In Who’s Interest?

If you arrived from some place where you had no prior information about the so-called recovery an obvious question would be: to solve which problem has economic policy been constructed?

To me there are a number of possibilities: do we solve unemployment? fix the banks? reduce the debt?

I think the answer is very clear.

The entire edifice of our policy making elite, complete with our business, media, and technocracy, has put the banking system ahead of anything else. Or rather, it has favored the past over the future.

By this I mean that the most concerted effort has been to preserving the value of assets accumulated through the years of illusion rather than assuring we have a solid foundation for building the future.

At the beginning of the crisis this was the most sensible approach: the folly of our banking system had so imperiled our entire economy that saving it was paramount. Soon after, as the tsunami unleashed by the bankers swept through the rest of the economy, and as unemployment rose dramatically, some of our policy making leaders switched towards remedial action. Hence the tepid stimulus. But very quickly after that they switched back. The presumption being that the economy needed no further help and that the huge debts piled up during the crisis were a larger threat than the ongoing damage to our future represented by the idle assets – notably our hugely underutilized workforce.

Thus we are spending our limited attention and effort on propping up the past instead of building, or rebuilding, the future.

This is just ridiculous.

Think about it: we have stopped all discussion of stimulus. Indeed just yesterday, Richard Fisher, president of the Dallas Fed, pronounced that he saw no need for any repeat of quantitative easing. It is time, he said, for us to rely on markets to heal themselves. It is not possible to be more retro. This is 1937 style talk. No wonder people are beginning to worry about a new recession. Our leadership seems to want one.

All these financial assets we are trying to protect are claims against the past. They represent loans -whether they are called bonds, loans or whatever – the proceeds of which have been spent on something. That something lies in the past. It could be something useful like a factory. It could be a bridge or a road. Or it could be a house. Unfortunately a very large portion of these claims are simply paper: they were never used to build anything or to produce a stream of future wealth. The proceeds were simply consumed, and left no future imprint on the economy at all. The funding for the Bush tax cuts is an example of this consumption debt.

The flip side of the debt is that it imposes a claim against cash flow in the future. It is a burden on our wealth going forward. This is why we are all so careful to deploy debt only when it will generate sufficient cash to offset that burden. Or at least that’s what we are supposed to do.

So the asset sits as a reminder of the past. And the liability haunts us into the future.

So there are two strategies to alleviate a debt burden. One is to allocate cash towards paying off the debt. The other is to focus on growing wealth more rapidly so that the cash flow associated with the debt is reduced as a percentage of total wealth.

The one is preserving the past. The other is building the future.

Under most circumstances there is no, or at least little, conflict between the past and future aspects of debt. Both can be accommodated within a cash flow. Those normal times are when there is sufficient stability in incomes that both interest and principal on a debt can be paid as promised.

A creditor, someone who lends, is always judging – perhaps guessing – whether such normal times will prevail. That is the essential skill of old fashioned banking. Credit analysis is paramount to preserving the value of financial assets. Misjudge and you will not be repaid in full. The asset you thought you owned turns out to be worth less. Sometimes literally worthless.

Notice that this entire process of credit judgement and then actual experience is played out through time. It is a mediation or matching of the past with the future. It is riven through with uncertainty, which is why banks lose money routinely. Losses are a normal cost of being in banking. As they are to any creditor. That’s why they charge for the money they lend. They are rewarded for their risk in the pricing of their loans or bonds. And they normally set aside an extra amount from their revenues to cover unexpected losses. Indeed, managing the level of that provision for loan losses occupies a great dal of bank management time.

So if losses are normal, and if creditors are compensated for the uncertainties they entertain in the process of lending, why are we so focused on preserving the value of their assets? Isn’t that their job? Aren’t we supposed to be focusing on the broader economy and its ability to generate future wealth?

Apparently not.

For two big reasons.

One is the obvious one. Our creditor class was inept at assessing the risk it was undertaking. It still is. It managed to delude itself by hiding within a rats nest of fancy so-called financial innovations that merely shifted risk around and did not eliminate it. To my primitive mind, risk is like energy. It is conserved within a system. You cannot eliminate risk. You simply move it somewhere else. The underlying risk of an economy is a reflection of its growth or its ability to generate real future wealth. We can set aside how to measure what we mean by “wealth” since that has no bearing on this discussion. In financial terms this boils down to whether the repayment of a bond or loan is going to rely on cash from production or from from new debt. In other words is something being put in place from which sufficient cash will flow to pay the bank back. Translated this means: are we adding to our store of productive assets? Is the economy really expanding? Are we using the cash we borrow to build assets or to fund consumption?

The crisis revealed that we used far too much past cash for consumption and not enough for asset construction. Worse: the crisis was a direct result of our use of debt to fund consumption. We became addicted to repaying debt by issuing new debt. Instead of investing we fell for the illusion that we could borrow our way int the future. Not only this, but all that innovation concentrated the risk instead of spreading it around. This intellectual failure within our financial system will become an epic tale to be retold well into the future. Awesome lemming like stupidity masquerading as Wall Street smarts.

That our creditor class persisted down this road is a mystery. The cash flowing into their pockets, and that needing to be invested, could have been allocated more wisely. Again, my old fashioned perspective on banking and all lending processes, is that asset allocation is one of the key reasons we have banks. They are supposed to have experience in allocation. That’s what they do.

But, as we all know, they blew themselves up by being awful at this core aspect of their reason for being.

Which brings me to the second main reason we are focusing on the past and not the future.

Our creditor class used its time in the years of illusion wisely. It bought influence. It dominated intellectual discourse. It swept away contrary opinion. It bullied its way into power. The creditor class has sufficient political clout, and has so persuaded our policy making elite, that it is able to divert resources from building the future, towards correcting its own errors of the past.

Almost every policy being enacted is designed to preserve the wealth of creditors.

Look at the Euro zone efforts to avoid a Greek default. Who would lose from a default? Creditors. Notably German and French banks. So we must avoid default, even if it means plunging Greeks into an age of austerity.

Look at the US and its shift away from stimulus and its focus on debt repayment. Why are we doing this? To avoid the ire of creditors – supposedly. We bailed out the banks. We are apparently not going to withdraw from loose monetary policy in favor of a harder approach. Why? To avoid inflation. Who is hurt by inflation? The creditor class.

It is this relentless focus on the past, and on protecting the wealth of creditors who accumulated assets during the bubble or illusion years, that is hobbling our future.

The classic argument is that someone who borrows has a moral obligation to repay. But that is a smoke screen. The lender has a moral obligation to perform their analysis well too. It is not the borrowers obligation to cover up the lunacy of the lender. And when the borrower is impaired by the actions of the lender there is absolutely no further obligation to repay.

This is the US situation.

Our lenders created a crisis one consequence of which was the inability of many of their borrowers to repay. Equity demands that in such circumstances the loss is shared. It isn’t all foisted on the borrower.

But that’s not the focus of our policy. We are obsessed with the past. We are obsessed with protecting the very people who created the disaster.

Which is why the immediate future looks so bleak.

It isn’t being constructed in the interest of the general public.