Last annotated on May 15, 2017
The “Forgash Plan,” named for Florida Senator Morris Forgash, proposed a World Bank for Economic Acceleration with an alternative policy to the existing World Bank – lending in domestic currency for land reform and greater self-sufficiency in food instead of plantation export crops. My first evening’s visit with him transfixed me with two ideas that have become my life’s work. First was his almost poetic description of the flow of funds through the economic system. He explained why most financial crises historically occurred in the autumn when the crops were moved. 39
Finance, natural resources and industry were parts of an interconnected system much like astronomy – and to me, an aesthetic thing of beauty. But unlike astronomical cycles, the mathematics of compound interest leads economies inevitably into a debt crash, because the financial system expands faster than the underlying economy, overburdening it with debt so that crises grow increasingly severe. Economies are torn apart by breaks in the chain of payments. 44
For the next twenty years, Terence and I spoke about an hour a day on current economic events. He had translated A History of Economic Doctrines: From the Physiocrats to Adam Smith, the first English-language version of Marx’s Theories of Surplus Value – which itself was the first real history of economic thought. 49
they are not taught in any university departments: the dynamics of debt, and how the pattern of bank lending inflates land prices, or national income accounting and the rising share absorbed by rent extraction in the Finance, Insurance and Real Estate (FIRE) sector. 55
the more prices rise, the more banks are willing to lend – as long as more people keep joining what looks like a perpetual motion wealth-creating machine. The process works only as long as incomes are rising. Few people notice that most of their rising income is being paid for housing. They feel that they are saving – and getting richer by paying for an investment that will grow. At least, that is what worked for sixty years after World War II ended in 1945. But bubbles always burst, because they are financed with debt, which expands like a chain letter for the economy as a whole. Mortgage debt service absorbs more and more of the rental value of real estate, and of homeowners’ income as new buyers take on more debt to buy homes that are rising in price. Tracking the upsweep of savings and the debt-financed rise in housing prices turned out to be the best way to understand how most “paper wealth” has been created 66
despite the fact that the economy’s largest asset is real estate – and is both the main asset and largest debt for most families – the analysis of land rent and property valuation did not even appear in the courses that I was taught in the evenings working toward my economics PhD. 75
export earnings and other foreign exchange receipts, which served as were a measure of how much revenue might be paid as debt service on new borrowings from U.S. banks. 80
international banks view the hard-currency earnings of foreign countries as potential revenue to be capitalized into loans and paid as interest. The implicit aim of bank marketing departments – and of creditors in general – is to attach the entire economic surplus for payment of debt service. 82
foreign debts mounted up at compound interest, an exponential growth that laid the ground for the crash that occurred in 1982 when Mexico announced that it couldn’t pay. In this respect, lending to Third World governments anticipated the real estate bubble that would crash in 2008. Except that Third World debts were written down in the 1980s (via Brady bonds), unlike mortgage debts. 89
using “flags of convenience” in Liberia and Panama enabled them to avoid paying income taxes either in the producing or consuming countries by giving the illusion that no profits were being made. The key was “transfer pricing.” Shipping affiliates in these tax-avoidance centers bought crude oil at low prices from Near Eastern or Venezuelan branches where oil was produced. These shipping and banking centers – which had no tax on profits – then sold this oil at marked-up prices to refineries in Europe or elsewhere. The transfer prices were set high enough so as not to leave any profit to be declared. 94
My charts revealed that the U.S. payments deficit was entirely military in character throughout the 1960s. The private sector – foreign trade and investment – was exactly in balance, year after year, and “foreign aid” actually produced a dollar surplus (and was required to do so under U.S. law). 110
I quickly discovered that of all the subdisciplines of economics, international trade theory was the silliest. Gunboats and military spending make no appearance in this theorizing, nor do the all-important “errors and omissions,” capital flight, smuggling, or fictitious transfer pricing for tax avoidance. These elisions are needed to steer trade theory toward the perverse and destructive conclusion that any country can pay any amount of debt, simply by lowering wages enough to pay creditors. All that seems to be needed is sufficient devaluation (what mainly is devalued is the cost of local labor), or lowering wages by labor market “reforms” and austerity programs. This theory has been proved false everywhere it has been applied, but it remains the essence of IMF orthodoxy. 116
Academic monetary theory is even worse. Milton Friedman’s “Chicago School” relates the money supply only to commodity prices and wages, not to asset prices for real estate, stocks and bonds. It pretends that money and credit are lent to business for investment in capital goods and new hiring, not to buy real estate, stocks and bonds. There is little attempt to take into account the debt service that must be paid on this credit, diverting spending away from consumer goods and tangible capital goods. So I found academic theory to be the reverse of how the world actually works. 122
early economists recognized the problems of governments (or others) relying on creditors for policy advice. As Adam Smith explained, a creditor of the public, considered merely as such, has no interest in the good condition of any particular portion of land, or in the good management of any particular portion of capital stock. … He has no inspection of it. He can have no care about it. Its ruin may in some cases be unknown to him, and cannot directly affect him. The bondholders’ interest is solely to extricate as much as they can as quickly as possible with little concern for the social devastation they cause. Yet they have managed to sell the idea that sovereign nations as well as individuals have a moral obligation to pay debts, even to act on behalf of creditors instead of their domestic populations. 129
My focus here too was to warn that Third World economies could not pay their foreign debts. Most of these loans were taken on to subsidize trade dependency, not restructure economies to enable them to pay. 158
IMF “structural adjustment” austerity programs – of the type now being imposed across the Eurozone – make the debt situation worse, by raising interest rates and taxes on labor, cutting pensions and social welfare spending, and selling off the public infrastructure (especially banking, water and mineral rights, communications and transportation) to rent-seeking monopolists. This kind of “adjustment” puts the class war back in business, on an international scale. 160
Although Wall Street bankers usually see the handwriting on the wall, their lobbyists insist that all debts can be paid, so that they can blame countries for not “tightening their belts.” Banks have a self-interest in denying the obvious problems of paying “capital transfers” in hard currency. My experience with this kind of bank-sponsored junk economics infecting public agencies inspired me to start compiling a history of how societies through the ages have handled their debt problems. It took me about a year to sketch the history of debt crises as far back as classical Greece and Rome, as well as the Biblical background of the Jubilee Year. But then I began to unearth a prehistory of debt practices going back to Sumer in the third millennium BC. 165
how interest-bearing debt first came into being – in the temples and palaces, not among individuals bartering. Most debts were owed to these large public institutions or their collectors, which is why rulers were able to cancel debts so frequently: They were cancelling debts owed to themselves, to prevent disruption of their economies. 172
shares were sold in Buenos Aires and San Paolo, mainly to the elites who held the high-yielding dollar bonds of their countries in offshore accounts. This showed us that the financial managers would indeed keep paying their governments’ foreign debts, as long as they were paying themselves as “Yankee bondholders” offshore. The Scudder fund achieved the world’s second highest-ranking rate of return in 1990. 184
