The End of Growth: Adapting to Our New Economic Reality (15 page)

But with the crash in the US real estate market starting in 2007, household net worth also crashed (falling by a total of $17.5 trillion or 25.5 percent from 2007 to 2009 — equivalent to the loss of one year of GDP); and as unemployment rose from 4.6 percent in 2007 to almost ten percent (as officially measured) in 2010, average household income declined. At the same time, banks tightened their lending standards, with credit card companies slashing the number of offers and mortgage lenders requiring much higher qualifications from borrowers. Thus the ability of households to take on more debt has contracted substantially. Less debt means less spending (households usually borrow money so they can spend it — whether for a new car or a kitchen makeover). This is potentially a short-term problem; however, the only way the situation will change is if somehow the economy as a whole begins to grow again (leading to higher house prices, lower unemployment, and easier credit). Here’s the catch: increased consumer demand is a big part of what would be needed to drive that shift back to growth.

So we just need to get households borrowing and spending again. Perhaps government could somehow put a bit of seed money in citizens’ pockets (“Cash for Clunkers,” anyone?) to start the process. Even if that doesn’t work, at some point consumers will have paid down (or defaulted on) their debts sufficiently so that they will want to borrow more. But, again, demographics suggest this would be a long wait: as mentioned earlier, Baby Boomers (the most numerous demographic cohort in the nation’s history, encompassing 70 million Americans) are reaching retirement age, which means that their lifetime spending cycle has peaked. It’s not that Boomers won’t continue to buy things (everybody has to eat), but their aggregate spending is unlikely to increase, given that cohort members’ savings are, on average, inadequate for retirement (one-third of them have no savings whatever). Out of necessity, Boomers will be saving more from now on, and spending less. And that won’t help the economy grow. We may not have hit a hard, final, and axiomatic limit to household debt, but (in the US, at least) there is no realistic basis for a resumption of rates of growth in borrowing and spending seen in recent decades.

Corporate Debt

When demand for products declines, corporations aren’t inclined to borrow to increase their productive capacity. Even corporate borrowing aimed at increasing financial leverage has limits. Too much corporate debt reduces resiliency during slow periods — and the future is looking slow for as far as the eye can see. Durable goods orders are down, housing starts and new home sales are down, savings are up. As a result, banks don’t
want
to lend to companies, because the risk of default on such loans is now perceived as being higher than it was a few years ago; in addition, the banks are reluctant to take on more risk of any sort given the fact that many of the assets on their balance sheets consist of now-worthless derivatives and CDOs. Nevertheless, corporate debt levels hit all-time highs in 2010.

Meanwhile, ironically and perhaps surprisingly, US corporations are sitting on over a trillion dollars of ready cash because they cannot identify profitable investment opportunities and because they want to hang onto whatever cash they have in anticipation of continued hard times.

If only we could get to the next upside business cycle, then more corporate debt would be justified for both lenders and corporate borrowers. But so far confidence in the future is still weak.

Financial Sector Debt

The category of financial sector debt — which, of the four categories, has grown the most — consists of debt and leverage within the financial system itself. This category can in principle be disregarded, as financial institutions are primarily acting as intermediaries for ultimate borrowers. However, in this case, standing on principle does not aid comprehension. We are not including within this category the notional value of derivatives contracts, which is roughly five times the amount of US government, household, corporate, and financial debt combined (roughly $260 trillion in outstanding derivates, versus $55 trillion in debt). But while this category does not directly include the value of derivatives, the expansion of the financial sector has largely been based on derivatives trading. And derivatives have arguably helped create a situation that limits further growth in the financial system’s ability to perform its only truly useful function within society — to provide investment capital for productive enterprise.

One of the main reforms enacted during the Great Depression, contained in the Glass Steagall Act of 1933, was a requirement that commercial banks refrain from acting as investment banks. In other words, they were prohibited from dealing in stocks, bonds, and derivatives. This prohibition was based on an implicit understanding that there should be some sort of firewall within the financial system separating productive investment from pure speculation, or gambling. This firewall was eliminated by the passage of the Gramm–Leach–Bliley Act of 1999 (for which the financial services industry lobbied tirelessly). As a result, all large US banks have for the past decade become deeply engaged in speculative investment, using both their own and their clients’ money.

With derivatives, since there is no requirement to own the underlying asset, other than a small percentage of its notional value, and since there is often no requirement of evidence of ability to cover the bet, there is no effective limit to the amount that can be wagered. It’s true that many derivatives largely cancel each other out, and that their ostensible purpose is to reduce financial risk. Nevertheless, if a contract is settled, somebody has to pay — unless they can’t.

Credit default swaps (CDSs, discussed in the last chapter) are usually traded “over the counter” — meaning without the knowledge of anyone other than the two counterparties; they are a sort of default insurance: a contract holder acts as “insurer” against default, bankruptcy, or other “credit event,” and collects regular “insurance” payments as premiums; this comes as “free money” to the “insurer.” But if default occurs, then a huge payment becomes due. Perversely, it is perfectly acceptable to take out a credit default swap on someone else’s debt. Here’s one example: In 2005, auto parts maker Delphi defaulted on $5.2 billion in outstanding bonds and loans — but over $20 billion in credit default derivative contracts had been written on those bonds and loans. The result: massive losses on the part of derivative holders, much more than for those who held the bonds or loans. This degree of leverage was not uncommon throughout corporate America, and the US financial system as a whole. Were derivatives really reducing risk, or merely spreading it throughout the economy?

