Bezemer and Hudson: Finance is not the economy

[Winehole23]

Immoderate debt creation was behind that “Great Moderation” (Grydaki and Bezemer 2013). That is what made this economy the “Great Polarization” between creditors and debtors. This financial expansion took the form more of rent extraction than of profits on production (Bezemer and Hudson 2012) — a fact missed in most analyses today (for a proposal, see Kanbur and Stiglitz 2015). This blind spot results from the fact that balance sheets, credit, and debt are missing from today’s models.


The credit crisis and recession are, therefore, a true paradigm test for economics (Bezemer 2011, 2012a, 2012b). We can only hope to understand crisis and recession by developing models that incorporate credit, debt, and the financial sector (Bezemer 2010; Bezemer and Hudson 2012). Here we provide the conceptual underpinning for this claim.

http://evonomics.com/finance-is-not-...ezemer-hudson/

[Winehole23]

The financial system determines what kind of industrial management an economy will have. Corporate managers, as well as money managers and funds, seek mainly to produce financial returns for themselves, their owners, and their creditors. The main objective is to generate capital gains by using earnings for stock buybacks and paying them out as dividends (Hudson 2015a, 2015b), while squeezing out higher profits by downsizing and outsourcing labor, and cutting back projects with long lead times. Leveraged buyouts raise the break-even cost of doing business, leaving the economy debt-ridden. Profits are used to pay interest, not to reinvest in tangible new capital formation or hiring. In due course, the threat of bankruptcy is used to wipe out or renegotiate pension plans, and to shift losses onto consumers and labor.

[Winehole23]

To explain how the bubble economy’s debt creation leads to debt deflation, we distinguish between two sets of dynamics: current production and consumption (GDP), and the Finance, Insurance and Real Estate (FIRE) sector. The latter is associated primarily with the acquisition and transfer of real estate, financial securities, and other assets. Our aim is to distinguish this financialized “wealth” sector — the balance sheet of assets and debts — from the “real” economy’s flow of credit, income, and expenses for current production and consumption.

In the next section, we state our case, distinguishing the financial sector from the rest of the economy, and rent from other income. It is as if there are “two economies,” which are usually conflated. They must be analyzed as separate but interacting systems, with real estate assets and household mortgage debt at the center of the bubble economy. In section three, therefore, we examine the significance of household debt. In today’s “rentier economy” this represents not real wealth, but a debt overhead. In section four, we discuss the pathologies arising from this overhead: loss of productivity and investment, with rising inequality and volatility.

[Winehole23]

Our aim is to revive the distinction between value and rent, which is all but lost in contemporary analysis. Only then can we understand how the bubble economy’s pseudo-prosperity was fueled by credit flows — debt pyramiding — to inflate asset markets in the process of transferring ownership rights to whomever was willing to take on the largest debt.


To analyze this dynamic, we must recognize that we live in “two economies.” The “real” economy is where goods and services are produced and transacted, tangible capital formation occurs, labor is hired, and productivity is boosted. Most productive income consists of wages and profits. The rentier network of financial and property claims — “Economy #2” — is where interest and economic rent are extracted.

[Winehole23]

The fiction is that all debt is required for investment in the economy’s means of production. But banks monetize debt, and attach it to the economy’s means of production and anticipated future income streams. In other words, banks do not produce goods, services, and wealth, but claims on goods, services, and wealth — i.e., Soddy’s “virtual wealth.” In the process, bank credit bids up the price of such claims and privileges because these assets are worth however much banks are willing to lend against it.


To the extent that the FIRE sector accounts for the increase in GDP, this must be paid out of other GDP components. Trade in financial and real estate assets is a zero-sum (or even negative-sum) activity, comprised largely of speculation and extracting revenue, not producing “real” output. The long-term impact must be to increase debt-to-GDP ratios, and ultimately to stifle GDP growth as the financial bubble gives way to debt deflation, austerity, unemployment, defaults, and forfeitures. This is the sense in which today’s financial sector is subject to classical rent theory, distinguishing real wealth creation from mere overhead.

[Winehole23]

It is now recognized that U.S. living standards since the 1970s have become debt-fueled, not income-supported.

[Winehole23]

Mortgages are also special in that real estate assets have grown into the largest asset market in all western economies, and the one with the most widespread participation. Following classical analysis, if every real estate asset bought on credit skims off the income of the owner-borrower, then the rise in home ownership since the 1970s has sharply increased rent extraction and turned it into a flow of interest to mortgage lenders. Securitization added another dimension to this. Not only domestic homeowners, but also global investors can participate in the mortgage market. As in a Ponzi scheme, the larger the flows of income the mortgage market commands, the longer the scheme can continue. This is a key reason for the unusually long mortgage credit boom synchronized across western economies from the 1990s to 2007.


Household mortgage loans are also unique among types of bank loans for their macroeconomic effects in downturns — that is, for their potential to increase the financial fragility of entire economies. Because of widely held debt-leveraged asset ownership, the effects of falling house prices and negative equity on household consumption are significant on a macroeconomic level.

[Winehole23]

Bank credit to the nonbank “asset” sector (mainly for real estate, but also LBOs and takeover loans to buy companies, margin loans for stock and bond arbitrage, and derivative bets) does not enter the “real sector” to finance tangible capital formation or wages. Its principal immediate effect is to inflate prices for property and other assets. Recent econometric analysis confirms that mortgage credit causes house price to increase (Favara and Imbs 2014) — and not just vice versa, as in the demand-driven textbook credit market theories.


