RE: The Financial Crisis 1. September 2008
Excepts from Chapter 20. "The Realm of Economy: A Search for Riches" in Hans L Zetterberg's forthcoming book The Many-Splendored Society.
The realm of the economy in a society rests on exchanging sentences that include executive evaluations such as prices and costs. Tokens to stabilize these evaluations were invented to facilitate an exchange of properties. Coins from about 6000 BC, stamped with a lion, have been found in Lydia, the present western Turkey. Coins are standardized pieces of a precious metal that trade at the value of that metal. When in olden times, household were no longer self-sufficient, they first traded for their wants in kind: exchanging cattle for cooking utensils, brides, or whatever that could be used in barters. There was an obvious advantage to using coins in such exchanges, and coins became essential to households.
With coinage, most everything — tools, produce, cattle, and slaves — could begin to receive generally known prices. Augustus put his picture, retouched to be a symbol of benevolent power, on Roman coins. This practice was how a sovereign power guaranteed to the users the weight and purity of coins. However, subsequent Roman emperors replaced increasing parts of the base metal in the coins with cheaper metals, thus "debasing" the currency, causing a general increase in prices, i.e. inflation in which too many tokens chased available products and services.
Inflation also occurred when the supply of gold increased. There was a scarcity of money in much of 14th and early 15th century Europe, driven by a decline in gold and silver production and a chronic deficit in European trade with the Levant. The Spaniards of the era who conquered and colonized South America had one overriding mission: to bring home gold. The scarcity reversed into its opposite. Gold and gold coins flooded Spain and Europe. This was a largely illusory riches due to the resulting inflation. In hindsight, this could probably have been avoided if the golden capital had been invested in productive pursuits in agriculture and manufacturing instead of in glamorous lifestyles as favored by the Spaniards. But the idea of productive investments was beyond the horizon of the economists of the day. They advised the kings that gold should be hoarded in state coffers. This mercantilism is not the only false theory that economists have brought to the world.
In the Middle Ages, Venice came to function as the principal bullion market for all Europe and the Mediterranean. Zecca, the mint of Venice, produced in successive periods the Penny, the Grosso, the Ducat, and the Soldino.
Paper instruments as tokens for coins of precious metals first developed in Venice and Genoa to finance loans to the state. Eventually foreign states, not just royal personalities and households, could become borrowers. Loans to states could be guaranteed by promising the lender a share of some tax. Special banks emerged to provide these loans and other banks came into being to manage these public debts; the latter we now call central banks .
For merchants, temporary tokens of coins in the from of financial instruments on paper also developed in Genoa and Venice. It could begin with something as simple as the arrival of German merchants to the Venice bullion market with unminted gold from their mines. They got negotiable receipts — we would call them bills or checks — from the Zecca. While waiting for the coins to be delivered they could, if necessary, use these receipts for their expenses and purchases in the city. In 1528, the mint in Venice broadened its assistance to private individuals and firms and began to pay market rates of interest on specie deposits, the so-called depositi in Zecca, a service to manage private capital.
Venice and Genoa succumbed in political strife and wars. The rest of the development of modern finance is located in Amsterdam, London, Philadelphia, and New York. For governments, raising money via bond markets became a form of deferred taxation to finance wars and infrastructures. For example, the young state of Pennsylvania raised money on the Amsterdam bourse to build canals. States need money most when they go to war. Wars have accelerated the buildup of the system for handling national debts.
The noticeable tendency in modern society to use currency as a reference evaluation also for artistic, scientific, and political achievements, is a fact that increases the pressure on the money supply.
All modern nations have developed a "square of power," to use a wording from Ferguson (2001). First, there is a tax-gathering bureaucracy, i.e. organized procurers with legal backing who claim money for use by the body politic. If necessary they use force to collect the money and they fine or imprison those who balk. Second, nations have parliamentary institutions, in the beginning not necessary based on universal franchise, that authorize taxation and also specify the state's use of the money. Consent of the governed, as represented by members of parliament, is a prerequisite for smooth tax collection. Third, there is a system of national debt, a system for delayed taxation. It has been essential to develop and maintain trust that these debts will be repaid. The state of Venice honored all its debts, but delayed payments did occur. Fourth, a central bank needs to manage this debt. This bank is a part of the state. Nowadays, however, the advanced central banks have charters that stress their independence. They are not obliged to take all instructions from the governments of the day, which often face the temptation to debase the currency, to "print money," as the saying goes.
