percent interest, producing a final value of £19,000,000, more than thirty times the original bequest.
Thelluson’s will was contested in litigation that lasted 62 years, from his death in 1797 to 1859. Under William Pitt the government calculated that at compound interest even as low as 4 percent, the trust would grow so enormous as to own the entire public debt by the time a century had elapsed. This prompted legislation known as Thelluson’s Act to be passed in 1800, limiting such trusts to just twenty‑one years’ duration. By the time all the lawyers were paid, “the property was found to be so much encroached on by legal expenses that the actual sum inherited was not much beyond the amount originally bequeathed by the testator.”
But the savings of the living have continued to mount up. The banker Geoffrey Gardiner observes that in the late 1970s, “the burgeoning oil revenues of the producers were further gilded by the addition of high interest earnings. At their highest British interest rates had the effect of doubling the cash deposits of the oil-producers in only five years, or 16.3 times in twenty years! … The wisdom of an earlier age, which had led to the passing of ‘Thelluson’s Act’ to discourage the establishment of funds which compounded interest indefinitely, had been forgotten.”
In his famous essay on usury, Francis Bacon observed: “Usury bringeth the treasure of a realm into few hands, for the usurer, being at certainties, and the other at uncertainties, in the end of the game most of the money will be in the box, and a State ever flourisheth where wealth is more equally spread.” The French socialist Proudhon echoed this basic principle in 1840, in his axiom that the financial “power of Accumulation is infinite, [yet] is exercised only over finite quantities.” “If men, living in equality, should grant to one of their number the exclusive right of property; and this sole proprietor should lend one hundred francs to the human race at compound interest, payable to his descendants twenty-four generations hence, – at the end of 600 years this sum of one hundred francs, at five per cent., would amount to 107,854,010,777,600 francs; two thousand six hundred and ninety-six times the capital of France (supposing her capital to be 40,000,000,000, or more than twenty times the value of the terrestrial globe!” Hopes to increase human welfare through higher economic productivity would be stifled, Proudhon warned (in good St. Simonian fashion), if the self-expanding power of interest-bearing claims were not checked by policies to replace debt with equity investment.
The moral is that no matter how greatly technology might increase humanity’s productive powers, the revenue it produced would be absorbed and overtaken by the growth of debt multiplying at compound interest.
Every country has seen its ratio of debt to national income rise in recent years. Most bank credit – some 70 percent – is for real estate mortgages, reflecting the fact that real estate remains the economy’s largest asset even in today’s industrialized world. These loans increase the volume of debt attached to the economy’s property and income streams. Also rising are corporate debt/equity ratios. Bankers begin to extend credit against what they project that property prices will be worth in the future, given current rates of asset-price inflation. The dependence on credit increases the debt burden.
Minsky described this as the third and final “Ponzi” phase of the financial cycle. The term was coined to describe Carlo Ponzi’s practice in the 1920s of promising much higher returns to investors than they could earn elsewhere. He pretended to make arbitrage gains by buying international postage stamps and cashing them in for different currencies, profiting from shifts currency values that were not reflected in the International Postal Union’s price policies. In reality, he didn’t use the money for this purpose at all, but simply repaid early subscribers to his scheme out of money that new investors were putting in, believing that his high payouts to early investors reflected actual trading gains.
It seems ironic at first glance – but quite logical when one stops to think about it – that the largest and presumably most secure borrowers are the first that are able to enter into this “Ponzi” stage of being able to most easily add the interest onto their existing debt balance, year after year. The irony is that precisely by being so large and prestigious, the leading classes of borrowers tend to become insolvent faster than anyone else: the U.S. Government, foreign governments, real estate investors, and the biggest banks.
The world’s largest borrower is the U.S. Government. Its debt now amounts to some $— trillion. It has been built up by running budget deficits – at first for military spending, and since 1980 by slashing taxes on the higher wealth brackets, which have become the largest backers of political campaigns. One could say that instead of taxing the rich as formerly in accordance with the philosophy of progressive taxation, the government now borrows from them and pays them interest.
