The basic economic problem of our time is financial.

by Michael Hudson

Exchange rates, stock and bond prices are fluctuating wildly as a result of huge waves of computerized bets on credit washing back and forth globally. This financial fibrillation is a result of transforming the character of money to make the privilege of credit creation “free” ­ and guaranteed by governments (taxpayers).  Banks can create new credit freely on their computer keyboards, borrowing liquidity from the central bank at only 0.25 percent in the United States and similarly low rates in Japan and other countries.

This free creation of low-interest credit enables banks and their large institutional customers to make economic gains in an unprecedented way: not by producing goods and services to sell at a markup (profit), but to make “capital” gains by buying assets expected to rise in price.

These assets include not only real estate and target companies in the “real” economy, but foreign currencies, and even bets on which way interest rates, exchange rates and asset prices will move. Much of this trading is done by computerized swapping in quick in-and-out deals.

The financial system and its credit creation have become decoupled from the “real”economy, even as they have risen to dominate it.

19th-century economists followed Ricardo in treating money (and hence its superstructure of credit) as “saved-up labor”. Writers in the Ricardian stream (down through the “naïve” populist economics of Henry George) treated economies as a barter system. Money was only a “veil”, a set of counters for underlying relationships of industrial capital, wage labor and landowners. But this failed to explain the buildup of unpayable bills, debts, etc.

Marx found two major sources of financial instability. The first source was in the economy’s production and distribution system, reflecting in the degree of exploitation of wage labor. The accumulation of profits saved by the industrial capitalist and other property owners would impoverish the domestic market by squeezing out too much surplus value. These savings exceed the opportunity to invest ­ or for the monetary base to support ­and shrinking markets would lead to a financial crash, approximately every eleven years.

Marx elaborated a second source of instability in Vol. III of Capital (and in his notes for Book III of his posthumous Theories of Surplus Value). That was the savings and debts to mount up at exponential rates ­ the “magic of compound interest”.  Marx described this as a purely mathematical law of doubling times for financial capital, decoupled from the “real” economy and its employment functions that he analyzed in Vol. I of Capital.

Today’s “free credit” distortion was not anticipated by the 19th-century classical economists.

Prior to World War II, economists integrated monetary theory into classical value theory in the way that William Petty had done in the 17th century. Money ultimately was convertible into gold or silver, which had a labor cost of production. The assumption was that a pound sterling embodied the same labor for digging and refining as goods for which it would exchange.

In reality, this assumption was always shaky. It was not miners who possessed bullion, after all, but their employers. The labor embodied in these precious metals was the surplus over and above their basic subsistence needs, not their labor itself. And this surplus was taken by the owners of the mines, along with the government as taxer.

Still, there was a tangible physical monetary foundation to national banking and credit systems. Debts were convertible into bullion on demand, prior to World War I.

This monetary constraint obliged economies to operate in balance, with a minimum of debts, unpaid bills, or the purchase of assets on credit ­because the volume of bullion would not support more than a small margin over this debt.

The result was savings that enabled banks to make loans. If banks lent out more than the value of assets they held in reserve, there would be a run on them, and they would be wiped out. In fact, all banks faced a basic liquidity problem. The key to 100% reserve banking (savings banks, S&Ls, etc.) was to pay low interest rates to short-term depositors, and make longer-term loans at a higher interest rate. This margin was how banks made their money. But even so, there was a liquidity problem: A bank could not turn a three-year mortgage into immediate cash to pay depositors.This disparity between short-term debt and long-term assets aggravated financial crises.

Central banks were formed to provide liquidity in times of need, against assets of basic long-term value.

The expansive tendency of free credit is to purchase all revenue-yielding assets with low-interest debt, up to the point where interest absorbs all profit, net rental income, public tax revenue, and living standards over and above basic subsistence levels ­ and then to intrude into the economy’s “bone” and push industry, real estate, the fiscal system and labor below break-even rates. The basic dynamic at work is much like that of a real estate speculator borrowing to buy a rental property, and paying interest to the bank, hoping to keep some surplus rent for himself, and to sell the property later for a price gain (“capital”) gain, although most of the price is a rising land value and rising capitalization rate as interest rates enable larger amounts of credit to be borrowed against a given flow of income.

What appeared to be a real estate bubble during 2001-2008 was basically a financial bubble. It resulted from banks making mortgage loans on easier terms to an unprecedented degree: falling interest rates, lower down payments (down to zero), and lower amortization rates (perpetual “interest-only” loans) enabled rental income to be “capitalized” at a more highly debt-leveraged rate than ever before. The price of housing or other assets is whatever banks will lend.

The process became self-feeding. As bank loans bid up real estate prices, borrowers factored in the anticipated asset-price gain into their borrowing plans. Banks themselves made loans of over 100% of the property, expecting the inflation of property prices to enable borrowers to refinance the mortgage loan at a high enough rate to cover the interest that was due. (This is what Hyman Minsky called the “Ponzi” phase of the business cycle: when banks lent their customers enough new credit to cover the interest charge.)

Real estate speculation and hoarding thus was a function of easier mortgage loan terms, not of intrinsically rising prosperity or rental income. In fact, the purchase of speculative rental property investment in search of capital gains grew so large that rents actually declined as new buyers sought renters to cover the property¹s carrying costs and bank charges.

Likewise as property prices have crashed by 30% in the United States, rents are rising as people prefer to rent than to buy, waiting for housing prices to fall further.

So the real estate sector has become an extension of the financial sector. The result is the symbiotic FIRE sector: finance, insurance and real estate. Politically, the dominance of landed aristocracies (from the 11th through 19th centuries) was replaced by that of a financial elite. Instead of “captains of industry” becoming the leaders of industrial capitalism, “emperors of finance” became the rulers of finance capitalism.

And, unlike industrialists, their financial time frame was short-term. It was based on the purchase and sale of property at “capital” gains caused by asset-price inflation, not by extracting rent or producing profits from employing labor to produce goods to sell at a profit.

The result of this shift from industrial to finance capitalism has been to shift the character of the economic crisis away from the circular flow of income between producers and consumers (“Say’s Law”) to making gains financially in balance-sheet terms (asset-price inflation, a.k.a. “the Bubble”).