In February 1797 war loomed between England and France. A frigate from the French fleet off Ireland landed a small number of soldiers at Fishguard in Pembrokeshire. The incident is often called "the last invasion of Britain." The alarming news travelled throughout the country. People wanted the safety of silver and gold coins hands-on, and not only as a promise on paper bank notes that, on demand, they could be exchanged for coins. An impulsive run on the country's banks occurred.
The reserves in the country banks and of the Bank of England quickly run down. Bank of England asked and got permission to suspend cash payments with coins. After February 26, the Bank would exchange only paper for paper. Paper notes of less than £5 in value, which previously had been prohibited was now printed en masse. The promise to pay in coins was replaced by a promise, or rather an unproven assertion, that the new notes were worth £1 and £2 and could be used as tender just as the old coins. This kind of monetary instrument is nowadays called "fiat money" in technical vocabulary.
To the surprise of the British bankers the new money was accepted by the public and by merchants without any serious protests. Paper money in small denominations, not backed by real precious metals, functioned in the markets! Not until 1821 was the exchange to silver and gold coins reintroduced. However, the habit of suspending gold standards at times of war continued. A suspension was also a common prerequisite for other big expenses such as taxing the economies of the Twentieth Century for the creation of state-run welfare, rather than using communitarian or market-based welfare measures.
The growth of riches in the 19th and 20th centuries is the greatest story never told in full to the rank and file of mankind. They hear more about relative poverty than about absolute riches. The expansion of wealth was not matched by an expansion of the production of gold. An increased role for paper money was inevitable. The United States was the last country to leave the gold standard. The triggering event was a US debt of about 3 billion dollars to France, that had helped the financing of the Vietnam War. In August 1971 the US government received a request that this loan be repaid in gold. Fort Knox did not have so much gold handy. President Nixon immediately took the country off the gold standard.
The fiat money took new shapes in credit cards ("plastic money,") and in electronically controlled accounts ("digital money"). The central banks learned to add (or subtract) to the total money supply by pressing the keys of a computer connected to the banking system; no need to start printing presses. In increasing numbers ordinary consumer also learned to press their computer keys, link up with their bank accounts via Internet, and do their transactions electronically.
With fiat money there is no limit to the money supply. But there is nevertheless a firm limit to the amount in circulation that has the value of money, money that keeps its value over time and space.
In several countries manufacturing and the sale of manufactured goods is no longer the main highway to riches. Purely financial transactions dominate the international flow of money; payments for imported manufactured goods and commodities come in a poor second.
Finance as a source of riches is the process of making money by means of money. It includes traditional organizations such as banks and insurance companies. A modern bank is much more than an institution that takes in, i.e. borrows, money from the public at low rates of interest an lends it to others at higher rates. Transactions other than this "interest gap" usually account for the lion's share of modern bank profits. Bankers are no longer mere Keepers of money. Banks act as Brokers for numerous financial services. Likewise, a modern insurance company is more than an insurer of households, factories, and ships. Most anything can be insured, including your health, bank account, and the bonds that depend on your mortgage payments. International networks of reinsurers spread the risks. The new financiers are Creators, innovators and entrepreneurs in riches, making money by money. They not only trade for their institution's account on financial markets. They have invented new types of monetary assets, not all of them sound ones.
In the first decade of the new millennium finance contributes about twice as much to the GNP as did manufacturing in the United States. Before the crash in 2008, bundles of consumer loans and home mortgages packaged as securities were the biggest U.S. export business. Between 2001 and 2007 a total of $27 trillion of these securities were exported, i.e. sold to financial institutions in Europe, Asia, Australia, and Africa. To buy them back would have required all of the gross national product of the United States during two years. Virtually all early issues were redeemed in good order, so this comparison with GNP is not a statement reflecting the volume in 2007. However, when the cash value of these securities became uncertain in 2007-2008, the many banks and other financial institutions on all continents that had bought them suddenly became suspected of approaching insolvency; each one knew their own situation and suspected that neighboring ones had the same or worse problem. The result was a global credit crunch.