Most of the growth in America’s public debt since the nation went off gold in 1971 has not been financed by U.S. savers, but by foreign central banks, which find themselves flooded with dollars thrown off by America’s foreign military spending and widening trade deficit. The problem is that after central banks agreed in 1971 to stop settling balance-of-payments deficits in gold, the only alternative seemed to be to keep their central-bank reserves in the form of loans to the U.S. Government, recycling their balance-of-payments surpluses by buying U.S. Treasury bonds. America’s foreign debt has soared far beyond its ability to pay in any foreseeable future, even if its politicians were willing to do so (which they are not).
One result is that despite the fact that most Asian and European voters oppose the U.S. invasion of Iraq and related global military buildup, the international financial system has been set up in a way that obliges foreign governments to finance it. In fact, the United States is running up about $50 billion in interest charges each year to countries such as China – and simply adds this amount to the bill it owes.
This is how Brazil and other Latin American governments operated in the financial sphere before the Third World “debt bomb” exploded in 1982 when Mexico teetered on the brink of default. Each year they would ask the international bank consortium to lend enough more to cover the interest falling due – in effect, to add the interest onto the loan balance. Their debts grew at compound interest, doubling and redoubling exponentially every ten to twelve years at the then-normal annual interest rate of 6 to 7 percent. In effect, banks were paying interest to themselves, using Third World debtors as vehicles in what was becoming an increasingly fictitious global economy. It was fictitious because there was no way that the debts really could be paid. They had grown beyond the point where this was feasible economically, to say nothing of politically.
For governments less powerful than the United States, the price of getting the world’s commercial banks to keep rolling over their loans was to submit to strict political conditions laid down by U.S. diplomats. To qualify as a “good client,” third world debtors had to pursue deflationary monetary policies laid down by the International Monetary Fund and trade-dependency policies dictated by the World Bank. These programs made their trade balance worse and worse, thereby preventing them from working out their debts in practice. This made the global economy increasingly polarized and unstable.
Lending to these countries resumed after §990 to debtor governments that agreed to obey creditor demands that they pay their debts by selling off their public enterprises and national infrastructure. These sales led to much higher prices charged for basic services, impairing their competitiveness and hence making a future international debt crisis inevitable once again.
After governments, the leading borrowers are real estate investors. They have followed the same strategy as Third World governments, and bankers have been equally facilitating. Speculators keep ahead of the game as long as property prices increase at a higher rate than the rate of interest charged by the banker, so that they can sell their asset at a capital gain. The idea is to use “other peoples’ money” – or more accurately, bank credit – which is created electronically rather than representing savings that people have built up.
Bankers succumb to a bubble mentality, going so far as to make “negative mortgages” – debts that are not paid off at all, but keep adding the accrual of interest to the debt burden. Investors buy real estate and other assets by taking out loans so large that the revenue their collateral generates does not even suffice to carry the interest charges, not to mention paying down the principal. But real estate has become so important to their bankers that when their rental income fails to pay the interest charges falling due, most bankers are willing to be patient and simply let the debt service mount up. The interest that falls due is simply borrowed – in effect, added onto the debt in an exponentially rising curve.
The hope of lenders and borrowers alike is that the latter can sell their homes or office buildings at a high enough price to cover the mortgage charges and still keep a “capital gain” (mainly the land’s site value beneath these properties) for themselves. Well-meaning academics and journalists with the usual array of prestigious credentials are hired to explain that all this adds to “capital formation” and “wealth creation,” and hence should be taxed at only half the rate at which earned income – wages and profits – is taxed. This tax favoritism for debt-financed speculation shifts the fiscal burden onto labor and industry.