most of the public is interested in understanding a great crash only after it occurs, not during the run-up when good returns are to be made. 190
the Near Eastern tradition of Biblical debt cancellations was firmly grounded. Two decades ago economic historians and even many Biblical scholars thought that the Jubilee Year was merely a literary creation, a utopian escape from practical reality. I encountered a wall of cognitive dissonance at the thought that the practice was attested to in increasingly detailed Clean Slate proclamations. Each region had its own word for such proclamations: Sumerian amargi, meaning a return to the “mother” (ama) condition, a world in balance; Babylonian misharum, as well as andurarum, from which Judea borrowed as deror, and Hurrian shudutu. Egypt’s Rosetta Stone refers to this tradition of amnesty for debts and for liberating exiles and prisoners. Instead of a sanctity of debt, what was sacred was the regular cancellation of agrarian debts and freeing of bondservants in order to preserve social balance. Such amnesties were not destabilizing, but were essential to preserving social and economic stability. 205
an economics curriculum in Modern Monetary Theory (MMT) at UMKC. For the past twenty years our aim has been to show the steps needed to avoid the unemployment and vast transfer of property from debtors to creditors that is tearing economies apart today. I presented my basic financial model in Kansas City in 2004, with a chart that I repeated in my May 2006 cover story for Harper’s. 225
The disabling force of debt was recognized more clearly in the 18th and 19th centuries (not to mention four thousand years ago in the Bronze Age). This has led pro-creditor economists to exclude the history of economic thought from the curriculum. Mainstream economics has become censorially pro-creditor, pro-austerity (that is, anti-labor) and anti-government (except for insisting on the need for taxpayer bailouts of the largest banks and savers). Yet it has captured Congressional policy, universities and the mass media to broadcast a false map of how economies work. 233
Spouting ostensible free market ideology, the pro-creditor mainstream rejects what the classical economic reformers actually wrote. One is left to choose between central planning by a public bureaucracy, or even more centralized planning by Wall Street’s financial bureaucracy. The middle ground of a mixed public/private economy has been all but forgotten – denounced as “socialism.” Yet every successful economy in history has been a mixed economy. 240
As for financial dynamics in the business sector, today’s “activist shareholders” and corporate raiders are financializing industry in ways that undercut rather than promote tangible capital formation and employment. Credit is increasingly predatory rather than enabling personal, corporate and government debtors to earn the money to pay. This pattern of debt is what classical economists defined as unproductive, favoring unearned income (economic rent) and speculative gains over profits earned by employing labor to produce goods and services. I therefore start by reviewing how the Enlightenment and original free market economists spent two centuries trying to prevent precisely the kind of rentier dominance that is stifling today’s economies and rolling back democracies to create financial oligarchies. 247
what is at work is an Orwellian strategy of rhetorical deception to represent finance and other rentier sectors as being part of the economy, not external to it. This is precisely the strategy that parasites in nature use to deceive their hosts that they are not free riders but part of the host’s own body, deserving careful protection. 254
leeches inject an anti-coagulant enzyme that helps prevent inflammation and thus steers the body to recovery. 270
countries under public sponsorship. Across the political spectrum, from “state socialism” under Bismarck to Marxist theorists, bankers were expected to become the economy’s central planners, by providing credit for the most profitable and presumably socially beneficial uses. A three-way symbiotic relationship emerged to create a “mixed economy” of government, high finance and industry. For thousands of years, from ancient Mesopotamia through classical Greece and Rome, temples and palaces were the major creditors, coining and providing money, creating basic infrastructure and receiving user fees as well as taxes. The Templars and Hospitallers led the revival of banking in medieval Europe, whose Renaissance and Progressive Era economies integrated public investment productively with private financing. To make this symbiosis successful and free immune to special privilege and corruption, 19th-century economists sought to free parliaments from control by the propertied classes that dominated their upper houses. 284
Parliamentary reform extending the vote to all citizens was expected to elect governments that would act in society’s long-term interest. Public authorities would take the lead in major capital investments in roads, ports and other transportation, communications, power production and other basic utilities, including banking, without private rent-extractors intruding into the process. The alternative was for infrastructure to be owned in a pattern much like absentee landlordship, enabling rent-extracting owners to set up tollbooths to charge society whatever the market would bear. Such privatization is contrary to what classical economists meant by a free market. They envisioned a market free from rent paid to a hereditary landlord class, and free from interest and monopoly rent paid to private owners. The ideal system was a morally fair market in which people would be rewarded for their labor and enterprise, but would not receive income without making a positive contribution to production and related social needs. 294
Adam Smith, David Ricardo, John Stuart Mill and their contemporaries warned that rent extraction threatened to siphon off income and bid up prices above the necessary cost of production. Their major aim was to prevent landlords from “reaping where they have not sown,” as Smith put it. Toward this end their labor theory of value (discussed in Chapter 3) aimed at deterring landlords, natural resource owners and monopolists from charging prices above cost-value. Opposing governments controlled by rentiers. 303
Recognizing how most great fortunes had been built up in predatory ways, through usury, war lending and political insider dealings to grab the Commons and carve out burdensome monopoly privileges led to a popular view of financial magnates, landlords and hereditary ruling elite as parasitic by the 19th century, epitomized by the French anarchist Proudhon’s slogan “Property as theft.” 307
Instead of creating a mutually beneficial symbiosis with the economy of production and consumption, today’s financial parasitism siphons off income needed to invest and grow. Bankers and bondholders desiccate the host economy by extracting revenue to pay interest and dividends. Repaying a loan – amortizing or “killing” it – shrinks the host. Like the word amortization, mortgage (“dead hand” of past claims for payment) contains the root mort, “death.” A financialized economy becomes a mortuary when the host economy becomes a meal for the financial free luncher that takes interest, fees and other charges without contributing to production. 311
The answer depends on whether the host can remain self-steering in the face of a parasitic attack. Taking control of the host’s brain/government Modern biology provides the basis for a more elaborate social analogy to financial strategy, by describing the sophisticated strategy that parasites use to control their hosts by disabling their normal defense mechanisms. To be accepted, the parasite must convince the host that no attack is underway. To siphon off a free lunch without triggering resistance, the parasite needs to take control of the host’s brain, at first to dull its awareness that an invader has attached itself, and then to make the host believe that the free rider is helping rather than depleting it and is temperate in its demands, only asking for the necessary expenses of providing its services. In that spirit bankers depict their interest charges as a necessary and benevolent part of the economy, providing credit to facilitate production and thus deserving to share in the surplus it helps create. 319
distinguish financial claims on wealth from real wealth creation. Their interest charges and fees typically eat into the circular flow of payments and income between producers and consumers. To deter protective regulations to limit this incursion, high finance popularizes promotes a “value-free” view that no sector exploits any other part. Whatever creditors and their financial managers take is deemed to be fair value for the services they provide 329