In the ballpark of finance, bankers and insurers are a minority. In the majority are the managers of pension funds, private investment funds, endowments, and charities. Here are also special companies that handle mortgages that borrow money at low rate of interest, provide mortgages for households and firms at higher rates of interest, package these mortgages as bonds for resale, and use the proceeds for further mortgages. Here are stock exchanges, currency traders, and bond dealers. Here are the credit card companies. Hedge funds can deal in anything expressed in money, and so does the whole world of finance. The successes of these financial services has lead to the customary circle of capitalism: over-establishment in good times followed by bankruptcies in bad times.
The new world of finance has also created a bridgehead to conquer the old world of manufacturing goods and producing services. It is called private equity. With its risk prone capital private equity buys industries, restructures them, improves their efficiency so that they can be sold off within ten or so years. This process may involve paying out parts of the working capital of the acquired firms (that admittedly have often been sleepy) to the new owners. It is replaced with loans from the market. This gives private equity more working capital for new forays of acquisitions. The management of the acquired company gets a new but acceptable pressure to perform better so that that the interests on its now borrowed capital can be paid. This process is particularly profitable where social democratic ideologies promote a high taxation of the own capital of firms, i.e. what belongs to the owners, and give borrowed capital in firms break in the form of a full tax deduction of interests. In the heyday of Swedish Social Democracy this was one measure in the attempt to create a "capitalism without capitalists."
Any combination of economic values, for example mortgage documents, can be combined and packed as a "derivative" and sold as a bond (or some other type immaterial property). There is nothing sinister in this; it is a rational device to spread risks, particularly in areas where some mortgages have been issued to persons with poor credit rating. The initial package may travel as collateral and/or sales object between different financial firm to end up in an investment bank. The investment bank raises its money for this purchase by selling certificates to ordinary banks with offices on main street in any country in the world. They can offer these at various rate of interest depending of the the level of risk. For banks to accept them as part of their capital base the certificates must be stamped, not like Roman coins by the image of an Emperor, but by a rating agency such as Moody's or Standard and Poor as "investment grade," popularly interpreted as "good as gold." An insurance company may furthermore insure the bonds against default. Now the risks have really been spread on many hands. Many hands have also a claim on a part of the income from the original mortgage documents.
But the transparency of these financial assets is much reduced. The risk of defaults at the first stage of this chain may be poorly understood. When salesmen from American investment banks turn up to place a certificate in a regional or foreign bank, neither he nor the buyer may be fully aware of all the intricacies in the history and buildup of the investment product that is to be added to the capital of the buying bank. Needless to say the salesman, like everyone else in this chain, is rewarded by high bonuses. Some packing and certifying actions of derivatives may well belong in the right hand part of the semiotic square of riches, that is, among swindles.
The market in the United States for derivatives, particularly those involving mortgages, grew significantly in the new century. The commitments involved in the loan transaction of all in-between instances in these chains also grew in numbers. The title documents of these financial assets abound with Saussarian symbols, garlands of words referring to one another, rather than to something concrete. Moreover, derivatives transactions were struck privately. The market was unregulated, with no central exchange where prices and volumes were disclosed. This chaotic situation with financial instruments of poor transparency was a hall mark of the worldwide financial crisis of 2008.
Many exchanges in a market involve delays between production and delivery. This causes booms and busts. A classic example is the so called "hog cycle." Farmers who produce pork must make production decisions before they know what price they will get on the market. About 10 months elapses between breeding a sow and the slaughter of her offspring. Since a hog breeder may not know the decisions made by other producers, cumulative overreactions to very good times as well as very bad times have resulted in a cyclical pattern of production and prices. Agricultural economists show that the full cycle of the pork market takes four years:
First year: In this good year prices are above production costs and the farmers increase production. Keeping more gilts on the farm for breeding brings less pork to the market. Prices go even higher.