But real estate prices may plunge when the debt overhead grows too large, leaving property owners with negative equity. Many simply walk away from their property, leaving the banks holding the bag – a portfolio of bad debts. This may leave banks with negative equity if they owe more to their depositors and other creditors (other banks, the government’s central banks, holders of their own bonds and commercial paper) than their portfolio of loans is worth.
This was the point at which Citibank and Chase Manhattan were said to be in back in the credit crunch of 1980. They saved themselves by explaining to financial officials (mainly their own former managers) that their failure would cause such widespread dislocations that it would bring down the economy, if not the government currently in office. They were deemed “too big to fail,” and were allowed to rebuild their asset base and capital reserves by holding the interest rates that they charged for consumer loans high – around 20 percent – throughout the 1980s and into the 1990s, even as normal interest rates plunged to 5 percent.
For the economy at large – for businesses and individuals lacking the economic clout to keep the banks letting their interest arrears mount up – most borrowers are dependent on the banking system’s own expansionist ambitions. The result is a confluence of interest that makes the entire economy look like a Ponzi scheme. The largest banks for their part claim that they are “too big to fail,” much as the U.S. Government has told foreign central banks and other dollar holders. The greatest need for such operations is enough new members to put in enough new money to pay investors who want to “cash out” and realize the return that has been promised. In this case the bankers play the role of demanding money – by stopping the practice of lending borrowers the credit to pay their interest charges.
“Ponzi borrowers” need their assets to rise steadily in price so as to keep refinancing their debts at high enough levels to cover the interest that accumulates. This exponential growth becomes more and more difficult to achieve. Defaults occur if assets fail to appreciate or begin to lose value. This leaves investors in such schemes – and ultimately, banks themselves – holding the bag. That is what occurred in Japan after 1990, and in the United States in 2007. It is the third and final stage of credit flaming out. And as F. Scott Fitzgerald put it, flaming youth ends when there is no more money to burn.
The largest economic sector is real estate, and it remains the key to any economy’s long-term dynamics. The U.S. real estate bubble of the late 1990s and early 2000s illustrates a repertory of tactics employed by the central bank to inflate asset prices. Three tactics are classic: (1) lowering interest rates; (2) stretching out debt maturities; (3) reducing the amount of money (“equity”) that asset buyers must put down. As Alan Greenspan recommended, homeowners borrowed against the rising market price of their real estate to maintain consumption levels that their earnings no longer were sustaining. [CHARTS]
As the financial sector becomes richer, it translates its economic power into political power, backing lawmakers who shift taxes off property and finance onto labor and industry, depressing the domestic market. Indeed, financialization requires the economic process to be increasingly politicized in order to keep evolving. Recognizing that the growth of debt entails tightening bankruptcy laws independent from democratic oversight and control, and indeed actively militates against it, the financial sector’s political lobbies and their academic cheerleaders demand that central banks be made independent from democratic political overrides.
I almost hesitate to use the term “parasitized” in an academic analysis, but biology provides a repertory of how the financial sector works to take over the economy’s policy-making. I use the term “parasitic finance” to explain how the financialization process intellectualizes itself. The strategy of parasites in nature is not simply to drain their host’s nourishment for themselves, but to take over its brain – its “planning function,” so to speak – so that the host imagines that it is feeding itself while actually it is nourishing and protecting its free rider.
Financialization transforms economic thought itself, including the economy’s statistical self-portrait. The classical 19th-century economists would have viewed it as an unproductive distortion of the “real” economy of industry, agriculture and commerce. Such a value judgment needs to be changed (“modernized”) in order for financialization to promote the idea of asset-price inflation as “wealth creation” for the population at large to make them willing and even eager to go deeper into debt in the belief that this is the easiest path to wealth, conceived as a positive net worth of inflated asset valuations relative to debt. But the financial sector’s rake-off is described as “providing a service,” not as a zero-sum transfer payment.