David Ricardo aimed his rent theory at Britain’s landlords while remaining silent about the financial rentiers – the class whose activities John Maynard Keynes playfully suggested should be euthanized. Landed proprietors, financiers and monopolists were singled out as the most visible free lunchers – giving them the strongest motive to deny the concept in principle. Familiar parasites in today’s economy include Wall Street’s investment bankers and hedge fund managers who raid companies and empty out their pension reserves; also, landlords who rack-rent their tenants (threatening eviction if unfair and extortionate demands are not met), and monopolists who gouge consumers with prices not warranted by the actual costs of production. Commercial banks demand that government treasuries or central banks cover their losses, claiming that their credit-steering activity is necessary to allocate resources and avoid economic dissolution. So here again we find the basic rentier demand: “Your money, or your life.” A rentier economy is one in which individuals and entire sectors levy charges for the property and privileges they have obtained, or more often that their ancestors have bequeathed. 352
The great reversal of classical Industrial Era reform ideology to regulate or tax away rentier income occurred after World War I. Bankers came to see their major market to be real estate, mineral rights, and monopolies. Lending mainly to finance the purchase and sale of rent-extracting opportunities in these sectors, banks lent against what buyers of land, mines and monopolies could squeeze out of their rent-extracting “tollbooth” opportunities. The effect was to pry away the land rent and natural resource rent that classical economists expected to serve as the natural tax base. In industry, Wall Street became the “mother of trusts,” creating mergers into monopolies as vehicles to extract monopoly rent. Precisely because a “free lunch” (rent) was free – if governments did not tax it away – speculators and other buyers sought to borrow to buy such rent-extracting privileges. 382
Biological nature provides a helpful analogy for the banking sector’s ideological ploys. A parasite’s toolkit includes behavior-modifying enzymes to make the host protect and nurture it. Financial intruders into a host economy use Junk Economics to rationalize rentier parasitism as if it makes a productive contribution, as if the tumor they create is part of the host’s own body, not an overgrowth living off the economy. A harmony of interests is depicted between finance and industry, Wall Street and Main Street, and even between creditors and debtors, monopolists and their customers. Nowhere in the National Income and Product Accounts is there a category for unearned income or exploitation. 409
about half of what the media report as “industrial profits” are FIRE-sector rents, that is, finance, insurance and real estate rents – and most of the remaining “profits” are monopoly rents for patents (headed by pharmaceuticals and information technology) and other legal privileges. Rents are conflated with profit. This is the terminology of financial intruders and rentiers seeking to erase the language and concepts of Adam Smith, Ricardo and their contemporaries depicting rents as parasitic. 416
The financial sector’s strategy to dominate labor, industry and government involves disabling the economy’s “brain” – the government – and behind it, democratic reforms to regulate banks and bondholders. Financial lobbyists mount attacks on public planning, accusing public investment and taxes of being a deadweight burden, not as steering economies to maximize prosperity, competitiveness, rising productivity and living standards. Banks become the economy’s central planners, and their plan is for industry and labor to serve finance, not the other way around. 420
today’s high (and low) finance rarely leaves the economy enough tangible capital to reproduce, much less to feed the insatiable exponential dynamics of compound interest and predatory asset stripping. In nature, parasites tend kill hosts that are dying, using their substance as food for the intruder’s own progeny. The economic analogy takes hold when financial managers use depreciation allowances for stock buybacks or to pay out as dividends instead of replenishing and updating their plant and equipment. Tangible capital investment, research and development and employment are cut back to provide purely financial returns. When creditors demand austerity programs to squeeze out “what is owed,” enabling their loans and investments to keep growing exponentially, they starve the industrial economy and create a demographic, economic, political and social crisis. This is what 443
As wages fall, suicide rates rise, life spans shorten, and marriage and birth rates plunge. Failure to reinvest enough earnings in new means of production shrinks the economy, prompting capital flight to less austerity-ravaged economies. 452
Today’s banks don’t finance tangible investment in factories, new means of production or research and development – the “productive lending” that is supposed to provide borrowers with the means to pay off their debt. Banks largely lend against collateral already in place, mainly real estate (80 percent of bank loans), stocks and bonds. The effect is to transfer ownership of these assets, not produce more. 3. Borrowers use these loans to bid up prices for the assets they buy on credit: homes and office buildings, entire companies (by debt-leveraged buyouts), and infrastructure in the public domain on which to install tollbooths and charge access rents. Lending against such assets bids up their prices – Asset-Price Inflation. 4. Paying off these loans with interest leaves less wage or profit income available to spend on consumer goods or capital goods. This Debt Deflation is the inevitable successor to Asset-Price Inflation. Debt service and rent charges shrink markets, consumer spending, employment and wages. 505
Austerity makes it harder to pay debts, by shrinking markets and causing unemployment. That is why John Maynard Keynes urged “euthanasia of the rentier” if industrial capitalism is to thrive. He hoped to shift the focus of fortune-seeking away from banking, and implicitly from its major loan markets in absentee landlordship and privatization of rent-extracting monopolies. 6. Mainstream policy pretends that economies are able to pay their debts without reducing their living standards or losing property. But debts grow exponentially faster than the economy’s ability to pay as interest accrues and is recycled (while new bank credit is created electronically). The “magic of compound interest” doubles and redoubles savings and debt balances by purely mathematical laws that are independent of the economy’s ability to produce and pay. Economies become more debt-leveraged as claims for payment are concentrated in the hands of the One Percent.514
Debts that can’t be paid, won’t be. The question is: how won’t they be paid? There are two ways not to pay. The most drastic and disruptive way (euphemized as “business as usual”) is for individuals, companies or governments to sell off or forfeit their assets. The second way to resolve matters is to write down debts to a level that can be paid. Bankers and bondholders prefer the former option, and insist that all debts can be paid, given the “will to do so,” that is, the will to transfer property into their hands. This is the solution that mainstream monetarist economists, government policy and the mass media popularize as basic morality. But it destroys Economy #1 to enrich the 1 percent who dominate Economy #2.522
Banks and bondholders oppose debt write-downs to bring debt in line with earnings and historical asset valuations. Creditor demands for payment run the economy in the interest of the financialized Economy #2 instead of protecting the indebted production-and-consumption Economy #1. The effect is to drive both economies bankrupt. 10. The financial sector (the One Percent) backs oligarchies. Eurozone creditors recently imposed “technocrats” to govern debt-strapped Greece and Italy, and blocked democratic referendums on whether to accept the bailouts and their associated austerity terms. This policy dates from the 1960s and ’70s when the IMF and U.S. Government began backing creditor-friendly Third World oligarchies and military dictatorships. 11. Every economy is planned. The question is, who will do the planning: banks or elected governments? Will planning and structuring the economy serve short-term financial interests (making asset-price gains and extracting rent) or will it promote the long-term upgrading of industry and living standards?536
That is why consumer spending has not risen since 2008. Even when income rises, many families find their paychecks eaten up by debt service. That is what debt deflation means. Income paid to creditors is not available for spending on goods and services. 566