Second year: The increased pork brought to the market from the now larger herd of sows brings prices to a fall.
Third year: Oversupply in the market is now apparent; prices fall below all costs of production. Many producers decide to reduce their herds. Fewer gilts are retained and more sows are sold, which causes an increased amount of pork to go to the market for even lower prices.
Fourth year: Production declines and prices increase to the break-even point or better. A new cycle can start.
This kind of boom and bust for agricultural products is used as justification for the price control that are practiced in some farming countries. We find similar cycles in the markets for art, fashion, novels, styles of pop music, architecture, and for all kinds of economic asset classes. Let us consider the stock market.
The fact that firms operating on markets also put themselves on a market is an ultimate crown of the market economy. The stock market takes funds from owners of capital who do not immediately have use for the money and puts it into firms that lack cash to realize their production ideas. The business plans, conditions and market prospects carry different levels of risks for different firms. By spreading the stocks between firms listed on the stock market the investor tries to achieve the risk he is willing to bear. In all, allocation of capital available for investments comes into the hands of those the firms believed to have the best chances of success.
By means of the stock market, capital is allotted by decisions inside the realm of the economy, and no decisions by tribal chiefs, priests, moralists, politicians, or military strongmen are needed. Without a stock market the realm of the economy would not be independent of other societal realms. A politically planned economy would be the nearest available alternative. A stock market is thus one of the several cornerstones of a many-splendored society.
At the same time, a stock market subjects all listed firms to the booms and busts that are inherited in markets. A bust affects not only investors but employees, distributors, and customers of these firms and, if severe cases, the effects may spread to the general public.
A first scientific understanding of the nature of the flow of communication on a stock market was provided by Vilfredo Pareto, an Italian social scientist who had started out as a political economist and who contributed a great deal to economic theory. He found economics to be too limited a field to help in understanding certain “irrational” problems, among them, those that appeared in politics. In order to be rational about the irrational, he turned to sociology. He used sociology to construct typologies and theories about the spirit of the times. He used them in interpreting movements of the stock market. In 1901 he wrote a paper about the importance of the climate of opinion on the Exchange.
Whereas during the upward trend every argument advanced in order to demonstrate that an enterprise will produce money is received with favor, the same arguments will be absolutely rejected during the downward trend... A man who during the downward trend refuses to buy certain stocks believes himself to be guided exclusively by reason and does not know that, unconsciously, he yields to the thousand of small impressions which he receives to some degree from the daily economic news. When, later, during the upward trend, he will buy those same stocks, or similar shares offering no reasonably better chance of success, he will again think that he is allowing only the dictates of reason, and will remain unaware of the fact that his transition from distrust to trust depends on sentiments generated by the atmosphere around him (pp. 93-94).
What people (such as our farmers) talk about during upturns and downturns of a market is governed by the Proposition on Convergence . As Pareto had noticed, a consensus on the trend emerges rather quickly. Let us say it is an upward trend.
In meeting face-to-face associates and in absorbing the mass media we know from the Proposition on Selective Scanning that people do not observe everything, but tend to focus, among other things, on the evaluative language in use. In a market this would usually be the price. Furthermore, the Rules of Emotive and Rational Choice tells us that emotively charged symbols are observed first; in this case it may well be the number that reveals how rich you are, i.e. the current market value of your assets. The rest of he information is more or less ignored. A period of continuous upward pricing of an asset sets the focus on the daily scanned price at the expense of other information about the asset.
The traders begin to ignore shifts in the underlying realties and follow only the rising price. This is now unrestrained and is bid higher and higher. The volume of trade in the asset increases. Preoccupation in a rising market with the rising price at the expense of anything else is a defining mark of a so called "bubble."