The bursting of America’s financial bubble not only wiped out much financial capital and savings, it also extinguished much of the pseudo-academic Junk Economics that rationalized the bubble economy’s asset-price inflation as “wealth creation.” Behind the overvaluation of property lay a belief that inflating prices for real estate and corporate stocks added as much to the wealth of nations as creating new fixed capital. What had been welcomed as a postindustrial economy turned out to be the kind of rentier economy that classical economists and Progressive Era reformers had tried to replace with a market free of the kind of “wealth formation” that the Federal Reserve sponsored for more than two decades. After Mr. Greenspan he left the Federal Reserve Board in 2006, his two-term tenure as cheerleader for encouraging irrational exuberance in the real estate market was seen to have built up fictitious wealth – paper valuations which collapse after 2006, leaving intact the debts that had been run up. His reputation as “maestro” turned to that of Bubblemeister.
How could economists and government officials ever have believed that the exponential growth of debt and asset prices could go on without constraint? If it is true that “a trend that can’t go on forever, won’t,” then what were the factors that bring such trends to an end?
For one thing, a rising debt means more income devoted to interest, amortization and other financial charges, not a demand for goods and services. And the higher property prices and stock prices were inflated, the more debt homeowners and corporate raiders had to take on to acquire these assets. One of the problems suffered by Ponzi debtors is that they no longer can afford to keep up their living standards. Market demand shrinks, constraining corporate profits. Price/earnings ratios rise even further, lowering the yield of dividends accordingly. This means that it costs more and more to purchase a retirement income – and part of the Greenspan financialization process was to pay Social Security (and health insurance) out of the income stream projected for prior savings. Higher capital gains meant lower yields of interest and dividends. The bubble economy thus had internal contradictions over and above the behavioral tendency for stability and good times to breed an overly optimistic financial instability.
One form of tortured logic was the idea of reversing the early Internal Revenue Service practice of taxing capital gains as normal income, on the ground that it increases the recipient’s balance sheet in the same way as earning income and saving it. John Stuart Mill expressed the classical idea of taxing the rise in land prices on the ground that it was an “unearned increment.” Post-classical thought tried to construe these gains as being earned – e.g., by “waiting” – yet simultaneously argued that they were really income at all and hence should not be taxed. Failure to tax such asset-price gains leads investors to speculate rather than to invest productively.
Another victim was the misnamed neoclassical school of thought – misnamed because it actually set out to replace classical political economy’s definition of cost-value in terms of the technologically necessary costs of production. Post-classical price theory adopted a pragmatic accountants’-eye view that focused on whatever out-of-pocket expenses were incurred by current buyers and operators of enterprises, even when these were loaded down with debts, exorbitant executive salaries and stock options, high rates of dividend payouts at the hands of “shareholder activists” (the new euphemism for corporate raiders), inflated property prices and patent fees – the institutional property and financial overhead that classical economists had termed economic rent. The distinction between cost-value and market price that formed the core of classical economics was lost.
The most blatant misnomer was “neoliberalism.” Classical liberalism sought to free markets from rentier claims for unearned income – landrent, monopoly rent and financial overhead. To neoliberals, a free market was one “free” of government regulation – a market where predatory finance and extortionate monopoly pricing had a free hand to engage in zero-sum exploitation of the economy at large. For pension and Social Security funding, new taxes and other rules are needed to force “savers” to contribute, however unwillingly. This was the kind of forced saving that the democracies of the 1930s had criticized when it was practiced only by Nazi Germany and Stalinist Russia.
The public domain and its natural monopolies were being privatized on credit. This raised the price of basic infrastructure services, without necessarily increasing their quality or supply – and often doing just the opposite. So the philosophy of privatization – and the ideology that economies did not need government – became another victim of the bubble economy. The concept of a mixed economy with mutual checks and balances, with the government providing basic infrastructure at cost to minimize the economy’s price structure while taxing away economic rent and the “free lunch” was lost. Neoclassical and neoliberal economics denied that there was any such thing as a free lunch – although that was what the post-industrial economy’s wealth-seeking was all about.
