Tuesday, December 9, 2008

The Third Economy

Unfortunately, it seems that we are heading into a depression. My prediction is that the depression will begin early next year, and that it will last for at least for 2 years. I’m going to define the beginning of a depression as the point where unemployment exceeds 10% of the workforce between 18 and 65 years of age. I hope I’m wrong.

Some time has passed since the beginning of this crisis, and more can now be understood in terms of the causes behind it. Many economists have been scratching their heads, wondering why they did not see this coming. Few, however, have been publicly talking about what they actually missed. In the public mind, and in the media discussion, everything is still centered on the problem of housing. Although that is significant, it is only a result of what I believe to be the real, broader, reason behind the crisis: the creation of a shadow economy.

Traditionally, you talk about two “economies” as existing in a country: the “real economy” and the “financial economy”. The real economy is comprised of things that concern ordinary people in their daily lives, or issues that are often referred to as “Main Street” issues. The financial economy is comprised of the business of banks and other investors, known as “Wall Street” issues. The line between the two has, as everyone knows, been seriously blurred in the last few years because of ordinary people’s increasingly severe reliance on Wall Street for their well-being. This is also an important reason behind the crisis, and this reliance will make the crisis much worse on a human level.

At some point in the early 90s, the financial economy started to change. The traditional role of this industry was to provide capital for new ventures and new investments in the real economy. Capitalists would hence invest money in things that they believed would be desired by people in the real economy in the future, and would be duly rewarded if that turned out to be true. Capitalists were, in essence, rewarded for betting on the right horse. Few people argue with the wisdom of this scheme, and even Marx regarded it as a pre-requisite to his final vision.

Then came financial deregulation. Financial regulation is something that has been around for thousands of years in human societies. The idea that someone with a lot money should not be able to profit from someone who does not have a lot of money, through deception or predatory practices, has usually been among the first things articulated in law when laws first came about in Europe, the Middle East and Asia. One of the most famous examples of this is the prohibition against charging interest that long existed in Christian countries, and still exists in Muslim countries. Ancient peoples always realized that we need laws that protect us from ourselves, such as a prohibition on murder. Likewise, they understood that we needed to protect us from ourselves when it came to financial crimes.

Financial deregulation in the United States made it so that acts that were formerly defined as crimes, became defined as completely legitimate, and even greatly encouraged by the government. It’s hard to imagine a situation where physical assault is decriminalized, and consequently encouraged by the government. What I’m saying is that, just because people have trouble understanding financial regulation doesn’t make that type of regulation any less important. (A case for intelligent politicians perhaps? Anti-intellectualism is still, unfortunately, celebrated in the United States)

At some point in the 1990s, the financial markets had been sufficiently deregulated and set free so that they could begin to create an entirely new business model that was not based on the traditional sources of revenue: interest on lent money and return on invested capital. When this happened, with the help of computer technology, what I call the “third economy” (the shadow economy) was created. This third economy was built almost entirely on borrowed money, a.k.a. credit.

By relaxing regulation with respect to capital ratios, leverage, accounting standards, ratings agencies, oversight, consumer protection, and much, much more, actors in the third economy were able to create a whole new, but fictitious, sector where a strange type of value-added financial service created a financial product. Traditionally, a so-called value-added service is something like taking a piece of wood and turning it into a chair. Everyone can understand that.

In the third economy, the actors would take a product from the real economy, such as a mortgage, and add its “value”-added service to it, and then sell it back to the financial economy and the real economy. Someone in the real economy would be a person with a mortgage. Someone in the financial economy would be Bank of America. Someone in the third economy would be Lehman Brothers. Lehman Brothers would take all these assets (they wouldn’t really buy them because they didn’t actually have much money), bundle them together, slap on a AAA-rating, and sell them.

In essence, the service that Lehman Brothers supposedly added, had no value at all. Because Lehman Brothers had access to so much credit, they could perform this trick over and over again, while giving off the illusion that they were adding a service. The combination of a worthless service sector employing millions, and non-existent capital created a giant bubble, and a new sector in the economy.

Going back to the example of the wood and the chair. Imagine that a carpenter buys a piece of wood, which he turns into a chair. A company contacts him and tells him that it will buy chairs from him at a higher price than what he could charge his customers. The company intends to add a special solution to the chairs which will make the chairs much more durable. The carpenter agrees, and starts selling all of his chairs to the company. He notices that a lot of people are buying the chairs, so he decides to buy some of them back, after they have been treated with the special solution (he does not know or own the formula, so he cannot apply it himself). He then sells the improved chairs to his own customers. This becomes greatly profitable for the carpenter, so he closes his production facility and starts only selling the chairs that have been treated with the special solution (now manufactured by someone else). After a little while, it turns out that the special solution not only does not increase the durability of the chairs, it reduces it from ten years to one year. Nobody wants to buy the chairs anymore, and customers are demanding their money back. The carpenter goes bankrupt and the company with the special solution is long gone. This is an analogy of the relationship between, for instance, Lehman Brothers and Bank of America. It could be extended by saying that the forestry company from which the wood originates also goes bankrupt, because the demand for wood has gone down the drain. The forestry company could be likened to the home owner.

Almost nobody knew about the third, shadow economy, in which borrowed money was used to add fictitious services, which in turn created the potential for more money to be borrowed by everyone. The third economy made it seem as if there were more money in the economy than there really was, and that it had been spread around for the benefit of all. The impact on the economy as a whole is as simple as it is brutal. Imagine that you thought you had $10,000 yesterday, but today you know for a fact that you only have $1,000. How would you act tomorrow?


Lisa M said...

Jacob, I also think we're on our way into a depression but I think it's going to last well beyond two years. I don't see how Obama's stimulous spending will lead to the sort of dramatic renewal of our economy that we need. We just don't manufacture anything or produce much real wealth in the country anymore - I don't see how a lot of spending on infrastructure will much affect that. Our country has got to go through some painful and maybe even violent transformations - economically and politically - and I think that's what we're in for.

Here's a question:

I find the predictions of Jim Rogers and Peter Schiff with regard to the crash of the dollar interesting. How likely is it, do you think, that we'll see a sudden collapse in the dollar in the near future?

Jacob said...

It's so difficult to pin down the currency market because so much is wrapped up in it. The crisis is global, and it spread very quickly, which is why I don't believe that there will be a collapse in the dollar. The fact that the crisis spread invalidates the theory that other parts of the world can operate financially somewhat independently of the U.S., a theory otherwise known as decoupling. Recently, small currencies have had tremendous trouble, regardless of the financial health of the country in question. Something would have to replace the dollar, and I don't think there's another viable candidate right now.

In the long term, all the debt and all the spending will lead to a great deal of inflation, and subsequently a drop in the dollar. That may not happen for a number of years, though. At least that's what I think, but I wouldn't put too much faith in that...