Debt deflation leads to defaults and foreclosures, while bondholders and banks get bailed out at government expense. In the workplace, many employees are so deep in debt that they are afraid to complain about working conditions out of fear losing their jobs and thus missing a mortgage payment or utility bill, which would bump their credit-card interest rates up to the penalty range of circa 29 percent. This has been called the debt-traumatized worker effect, and it is a major cause of wage stagnation. 572
Finance and land rent: How bankers replaced the landed aristocracy The Norman Conquest of Britain in 1066 and similar conquests of the land in other European realms led to a constant fiscal struggle over who should receive the land’s rent: the king as his tax base, or the nobility to whom the land had been parceled out for them to manage, nominally on behalf of the palace. Increasingly, the hereditary landlord class privatized this rent, obliging kings to tax labor and industry. This rent grab set the stage for the great fight of classical free market economists, from the French Physiocrats to Adam Smith, John Stuart Mill, Henry George and their contemporaries to tax land and natural resource rents as the fiscal base. Their aim was to replace the vested aristocracy of rent recipients with public taxation or ownership of what was a gift of nature 576
The main aim of political economy for the past three centuries has been to recover the flow of privatized land and natural resource rent that medieval kings had lost. The political dimension of this effort involved democratic constitutional reform to overpower the rent-levying class. By the late 19th century political pressure was rising to tax landowners in Britain, the United States and other countries. In Britain a constitutional crisis over land taxation in 1910 ended the landed aristocracy’s power in the House of Lords to block House of Commons tax policy. Sun Yat-Sen’s revolution in China in 1911 to overthrow the Qing dynasty was fueled by demands for land taxation as the fiscal base. And when the United States instituted the income tax in 1913, it fell mainly on rentier income from real estate, natural resources and financial gains. Similar democratic tax reform was spreading throughout the world. 588
most of the rental income hitherto paid to a landlord class is now paid to banks as mortgage interest, not to the government as classical doctrine had urged. Today’s financial sector thus has taken over the role that the landed aristocracy played in feudal Europe. But although rent no longer supports a landed aristocracy, it does not serve as the tax base either. It is paid to the banks as mortgage interest. Homebuyers, commercial investors and property speculators are obliged to pay the rental value to bankers as the price of acquiring it. 604
The buyer who takes out the biggest mortgage to pay the bank the most gets the asset. So real estate ends up being worth whatever banks will lend against it. 608
Finance as the mother of monopolies The other form of rent that Adam Smith and other classical economists sought to minimize was that of natural monopolies such as the East India Companies of Britain, France and Holland, and kindred special trade privileges. This was what free trade basically meant. Most European countries kept basic infrastructure in the public domain – roads and railroads, communications, water, education, health care and pensions so as to minimize the economy’s cost of living and doing business by providing basic services at cost, at subsidized rates or even freely. 609
The financial sector’s aim is not to minimize the cost of roads, electric power, transportation, water or education, but to maximize what can be charged as monopoly rent. Since 1980 the privatization of this infrastructure has been greatly accelerated. Having financialized oil and gas, mining, power utilities, financial centers are now seeking to de-socialize society’s most important infrastructure, largely to provide public revenue to cut taxes on finance, insurance and real estate (FIRE). 615
The reality is that debt service (interest and dividends), exorbitant management fees, stock options, underwriting fees, mergers and acquisitions add to the cost of doing business. 624
Property speculators and buyers of price-gouging opportunities for monopoly rent on credit have a similar operating philosophy: “rent is for paying interest.” The steeper the rate of monopoly rent, the more privatizers will pay bankers and bond investors for ownership rights. The financial sector ends up as the main recipient of monopoly rents and land rents, receiving what the landlord class used to obtain. 625
banks rarely fund new means of production. They prefer to lend for mergers, management buyouts or raids of companies already in place. As for bondholders, they found a new market in the 1980s wave of high-interest “junk-bond” takeovers. Lower interest rates make it easier to borrow and take over companies – and then break them up, bleed them via management fees, and scale back pensions by threatening bankruptcy. 639
Bank lending focused on trade financing, not capital investment. 643
industry has become financialized, “activist shareholders” treat corporate industry as a vehicle to produce financial gains. Managers are paid according to how rapidly they can increase their companies’ stock price, which is done most easily by debt leveraging. This has turned the stock market into an arena for asset stripping, using corporate profits for share buybacks and higher dividend payouts instead of for long-term investment (Chapter 8). 645
Financializing industry thus has changed the character of class warfare from what socialists and labor leaders envisioned in the late 19th century and early 20th century. Then, the great struggle was between employers and labor over wages and benefits. Today’s finance is cannibalizing industrial capital, imposing austerity and shrinking employment while its drive to privatize monopolies increases the cost of living. 649
budget deficits have increased the power of financial lobbyists who have pushed politicians to reverse progressive income taxation and cut taxes on capital gains. Instead of central banks monetizing deficit spending to help the economy recover, they create money mainly to lend to banks for the purpose of increasing the economy’s debt overhead. Since 2008 the U.S. Federal Reserve has monetized $4 trillion in Quantitative Easing credit to banks. The aim is to re-inflate asset prices for the real estate, bonds and stocks held as collateral by financial institutions (and the One Percent), not to help the “real” economy recover. 655
Financial sector advocates have sought to control democracies by shifting tax policy and bank regulation out of the hands of elected representatives to nominees from world’s financial centers. The aim of this planning is not for the classical progressive objectives of mobilizing savings to increase productivity and raise populations out of poverty. The objective of finance capitalism is not capital formation, but acquisition of rent-yielding privileges for real estate, natural resources and monopolies. These are precisely the forms of revenue that centuries of classical economists sought to tax away or minimize. By allying itself with the rentier sectors and lobbying on their behalf – so as to extract their rent as interest – banking and high finance have become part of the economic overhead from which classical economists sought to free society. 667
The result of moving into a symbiosis with real estate, mining, oil, other natural resources and monopolies has been to financialize these sectors. As this has occurred, bank lobbyists have urged that land be un-taxed so as to leave more rent (and other natural resource rent) “free” to be paid as interest – while forcing governments to tax labor and industry instead. To promote this tax shift and debt leveraging, financial lobbyists have created a smokescreen of deception that depicts financialization as helping economies grow. They accuse central bank monetizing of budget deficits as being inherently inflationary – despite no evidence of this, and despite the vast inflation of real estate prices and stock prices by predatory bank credit. 674
Money creation is now monopolized by banks, which use this power to finance the transfer of property – with the source of the quickest and largest fortunes being infrastructure and natural resources pried out of the public domain of debtor countries by a combination of political insider dealing and debt leverage – a merger of kleptocracy with the world’s financial centers. 680
The financial strategy is capped by creating international financial institutions (the International Monetary Fund, European Central Bank) to bring pressure on debtor economies to take fiscal policy out of the hands of elected parliaments and into those of institutions ruling on behalf of bankers and bondholders. This global power has enabled finance to override potentially debtor-friendly governments. 683