An even more telling example relates to the insurance giant AIG, which insured the obligations of various financial institutions through CDSs. The transaction went like this: AIG received a periodic premium in exchange for a promise to pay party A if party B defaulted. As it turned out, AIG did not have the capital to back its CDS commitments when defaults began to spread throughout the US financial system in 2008, and a failure of AIG would have brought down many other companies in a kind of financial death-spiral. Therefore the Federal government stepped in to bail out AIG with tens of billions of dollars.

In the heady years of the 2000s, even the largest and most prestigious banks engaged in what can only be termed criminal behavior on a massive scale. As revealed in sworn Congressional testimony, firms including Goldman Sachs deliberately created flawed securities and sold tens of billions of dollars’ worth of them to investors, then took out many more billions of dollars’ worth of derivatives contracts essentially betting against the securities they themselves had designed and sold. They were quite simply defrauding their customers, which included foreign and domestic pension funds. To date, no senior executive with any bank or financial services firm has been prosecuted for running these scams. Instead, most of the key figures are continuing to amass immense personal fortunes, confident no doubt that what they were doing — and in many cases continue to do — is merely a natural extension of the inherent logic of their industry.

The degree and concentration of exposure on the part of the biggest banks with regard to derivatives was and is remarkable: As of 2005, JP Morgan Chase, Bank of America, Citibank, Wachovia, and HSBC together accounted for 96 percent of the $100
trillion
of derivatives contracts held by 836 US banks.
²⁰

Even though many derivatives were insurance against default, or wagers that a particular company would fail, to a large degree they constituted a giant hedged bet that the economy as a whole would continue to grow (and, more specifically, that the value of real estate would continue to climb). So when the economy
stopped
growing, and the real estate bubble began to deflate, this triggered a systemic unraveling that could be halted (and only temporarily) by massive government intervention.

Suddenly “assets” in the form of derivative contracts that had a stated value on banks’ ledgers were clearly worth much less. If these assets had to be sold, or if they were “marked to market” (valued on the books at the amount they could actually sell for), the banks would be shown to be insolvent. Government bailouts essentially enabled the banks to keep those assets hidden, so that banks could appear solvent and continue carrying on business.

Despite the proliferation of derivatives, the financial system still largely revolves around the timeworn practice of receiving deposits and making loans. Bank loans are the source of money in our modern economy. If the banks go away, so does the rest of the economy (at least temporarily, until the functions of the banks can be taken up by other institutions).

But as we have just seen, many banks are probably actually insolvent because of the many near-worthless derivative contracts and bad mortgage loans they count as assets on their balance sheets.

One might well ask:
If commercial banks have the power to create
money, why can’t they just write off these bad assets and carry on
? Ellen Brown explains the point succinctly in her useful book
The Web of Debt
:

[U]nder the accountancy rules of commercial banks, all banks are obliged to balance their books, making their assets equal their liabilities. They can
create
all the money they can find borrowers for, but if the money isn’t paid back, the banks have to record a loss; and when they cancel or write off debt, their assets fall. To balance their books...they have to take the money either from profits or from funds invested by the bank’s owners [i.e., shareholders]; and if the loss is more than its owners can profitably sustain, the bank will have to close its doors.
²¹

So, given their exposure via derivatives, bad real estate loans, and MBSs, the banks aren’t making new loans because they can’t take on more risk. The only way to reduce that risk is for government to guarantee the loans. Again, as long as the down-side of this business cycle is short, such a plan could work in principle.

But whether it actually will work in the current situation is problematic. As noted above, Ponzi schemes can theoretically go on forever, as long as the number of new investors is infinite. Yet in the real world the number of potential investors is always finite. There are limits. And when those limits are hit, Ponzi schemes can unravel very quickly.

All Loaned Up and Nowhere to Go

These are the four categories of debt. Over the short term, there is no room for growth of debt in the household or corporate sectors. Within the financial sector, there is little room for growth in productive lending. The shadow banks can still write more derivative contracts, but that doesn’t do anything to help the real economy and just spreads risk throughout the system. That leaves government, which (if it controls its own currency and can fend off attacks from speculators) can continue to run large deficits, and the central banks, which can enable those deficits by purchasing government debt outright. But unless such efforts succeed in jump-starting growth in the other sectors, this is just a temporary end-game strategy.

A single statistic is revealing: in the US, the ratio of total debt to GDP has risen to more than 300 percent, exceeding the previous record of 290 percent achieved immediately prior to the stock market crash of 1929.
²²
If there is a theoretical or practical limit to debt, the US seems destined to reach it, and soon.

Remember: in a system in which money is created through bank loans, there is never enough money in existence to pay back all debts with interest. The system only continues to function as long as it is growing.
²³

So, what happens to the existing mountain debt in the absence of economic growth? Answer: Some kind of debt crisis. And that is what we are seeing.

Debt crises have occurred throughout the history of civilizations, beginning long before the invention of fractional reserve banking and credit cards. Many societies learned to solve the problem with a “debt jubilee”: According to the Book of Leviticus in the Bible, every fiftieth year is a Jubilee Year, in which slaves and prisoners are to be freed and debts are to be forgiven. Evidence of similar traditions can be found in an ancient Hittite-Hurrian text entitled “The Song of Debt Release”; in the history of Ancient Athens, where Solon (638–558 bce) instituted a set of laws called
seisachtheia
, canceling all current debts and retroactively canceling previous ones that had caused slavery and serfdom (thus freeing debt slaves and debt serfs); and in the Qur’an, which advises debt forgiveness for those who are genuinely unable to pay.