Continues increases in the value of an asset raises the rank of the owner in his social encounters and raises his self-evaluation. For little effort and a small initial commitment of money the investor reaps big rewards. The Proposition on Emotive Sense of Justice gives the investor a sense of exuberance. At this point asset owners tend to spend more on personal and family consumption. The process in the Proposition on Rank Equilibration in Status-sets begins to work to equalize their ranks of investor and consumer, making the level of consumption more commensurate with the level of the brokerage account. Thus we get extravagance in spending during the rise of the bubble.
When prices of the bubbling asset reflect evermore the expectation of future gains in prices the equilibrium component in Gary Becker's famous definition of economics — “the combined assumptions of maximizing behavior, market equilibrium, and stable preferences, used relentlessly and unflinchingly, form the heart of the economic approach” — breaks down. Prices in financial markets no longer reflect the supply and demand in the way they were supposed to do.
Bubbles come and go. As a bubble grows, many investors are apt to say “it is different this time.” A good rule of thumb is to be skeptical of any such talk. During the IT-bubble in the 1990s the financial world was full of talk about "a new economy." It had new indices of success, for example "burn rate," the estimated number of month before new capitalization was needed. To the IT-enthusiasts in the stock market, burn rate became more of a buy signal for a company stock than profit.
The Proposition on Satiation indicates that swings that reverse opinion during a trend are an ever present possibility. They become a certainty when the talk of a trend no longer continues the string of positive novelties. Then someone with knowledge pays attention.
Only a trained participant in the market may notice the early shift in the flow of information. “This is the first ripple on the waves in many years that shows that the wind with good news from the Exchange is changing course.” This was Bernard Baruch’s comment on an annual report that mentioned a slight downturn from the otherwise high profit level maintained by a technological darling of those days, the Radio Corporation of America. (Cited from Galbraith 1964, p. ??). It was the new year of 1929, a splendid time for Wall Street where Baruch worked. He sold his shares, and thereby secured a permanent fortune of 10 million dollars. Thereafter, he became a legendary participant in discussions on New York’s park benches and an advisor to several presidents. The crash in 1929 of the overpriced Exchange on Wall Street came when even other news began to be viewed with pessimism. “Such thoughts roused first dozens, then hundreds, and finally thousands of breasts… and at last stopped the upward trend,” says Galbraith.
During a rising bubble people increasingly borrow money to invest in the uptick. After a period of such increasingly leveraged speculation in a widespread bubble, bank credits tend to become tighter. The shortage of new credits affects also other branches than the bubbling ones. When a big bubble in this way has infected the bank system, a general decline, an economic recession, is close at hand.
The bursting of a market bubble leads to a downtrend in prices that is usually steeper than the uptrend that built the bubble. At least in part, the increased steepness is due to the fact that we pay more attention to negative news than positive news according to Rules of Emotive and Rational Choice. Yet there still are days of upticks in the decline: Wall Street rose about one day in three or four during the worst months of the great depression, raising hopes of the die-hearts.
A rapid decline in the accustomed level of high assets opens the door to the Threats of Anomie. The price offered to a seller of the assets pushes some of them into the lower anomic range (Figure 14.3) and they loose their bearings. In this range the participants in a market can no longer distinguish reasonable levels of bids. In a pioneering controlled bargaining experiment only few subjects entered this stage of "panic or demoralized behavior" and "rapid and complete concession" (Siegel and Fouraker 1960, p. 82). One can arrange follow-up experiments when these few sellers start Circular Reactions on a large scale. This would correspond to an economic bust in real life that ends in a "capitulation" on the exchange when a large crowd throw in their towels and sell at bargain prices. Only strong and experienced traders can stay aloof when this happens — and they pick up the bargains.
A high volume of capitulation trades is usually a mark of the bottom of a cycle. The process of boom and bust can now start all over. The end result of a cycle is that money has moved from the weak to the strong, the usual highway in a market of assets.
The market economy, as we often have noted, gives unprecedented riches to mankind. But the price is the ever recurrent booms and busts, not easy to cope with for earthlings who have a bias for status quo when they use evaluative language, including the language of money. Political movements critical of the market economy therefore become endemic in all market economies.
This is a part of the text in a chapter of The Many-Splendored Society. For the full chapter click here.