Financial oligarchy replaces democracy All this contradicts what the 18th, 19th and most of the 20th century fought for in their drive to free economies from landlords, monopolists and “coupon clippers” living off bonds, stocks and real estate (largely inherited). Their income was a technologically and economically unnecessary vestige of past conquests – privileges bequeathed to subsequent generations. When parliamentary reform dislodged the landed aristocracy’s control of government, the hope was that extending the vote to the population at large would lead to policies that would manage land, natural resources and natural monopolies in the long-term public interest. Yet what Thorstein Veblen called the vested interests have rebuilt their political dominance, led by the financial sector which used its wealth to gain control of the election process to create a neo-rentier society imposing austerity. 686
A cultural counter-revolution has taken place. If few people have noticed, it is because the financial sector has rewritten history and re-defined the public’s idea of what economic progress and a fair society is all about. The financial alternative to classical economics calls itself “neoliberalism,” but it is the opposite of what the Enlightenment’s original liberal reformers called themselves. Land rent has not ended up in government hands, and more and more public services have been privatized to squeeze out monopoly rent. Banks have gained control of government and their central banks to create money only to bail out creditor losses, not to finance public spending. 696
finance has backed the rent-extracting sectors. And instead of central banks creating money to finance their budget deficits, governments are now forced to rely on bondholders, leaving it up to commercial banks and other creditors to provide the credit that economies need to grow. The result is that today’s society is indeed moving toward the central planning that financial lobbyists have long denounced. But the planning has been shifted to financial centers (Wall Street, the City of London or Frankfurt). And its plan is to create a neo-rentier society. Instead of helping the host economy grow, banking, bond markets and even the stock market have become part of a predatory, extractive dynamic. 704
This destructive scenario would not have been possible if memory of the classical critique of rentiers had remained at the center of political discussion. Chapter 2 therefore reviews how three centuries of Enlightenment reform sought to free industrial capitalism from the rentier overhead bequeathed by feudalism. Only by understanding this legacy can we see how today’s financial counter-Enlightenment is leading us back to a neo-feudal economy. 710
Marxism diagnosed the main inner contradiction of industrial capitalism to be that its drive to increase profit by paying labor as little as possible would dry up the domestic market. The inner contradiction of finance capitalism is similar: Debt deflation strips away the economy’s land rent, natural resource rent, industrial profits, disposable personal income and tax revenue – leaving economies unable to carry their exponential rise in credit. Austerity leads to default, as we are seeing today in Greece. The financial sector’s response is to double down and try to lend enough to enable debtors to pay. When this financial bubble bursts, creditors foreclose on the public domain of debtor economies, much as they foreclose on the homes of defaulting mortgage debtors. Central banks flood the economy with credit in an attempt to inflate a new asset-price bubble by lowering interest rates. U.S. Treasury bonds yield less than 1 percent, and the interest rate on German government bonds is actually negative, reflecting the “flight to safety” when debt write-downs look inevitable. In the end even zero-interest loans cannot be paid. 713
The underlying theme of this book thus can be summarized in a single sentence: Debts that can’t be paid, won’t be. But trying to pay such debts will plunge economies into prolonged depression. 723
The Long Fight to Free Economies from Feudalism’s Rentier Legacy If you do not own them, they will in time own you. They will destroy your politics [and] corrupt your institutions. — Cleveland mayor Tom Johnson (1901-09) speaking of power utilities726
Classical economics was part of a reform process to bring Europe out of the feudal era into the industrial age. This required overcoming the power of the landed aristocracy, bankers and monopolies to levy charges that were unfair because they did not reflect actual labor or enterprise. Such revenue was deemed “unearned.” The original fight for free markets meant freeing them from exploitation by rent extractors: owners of land, natural resources, monopoly rights and money fortunes that provided income without corresponding work – and usually without tax liability. Where hereditary rental and financial revenue supported the richest aristocracies, the tax burden was shifted most heavily onto labor and industry, in addition to their rent and debt burden. 730
The classical reform program of Adam Smith and his followers was to tax the income deriving from privileges that were the legacy of feudal Europe and its military conquests, and to make land, banking and monopolies publicly regulated functions. 736
Neoliberals have re-defined “free markets” to mean an economy free for rent-seekers, that is, “free” of government regulation or taxation of unearned rentier income (rents and financial returns). 738
The best way to undo their counter-revolution is to revive the classical distinction between earned and unearned income, and the analysis of financial and debt relations (the “magic of compound interest”) as being predatory on the economy at large. This original critique of landlords, bankers and monopolists has been stripped out of the current political debate in favor of what is best characterized as trickle-down junk economics. 741
The title of Adam Smith’s chair at the University of Edinburgh was Moral Philosophy. This remained the name for economics courses taught in Britain and America through most of the 19th century. Another name was Political Economy, and 17th-century writers used the term Political Arithmetic. The common aim was to influence public policy: above all how to finance government, what best to tax, and what rules should govern banking and credit. 744
The French Physiocrats were the first to call themselves économistes. Their leader François Quesnay (1694-1774) developed the first national income models in the process of explaining why France should shift taxes off labor and industry onto its landed aristocracy. Adam Smith endorsed the view of the Marquis de Mirabeau (father of Honoré, Comte de Mirabeau, an early leader of the French Revolution) that Quesnay’s Tableau Économique was one of the three great inventions of history (along with writing and money) for distinguishing between earned and unearned income. The subsequent debate between David Ricardo and Thomas Malthus over whether to protect agricultural landlords with high tariffs (the Corn Laws) added the concept of land rent to the Physiocratic analysis of how the economic surplus is created, who ends up with it and how they spend their income. 749
The guiding principle was that everyone deserves to receive the fruits of their own labor, but not that of others. Classical value and price theory provided the analytic tool to define and measure unearned income as overhead classical economics. It aimed to distinguish the necessary costs of production – value – from the unnecessary (and hence, parasitic) excess of price over and above these costs. This monopoly rent, along with land rent or credit over intrinsic worth came to be called economic rent, the source of rentier income. An efficient economy should minimize economic rent in order to prevent dissipation and exploitation by the rentier classes. 756
For the past eight centuries the political aim of value theory has been to liberate nations from the three legacies of feudal Europe’s military and financial conquests: land rent, monopoly pricing and interest. Land rent is what landlords charge in payment for the ground that someone’s forbears conquered. Monopoly rent is price gouging by businesses with special privileges or market power. These privileges were called patents: rights to charge whatever the market would bear, without regard for the actual cost of doing business. Bankers, for instance, charge more than what really is needed to provide their services. 761
Bringing prices and incomes into line with the actual costs of production would free economies from in these rents and financial charges. Landlords do not have to work to demand higher rents. Land prices rise as economies become more prosperous, while public agencies build roads, schools and public transportation to increase site values. Likewise, in banking, money does not “work” to pay interest; debtors do the work. 766