How does this asset-price inflation affect the economy of production and wages and profits? In due course this process involves increasing the debt-to-GDP ratio by raising household debt, mortgage debt, corporate and state, local and government debt levels. This debt requires the real sector to pay debt service — a fact that prompted Benjamin Friedman (2009, 34) to write that “an important question — which no one seems interested in addressing — is what fraction of the economy’s total returns … is absorbed up front by the financial industry.”

[Winehole23]

In fact, to assess credit for its income growth potential is to miss its true function in the rentier economic system. The FIRE sector’s real estate, financial system, monopolies, and other rent-extracting “tollbooth” privileges are not valued in terms of their contribution to production or living standards, but by how much they can extract from the economy. By classical definition, these rentier payments are not technologically necessary for production, distribution, and consumption. They are not investments in the economy’s productive capacity, but extraction from the surplus it produces.

[Winehole23]

This polarization occurred largely because resources were flowing to FIRE speculation and arbitrage instead of to more moderate-return, fixed capital formation. The main dynamic was financial, not the industrial relationship between employers and workers described by socialists a century ago. It originated in the United States and spread to most industrial economies via the carry trade and other international lending in an increasingly deregulated environment. Toxic financial waste became the most profitable product and the fastest way to quick fortunes, selling junk mortgages to ins utional investors in a financial free-for-all.

Robin Greenwood and David Scharfstein’s (2012) “The Growth of Modern Finance” provides a telling empirical illustration of the transfer (rather than income- generating) character of today’s financial sector. In addition to showing that the financial industry accounted for 7.9 percent of U.S. GDP in 2007 (up from 2.8 percent in 1950), they calculated that much of this took the form of fees and markups — the quintessential transfer payments. Such charges by asset managers of mutual funds, hedge funds, and private equity concerns now account for 36 percent of the growth in the financial sector’s share of the economy, as Gretchen Morgenson (2012) reports. Finance also accounts for some 40 percent of corporate profits. But our point is that financial “profits” in the classical scheme are largely rents, not profit. They are not the same thing as industrial earnings from tangible capital formation.

[Winehole23]

An economy based increasingly on rent extraction by the few and debt buildup by the many is, in essence, the feudal model applied in a sophisticated financial system. It is an economy where resources flow to the FIRE sector rather than to moderate-return fixed capital formation. Such economies polarize increasingly between property owners and industry/labor, creating financial tensions as imbalances build up. It ends in tears as debts overwhelm productive structures and household budgets. Asset prices fall, and land and houses are forfeited.


This is the age-old pattern of classical debt crises. It occurred in Babylonia, Israel, and Rome. Yet, despite its relevance to the United States and Europe today, this experience is virtually unknown in today’s academic and policy circles. There is no perspective forum in which to ask in what forms debt growth may hurt the economy today. To start to fill the gap, we now consider what “too much finance” (Arcand, Berkes and Panizza 2011) does to the economy. It decreases productivity and investment, and increases inequality and volatility. In each of these mechanisms, the role of household mortgages is pivotal.

[Winehole23]

Much as real estate speculators grow rich on inflated land values rather than production, so financialization threatens to undermine long-term growth. Since the 1980s, the major OECD economies have seen rising capital gains divert bank credit and other financial investment away from industrial productivity growth. Engelbert Stockhammer (2004) shows a clear link between financialization and lower fixed capital formation rates.


This turns out to be finance capitalism’s analogue to the falling rate of profit in industrial capitalism. Instead of depreciation of capital equipment and other fixed investment (a return of capital investment) rising as a proportion of corporate cash flow as production becomes more capital-intensive (“roundabout,” as the Austrians say), it is interest charges that rise. Adam Smith assumed that the rate of profit would be twice the rate of interest, so that returns could be shared equally between the “silent backer” and entrepreneur. But as bonds and bank loans replace equity, interest expands as a proportion of cash flow. Nothing like this was anticipated during the high tide of industrial capitalism.

[Winehole23]

The banking and financial system may fund productive investment, create real wealth, and increase living standards; or it may simply add to overhead, extracting income to pay financial, property, and other rentier claimants. That is the dual potential of the web of financial credit, property rights, and debts (and their returns in the form of interest, economic rent, and capital gains) vis-à-vis the “real” economy of production and consumption.


The key question is whether finance will be industrialized — the hope of nineteenth-century bank reformers — or whether industry will be financialized, as is occurring today.

[boutons_deux]

"The key question is whether finance will be industrialized — the hope of nineteenth-century bank reformers — or whether industry will be financialized, as is occurring today."

Is that still a question? Like lots of other ty stuff in declining America, BigFinance, financialization are unstoppable.

Selling debt, selling risk.

Note that Trash's infrastructure plan is financialization of infrastructure, where Americans pay usage fees to unaccountable capitalist owners forever.

[Winehole23]

it probably takes another panic (read: depression) to set the table for reform.

[boutons_deux]

it probably takes another panic (read: depression) to set the table for reform.

nope, taxpayers will bail out BigFinance again, and BigFinance will get too bigger to fail.

BigFinance is one of the primary owners/operators of govt, politically impregnable.

Note that Trash/Repugs will kill all Obama's finance regs, defund SEC and IRS, effectively kill CFPB, and kill/block anything else that restrains BigFinance.

[Winehole23]

that's a plausible outcome, but it's not the only possible one just because no other ones occur to you.

[boutons_deux]

Immelt sold GE Capital

The Man Who Destroyed GE (financialization)

http://www.businessinsider.com/the-man-who-destroyed-ge-2009-3

[RandomGuy]

"It is now recognized that U.S. living standards since the 1970s have become debt-fueled, not income-supported."

But America is the land of opportunity... we need tax cuts for the wealthy. GMAFB.