Instead of the industrial economy that economic futurists around the turn of the 20th century had anticipated, a neo-rentier economy emerged. It was driven not by what the classical economists called productive loans – those that provided borrowers with the means to earn the revenue to pay off the loan with its interest charges, and still keep normal profit for themselves by creating new means of production – but increasingly by predatory credit, above all by loans extended simply to enable buyers to bid up prices for assets already in place.
A rising proportion of debts cannot be paid, including government debt (especially foreign debt), real estate speculation, corporate takeover debts and many personal debts. The economy’s shape changes as debtors default, creditors foreclose and governments are forced to privatize the public domain as an alternative to defaulting or repudiating their debts outright. All this is called a “free market,” as if the only form of economic freedom is from government.
It would better be viewed as a free lunch for the financial and property sector. It is a travesty of the historical idea of liberty from the third millennium BC through classical antiquity, when the meaning of liberty connoted primarily freedom from debt bondage. This is the liberty to which early Judaism and Christianity referred. It survives in the inscription on America’s Liberty Bell in Philadelphia from Leviticus 25: “Proclaim liberty throughout the land, and to all the inhabitants thereof.” The Hebrew word corresponding to “liberty” in this inscription was d’r’r (deror), cognate to Babylonian andurarum, the word rulers used for Clean Slates. These royal proclamations comprised three interrelated policies: cancellation of personal debts, freedom for bondservants who were pledged to creditors as collateral to return home to their families of origin, and return to their customary holders of land and crop rights that had been pledged to creditors as collateral. Viewed in this long-term perspective, financial freedom for government means the right to infringe on the liberty of debtors and indeed, entire debtor economies.
The U.S. economy’s fate threatens to go far beyond a “Minsky moment” in which markets crash to wipe out the overhang of speculative debt. Creditor interests have turned their economic power into political power and shift taxes onto labor and industry, off the financial sector and its major customers (real estate and monopolies), even as the economy leaves the stage of asset-price inflation and enters the negative-equity stage in which the debts attached to much property, many companies, financial intermediaries and money management firms exceed the post-inflationary market price of the assets collateralized (“financialized”) by this debt.
The reverberations of financialization radiate outward from the U.S. financial sector to the fiscal system (the Treasury’s tax policy, cutting taxes on finance and on property income pledged to pay interest overhead), global diplomacy (suspension of the balance-of-payments constraint on the central bank’s ability to cut interest rates), economic theory, and the statistics which reflect the categories of economic theory." (http://michael-hudson.com/2007/08/why-the-%E2%80%9Cmiracle-of-compound-interest%E2%80%9D-leads-to-financial-crises/)
Hazel Henderson: Compound Interest in the context of Abstract Economics
"In The Politics of the Solar Age (1981, 1988), I warned that compound interest violated the Second Law of Thermodynamics:
“Much confusion arises because economics inappropriately analogizes from some of these models from the physical, social, and biological realms. For example, the best example of a “runaway” can be found in the hypothetical model that economists have imposed on the real world: compounded interest. Here, they have set up an a priori, positive feedback system (based on the value system of private property and its accumulation), in which the interest earned on a fixed quantity of money (capital) will be compounded and the next calculation of interest added on cumulatively. But this “runaway” accumulation process bears no relationship to the real world – only to the value system. However, it has profound real-world effects if enough people believe it is legitimate and employ lawyers, courts, etc., to enforce it!” (p. 228)
I also pointed out that Frederick Soddy, Nobel laureate in chemistry, decided that economists’ dangerous drift into pseudo-scientific abstraction must be halted before they destroyed industrial societies, because their uninformed ideas contravened the first and second laws of thermodynamics. (p. 225)
The mathematical fantasy that money is wealth and can reproduce itself is revealed again in the US housing and foreclosure crisis. Money is a useful information system for tracking our use of nature’s resources and scoring the games we humans play, but it gradually became mistakenly equated with the real wealth of nations. Similarly, too often economists and politicians describe money flows in economies as analogous to the human body’s circulatory system. Yet human blood’s hemoglobin cells do not charge money or interest for the life-giving oxygen they deliver to every other cell in our bodies.