Distinguishing the return to labor from that to special privilege (headed by monopolies) became part of the Enlightenment’s reform program to make economies more fair, and also lower-cost and more industrially competitive. But the rent-receiving classes – rentiers – argue that their charges do not add to the cost of living and doing business. Claiming that their gains are invested productively (not to acquire more assets or luxuries or extend more loans), their supporters seek to distract attention from how excessive charges polarize and impoverish economies. The essence of today’s neoliberal economics is to deny that any income or wealth is unearned, or that market prices may contain an unnecessary excessive rake-off over intrinsic value. If true, it would mean that no public regulation is necessary, or public ownership of infrastructure or basic services. Income at the top is held to trickle down, so that the One Percent serve the 99 Percent, creating rather than destroying jobs and prosperity. 770
The Churchmen’s theory of Just Price was an incipient labor theory of value: The cost of producing any commodity ultimately consists of the cost of labor, including that needed to produce the raw materials, plant and equipment used up in its production. Thomas Aquinas (122574) wrote that bankers and tradesmen should earn enough to support their families in a manner appropriate for their station, including enough to give to charity and pay taxes. The problem that he Aquinas and his fellow Scholastics addressed was much like today’s: it was deemed unfair for bankers to earn so much more for the services they performed (such as transferring funds from one currency or realm to another, or lending to business ventures) than what other professionals earned. It resembles today’s arguments over how much Wall Street investment bankers should make. The logic of Church theorists was that bankers should have a living standard much like professionals of similar station. This required holding down the price of services they could charge (e.g., by the usury laws enacted by most of the world prior to the 1980s), by regulating prices for their services, and by taxing high incomes and luxuries. 786
It took four centuries to extend the concept of Just Price to ground rent paid to the landlord class. Two decades after the Norman Conquest in 1066, for instance, William the Conqueror ordered compilation of the Domesday Book (1086). This tributary tax came to be privatized into ground rent paid to the nobility when it revolted against the greedy King John Lackland (1199-1216). The Magna Carta (1215) and Revolt of the Barons were largely moves by the landed aristocracy to avoid taxes and keep the rent for themselves, shift the fiscal burden onto labor and the towns. The ground rent they imposed thus was a legacy of the military conquest of Europe by warlords who appropriated the land’s crop surplus as tribute. 796
By the 18th century, attempts to free economies from the rent-extracting privileges and monopoly of political power that originated in conquest inspired criticisms of land rent and the aristocracy’s burdensome role (“the idle rich”). These flowered into a full-blown moral philosophy that became the ideology driving the Industrial Revolution. Its political dimension advocated democratic reform to limit the aristocracy’s power over government. The aim was not to dismantle the state as such, but to mobilize its tax policy, money creation and public regulations to limit predatory rentier levies. That was the essence of John Stuart Mill’s “Ricardian socialist” theory and those of America’s reform era with its anti-trust regulations and public utility regulatory boards. 802
Tax favoritism for rentiers and the decline of nations What makes these early discussions relevant today is that economies are in danger of succumbing to a new rentier syndrome. Spain might have used the vast inflows of silver and gold from its New World conquests to become Europe’s leading industrial power. Instead, the bullion it looted from the New World flowed right through its economy like water through a sieve. Spain’s aristocracy of post-feudal landowners monopolized the inflow, dissipating it on luxury, more land acquisition, money lending, and more wars of conquest. The nobility squeezed rent out of the rural population, taxed the urban population so steeply as to impose poverty everywhere, and provided little of the education, science and technology that was flowering in northern European realms more democratic and less stifled by their landed aristocracy. 808
The “Spanish Syndrome” became an object lesson for what to avoid. It inspired economists to define the various ways in which rentier wealth – and the tax and war policies it supported – blocked progress and led to the decline and fall of nations. Dean Josiah Tucker, a Welsh clergyman and political economist, pointed out in 1774 that it made a great difference whether nations obtained money by employing their population productively, or by piracy or simply looting of silver and gold, as Spain and Portugal had done with such debilitating effects, in which “very few Hands were employed in getting this Mass of Wealth … and fewer still are supposed to retain what is gotten.” 816
…Taxes were tripled between 1556 and 1577. Spending went up even faster… By 1600, interest on the national debt took 40 percent of the budget. Spain descended into bankruptcy and never recovered. Despite its vast stream of gold and silver, Spain became the most debt-ridden country in Europe – with its tax burden shifted entirely onto the least affluent, blocking development of a home market. Yet today’s neoliberal lobbyists are urging similar tax favoritism to un-tax finance and real estate, shift the tax burden onto labor and consumers, cut public infrastructure and social spending, and put rentier managers in charge of government. The main difference from Spain and other post-feudal economies is that interest to the financial sector has replaced the rent paid to feudal landlords. And as far as economic discussion is concerned, there is no singling out of rentier income as such. 825
The main distinction between today’s mode of conquest and that of 16th-century Spain (and 18th-century France) is that it is now largely financial, not military. Land, natural resources, public infrastructure and industrial corporations are acquired by borrowing money. The cost of this conquest turns out to be as heavy as overt military warfare. Landlords pay out their net rent as interest to the banks that provide mortgage credit for them to acquire property. Corporate raiders likewise pay their cash flow as interest to the bondholders who finance their takeovers. Even tax revenue is increasingly earmarked to pay creditors (often foreign, as in medieval times), not to invest in infrastructure, pay pensions or spend for economic recovery and social welfare. 835
Today’s monopolization of affluence by a rentier class avoiding taxes and public regulation by buying control of government is the same problem that confronted the classical economists. Their struggle to create a fairer economy produced the tools most appropriate to understand how today’s economies are polarizing while becoming less productive. The Physiocrats, Adam Smith, David Ricardo and their successors refined the analysis of how rent-seeking siphons off income from the economy’s flow of spending. 842
The classical critique of economic rent Classical value theory provides the clearest conceptual tools to analyze the dynamics that are polarizing and impoverishing today’s economies. The labor theory of value went hand-in-hand with a “rent theory” of prices, broadening the concept of economic rent imposed by landholders, monopolists and bankers. Rent theory became the basis for distinguishing between earned and unearned income. Nearly all public regulatory policy of the 20th century has followed the groundwork laid by this Enlightenment ideology and political reform from John Locke onward, defining value, price and rent as a guide to progressive tax philosophy, anti-monopoly price regulation, usury laws and rent controls. 846
Defenders of landlords fought back. Malthus argued that landlords would not simply collect rent passively, but would invest it productively to increase productivity. Subsequent apologists simply left unearned income out of their models, hoping to leave it invisible so that it would not be taxed or regulated. 853
Instead of acknowledging the reality of predatory rentier behavior, financial lobbyists depict lending as being productive, as if it normally provides borrowers with the means to make enough gain to pay. Yet little such lending has occurred in history, apart from investing in trade ventures. Most bank loans are not to create new means of production but are made against real estate, financial securities or other assets already in place. The main source of gain for borrowers since the 1980s has not derived from earnings but seeing the real estate, stocks or bonds they have bought on credit rise as a result of asset-price inflation – that is, to get rich from the debt-leveraged Bubble Economy. 859
What makes classical economics more insightful than today’s mainstream orthodoxy is its focus on wealth ownership and the special privileges used to extract income without producing a corresponding value of product or service. Most inequality does not reflect differing levels of productivity, but distortions resulting from property rights and other special privileges. Distinguishing between earned and unearned income, classical economists asked what tax philosophy and public policy would lead to the most efficient and fair prices, incomes and economic growth. 865
Government was situated to play a key role in allocating resources. But although nearly all economies in history have been mixed public/private economic systems, today’s anti-government pressure seeks to create a one-sided economy whose control is centralized in Wall Street and similar financial centers abroad. Democratic political reforms were expected to prevent this development, by replacing inherited privilege with equality of opportunity. The aim was to do away with such privileges and put everyone and every business on an equal footing. Economies were to be freed by turning natural monopolies and land into public utilities. 869
This is how classical free market reforms evolved toward socialism of one form or another on the eve of the 20th century. The hereditary landlord class was selling its land to buyers on credit. That is how land and home ownership were democratized. The unanticipated result has been that banks receive as mortgage interest the rental income formerly paid to landlords. The financial sector has replaced land ownership as the most important rentier sector, today’s post-industrial aristocracy. 874
In Britain, the House of Lords lost its ability to block revenue bills passed by the House of Commons in 1910. 881
The objective of most lending is to extract interest charges by attaching debt to real estate rent, corporate profits and personal income streams, turning them into a flow of interest charges. The “real” economy slows in the face of these exponentially growing financial claims (bank loans, stocks and bonds) that enrich primarily the One Percent. Instead of finance being industrialized, industry has become financialized. The stock and bond markets have been turned into arenas for debt-leveraged buyouts and asset stripping (described in Chapters 9 and 10 below). These dynamics represent a counter-revolution against classical ideas of free markets. Today’s neoliberal tax and financial philosophy is corrosive and destructive, not productive. Instead of promoting industry, capital formation and infrastructure, finance has moved into a symbiosis with the other rentier sectors: real estate, natural resource extraction, and natural monopolies.Acquisition of rent-yielding privileges on credit (or simply by insider dealing and legal maneuvering) does not require the fixed capital investment that manufacturing entails. 884
The Critique and Defense of Economic Rent, From Locke to Mill The main substantive achievement of neoliberalization … has been to redistribute, rather than to generate, wealth and income. [By] ‘accumulation by dispossession’ I mean … the commodification and privatization of land and the forceful expulsion of peasant populations; conversion of various forms of property rights (common, collective, state, etc.) into exclusive private property rights; suppression of rights to the commons; … colonial, neocolonial, and imperial processes of appropriation of assets (including natural resources); …and usury, the national debt and, most devastating of all, the use of the credit system as a radical means of accumulation by dispossession. … To this list of mechanisms we may now add a raft of techniques such as the extraction of rents from patents and intellectual property rights and the diminution or erasure of various forms of common property rights (such as state pensions, paid vacations, and access to education and health care) won through a generation or more of class struggle. The proposal to privatize all state pension rights (pioneered in Chile under the dictatorship) is, for example, one of the cherished objectives of the Republicans in the US. —David Harvey, A Brief History of Neoliberalism (Oxford, 2005)895
The phenomena cited by Harvey represent opportunities for rent extraction. Neoliberals claim that such special privileges and expropriation of hitherto public assets promote economic efficiency. Classical free marketers defined the rents they yielded as neither earned nor necessary for production to occur. They were a post-feudal overhead. 907
The year 1690 usually is treated as the takeoff point for the classical distinction between earned and unearned wealth and its income stream. At issue then was the contrast between real wealth created by labor, and special privileges – mainly post-feudal overhead – from which society could free itself and thus lower its cost structure. John Locke’s guiding axiom was that all men have a natural right to the fruits of their labor. A corollary to this logic was that landlords have a right only to what they themselves produce, not to exploit and appropriate the labor of their tenants: Though the earth and all inferior creatures be common to all men, yet every man has a property in his own person … The labour of his body and the work of his hands, we may say, are properly his. Whatsoever then he removes out of the state that nature hath provided and left it in, he hath mixed his labour with, and joined to it something that is his own, and thereby makes it his property. … For this labour being the unquestionable property of the labourer, no man but he can have a right to what that is once joined to, at least where there is enough and as good left in common for others. 910
Locke’s labor theory of property and wealth ownership set the stage for distinguishing between the portion of land rent that resulted from its owner’s expenditure of labor and capital investment, and what was received simply from ownership rights without labor effort. This contrast guided tax reform down through the Progressive Era in the early 20th century. Despite his conflation of former and present landholder’s labor, Locke’s exposition initiated a centuries-long discussion. By the 19th century the rising price of land sites was seen as occurring independently of effort by landlords. The rent they charged reflected prosperity by the rest of the economy, not their own effort. Economists call this kind of gain a windfall. It is like winning a lottery, including in many cases the inheritance lottery of how much wealth one’s parents have. 922
Classical economists argued that labor and capital goods require a cost necessary to bring them into production. Labor must receive wages sufficient to cover its basic subsistence, at living standards that tend to rise over time to sustain personal investment in better skills, education and health. And capital investment will not take place without the prospect of earning a profit. More problematic are accounting for land and natural resources. Production cannot take place without land, sunlight, air and water, but no labor or capital cost is necessary to provide them. They can be privatized by force, legal right or political fiat (sale by the state). 931
Classical economists focused on this kind of property claim in defining a fair distribution of income from land and other natural resources as between their initial appropriators, heirs and the tax collector. At issue was how much revenue should belong to the economy at large as its natural patrimony, and how much should be left in the hands of discoverers or appropriators and their descendants. The resulting theory of economic rent has been extended to monopoly rights and patents such as those which pharmaceutical companies obtain to charge for their price gouging. 938
The history of property acquisition is one of force and political intrigue, not labor by its existing owners. The wealthiest property owners have tended to be the most predatory – military conquerors, landed aristocracies, bankers, bondholders and monopolists. Their property rights to collect rent for land, mines, patents or monopolized trade are legal privileges produced by the legal system they control, not by labor. Medieval land grants typically were given to royal companions in return for their political loyalty. This land acquisition process continued from colonial times down through America’s land grants to the railroad barons and many other political giveaways to supporters in most countries, often for bribery and similar kinds of corruption. Most recently, the post-Soviet economies gave political insiders privatization rights to oil and gas, minerals, real estate and infrastructure at giveaway prices in the 1990s. 943