Charging interest for lending money was frowned on by our ancestors and considered a sin in Christian, Judaic as well as Islamic and other religious traditions. This view survives today in Sharia finance where lending at interest is shunned in favor of requiring the investor or creditor to share risks of any enterprise with the entrepreneur.
Generations of scholars since Aristotle’s treatises on “just prices” have examined the myths and human experiments in creating money and systems of exchange, from mutual fund manager Stephen Zarlenga’s The Lost Science of Money (2002) and Prof. Margrit Kennedy’s Interest and Inflation Free Money (1995) to lawyer Ellen Brown’s Web of Debt (2007). In my Creating Alternative Futures (1978), I posed the question: Is there any such thing as profit without some equal, unrecorded debt entry in some social or environmental ledger or passed on to future generations? My answer was “yes,” provided all costs of production were internalized and thermodynamic, not economic, measures of efficiency were calculated.
The mismatch is between the real-world economies, where real people grow food, make shoes, clothes, shelter and tools in real factories, versus the human mind’s tendencies toward abstraction. Understanding the real world in which we live requires us to recognize patterns and to abstract reality into mental models. The map is not the territory, as we have been reminded by many epistemologists. The danger is that we routinize our perception through these models, forgetting the need for constant updating and course-correcting as conditions change around us. Thus our mental models are memes that crystallize into habits, dogmas and outdated theories such as those in conventional economics and finance. These led to collective illusions: about “efficient markets,” “humans as rational actors” and the lure of “compound interest” that still guide the decisions of too many asset managers. New models of triple bottom line accounting for environmental, social and governance (ESG) have been adopted by responsible investors and institutional investors, including those engaged with the UN Principles of Responsible Investment, managing $22 trillion in assets. The current US mortgage and foreclosure mess provides a new teachable moment where we can re-examine the obsolete beliefs still at the core of economics and now refuted by physicists, thermodynamics, endocrinologists, brain and behavioral scientists.
The computerized efficiency of digitizing mortgages for rapid securitization in the Mortgage Electronic Registration System (MERS) is at the root of the foreclosure and toxic assets dilemma. We must examine how computers when introduced into Wall Street, financial and housing markets drove economic theories further into mathematization, led by the Arrow-Debreu modeling of national economies in the 1960s, beyond earlier attempts by Leon Walras. Bank of Sweden Prizes in Memory of Alfred Nobel were given to Arrow and Debreu and others for mathematical models inappropriately applied to economics and finance. Similar mathematical models on which economists still rely, accept Arrow-Debreu’s assumption of a process of “market completion” where markets could be extended to enclose ever more of the global commons: air, carbon emissions, water, forests, biodiversity, ecological assets and their productivity which supports all life. The newest commons are global communications infrastructure, the internet, the electromagnetic spectrum and space, all of which required massive public investments and underpin global finance and its extensive bailouts. The report of the Global Commission to Fund the UN, The UN: Policy and Financing Alternatives, Eds. H. Cleveland, H. Henderson and I. Kaul (Elsevier Science Press, UK, 1995) proposed taxing all commercial uses of the global commons and fines for misuse, including a tax on currency speculation.
For any market to efficiently allocate resources, buyers and sellers must have equal information and power, while their transactions should not harm any innocent bystanders. These conditions identified by Adam Smith in The Wealth of Nations in 1776 are now violated everywhere due to the scale and technological reach of global corporations and finance. Examples include the earliest forms of industrial pollution and exploitation of workers to today’s toxic sludge dam failure in Hungary; BP’s Gulf oil contamination and the growing costs in lives and ecological destruction of coal mining; the Wall Street volatility due to program trading; the financial meltdown of 2007-2008; the May 6, 2010 “flash crash,” and the new revelations of US mortgage and foreclosure frauds. An ingenious enterprise, the Open Models Company (OMC) founded by Prof. Chuck Bralver at the Fletcher School of Tufts University, based on Linux principles, provides an open-source platform for global experts and critics in finance to examine the assumptions underlying derivatives and risk models – a huge help for underfunded regulators. Mervyn King, head of the Bank of England, called for restructuring beyond Dodd-Frank, Basel III and other recent reforms of today’s unsustainable “financial alchemy.” King reflects most of the issues identified by experts in our Transforming Finance statement of September 13, 2010.
The scale of industrial and financial operations become global and ever more computerized and digitized, accelerating the abstraction of management, global supply chains, risk assessment, calculations of accountants for profits and losses, strategies of national governments and central bankers using defunct models such as NAIRU (non-accelerating inflation rate of unemployment) to set interest rates, along with subsidies, tax policies, and quantitative easing to “manage” their economies. All are based on levels of aggregation in statistical indicators akin to assessing national economies while over-flying a country’s territory at 50,000 feet. The digitization of Wall Street and security analysis is cancelling out strategies for diversification of portfolios. In the post-Bretton Woods, turbulent global casino, the $3 trillion plus daily electronic trading of currencies and sovereign bonds are driven largely by speculation, credit default swaps, and high-frequency trader’s algorithms. The proliferation of electronic trading platforms, credit cards and digital payment and credit systems bypass regulatory models of governments and central banks.
Today’s ad hoc global financialization cannot be described as a system since it is still driven by the long-outdated assumptions and models in economics and the sloppy generalizations and categories that underlie economics and its theories: “capital” (not clearly defined); “growth” (GDP is the output of goods and services measured in money without subtracting social and environmental costs or adding the unpaid services in families and communities which support official paid production); “innovation” (does not distinguish between new brands of dog food, potato chips, credit default swaps vs. computer chips, gene sequencing or renewable energy); “productivity” (if measured as output per worker, this leads to further automation and technological unemployment); “free trade” (which led to the hollowing out of the US economy, outsourcing of jobs in manufacturing and services, trade deficits); “inflation” and “deflation.” Statistical illusions: CPI, “core CPI” (which excludes energy and food), drives Fed policies, Social Security, taxes as well as employment and macroeconomic policies (see www.calvert-henderson.com Current Issues).
Perhaps the most obvious policy errors were the models used by Alan Greenspan to describe the global economy in the dot.com boom and by Ben Bernanke during the period from 2003-2006 as “The Great Moderation” (economic cycles had been tamed) and then, as the global imbalances grew, labeling them “the Global Glut of Savings” (China, Japan and other countries supposedly saved too much). Instead, I and others labeled this a growing global bubble of fiat currencies, led by the US dollar, acting as a global reserve currency. The crisis was one of macro-economic management – sinking under mounting deficits, debt and compound interest, while facing growing systemic risks due to deregulation in the global casino.
Nassim Nicholas Taleb pointed out all these conceptual errors in Fooled by Randomness (2005) and The Black Swan (2007), digging even deeper into the fallacies of the human mind, including confirmation bias, herd behavior and excessive optimism verified by behavioral psychologists. Mathematician Benoît Mandelbrot warned of the limits of statistical models of probability and risk informed by Gaussian normal distribution “bell curves.” Fat tails, black swans and perfect storms entered the language, but instead of examining these human perceptual errors, they became excuses for Robert Rubin and his protégés, Larry Summers, Tim Geithner, as well as central bankers, Wall Street CEOs and asset managers – all claiming that “no one could have predicted the financial crises.” As Richard Bookstaber described in A Demon of Our Own Design (2007), Wall Street’s financial models were bound to fail." (http://www.ethicalmarkets.com/2010/11/05/real-economies-and-the-illusions-of-abstraction/)