Russia and other countries followed American and World Bank advice to simply give property to individuals, as if this would automatically produce an efficient (idealized) Western European-style free market. What it actually did was to empower a class of oligarchs who obtained these assets by insider dealings. Popular usage coined the word “grabitization” to describe “red company” managers getting rich by registering natural resources, public utilities or factories in their own name, obtaining high prices for their shares by selling large chunks to Western investors, and keeping most of their receipts for these shares abroad as flight capital (about $25 billion annually since 1991 for Russia). This neoliberal privatization capped the Cold War by dismantling the Soviet Union’s public sector and reducing it to a neofeudal society. 950
The great challenge confronting post-Soviet economies is how to undo the effects of these kleptocratic grabs. One way would be to re-nationalize them. This is difficult politically, given the influence that great wealth is able to buy. A more “market oriented” solution is to leave these assets in their current hands but tax their land or resource rent to recapture portions of the windfall for the benefit of society. Without such restructuring, all that Vladimir Putin can do is informal “jawboning”: pressuring Russia’s oligarchs to invest their revenue at home. 957
these economies are going directly into neoliberal rentier decadence. The problem of how an economy can best recover from such grabitization is not new. Classical economists in Britain and France spent two centuries analyzing how to recapture the rents attached to such appropriations. Their solution was a rent tax. Today’s vested interests fight viciously to suppress their concept of economic rent and the associated distinction between earned and unearned income. It would save today’s reformers from having to reinvent the methodology of what constitutes fair value. Censoring or rewriting the history of economic thought aims at thwarting the logic for taxing rent-yielding assets. 962
Seeking to reform the French monarchy in the decades preceding the 1789 Revolution, the Physiocrats popularized the term laissez faire, “let us be.” Coined in the 1750s to oppose royal regulations to keep grain prices and hence land rents high, the school’s founder, Francois Quesnay, extended the slogan to represent freedom from the aristocracy living off its rents in courtly luxury while taxes fell on the population at large. Quesnay was a surgeon. The word Physiocracy reflected his analogy of the circulation of income and spending in the national economy with the flow of blood through the human body. This concept of circular flow inspired him to develop the first national income accounting format, the Tableau Économique in 1759 to show how France’s economic surplus – what was left after defraying basic living and business expenses – ended up in the hands of landlords as groundrent. 969
they did not characterize landlords as taking rent by virtue of their labor. The crop surplus was produced by the sun’s energy. This logic underlay their policy proposal: a Single Tax on land, l’impôt unique. Taxing land rent would collect what nature provided freely (sunlight and land) and hence what should belong to the public sector as the tax base. The 19th century came to characterize landlords and other rentiers as the Idle Rich. 979
Quesnay’s ploy was to claim that the class that produces the surplus is the natural source of taxation. Depicting agricultural land as the ultimate source of surplus implied that all taxes would end up being paid out of it. Deeming manufacturing to be “sterile,” merely working up the raw materials supplied by nature, meant that taxing industry or the labor it hired would raise the break-even cost that business needed to cover. Any taxes on industry or labor would simply be passed on to the source of the surplus (agricultural landlords). In effect, the Physiocrats said: “Indeed you landowners are the source of our nation’s wealth. That is why all taxes end up being paid by you, indirectly if not directly. Let us avoid the convoluted pretenses at work and tax you directly by our Single Tax instead of impoverishing French industry and commerce.” 990
the net surplus (produit net), defined as income over and above break-even costs. They asked who ends up with it, and who ended up bearing the tax? 997
Adam Smith broadens Physiocratic rent theory Adam Smith met Quesnay and Les Économistes on his travels in France during 1764-66. He agreed with the need to free labor and industry from the land rent imposed by Europe’s privileged nobilities: “Ground-rents and the ordinary rent of land are … the species of revenue which can best bear to have a peculiar tax imposed on them.” But in contrast to the Physiocratic description of industry being too “sterile” to tax, Smith said manufacturing was productive. In his lectures at Edinburgh a decade before he wrote The Wealth of Nations, Smith generalized the concept of rent as passive, unearned income – and used the labor theory of value to extend this idea to finance as well as land ownership: The labour and time of the poor is in civilized countries sacrificed to the maintaining of the rich in ease and luxury. The landlord is maintained in idleness and luxury by the labour of his tenants. The moneyed man is supported by his exactions from the industrious merchant and the needy who are obliged to support him in ease by a return for the use of his money. But every savage has the full enjoyment of the fruits of his own labours; there are no landlords, no usurers, no tax gatherers. 1003
Failure to tax this rent burden shifted taxes onto commerce and industry, eroding its profits and hence capital accumulation. In addition to bearing the cost of land rents, populations had to pay excise taxes levied to pay interest on public debt run up as a result of the failure to tax landlords. 1016
In 1848, John Stuart Mill explained the logic of taxing it away from the landlord class: “Suppose that there is a kind of income which constantly tends to increase, without any exertion or sacrifice on the part of the owners: those owners constituting a class in the community.” Rejecting the moral justification that Locke provided for landownership – that their land owed its value to their own labor – Mill wrote that landlords grow richer, as it were in their sleep, without working, risking, or economizing. What claim have they, on the general principle of social justice, to this accession of riches? In what would they have been wronged if society had, from the beginning, reserved the right of taxing the spontaneous increase of rent … ? The value of land rose as a result of the efforts of the entire community. Mill concluded that rising site value should belong to the public as the natural tax base rather than leaving it as “an unearned appendage to the riches of a particular class.” 1020
Mill justified taxing land rent on grounds of national interest as well as moral philosophy. The aim was to avoid taxing labor and industry, but on income that had no counterpart in labor. In time the labor theory of value was applied to monopoly rents. The remainder of the 19th century was filled with proposals as to how best to tax or nationalize the land’s economic rent. 1029
orthodox trade theory explaining the (supposed) virtues of global specialization of labor. Ricardo’s logic reflected the self-interest of his banking class: Globalization promoted commerce, which was still the major market for bank lending in the early 19th century. 1050
The desirability of sites in good neighborhoods is enhanced by public infrastructure investment in transportation and other improvements, combined with the general level of prosperity – and most of all in recent times, by bank credit on easier (that is, more debt-leveraged) lending terms. Owners enjoy a price rise without having to invest more of their own money – the situation Ricardo described with regard to agricultural landowners. 1073
Contrary to Ricardo’s description of rent as “a transfer of wealth, advantageous to the landlords and proportionally injurious to the consumers,” Malthus countered that new capital investment in the land could not be afforded without high crop prices: 1086
Landlords were what today’s One Percent call themselves: “job creators” who hired coachmen, tailors and seamstresses, butlers and other servants, and bought coaches, fine clothes and furnishings. So even when rent recipients spent their revenue on luxuries, they augmented the demand for labor. This argument failed to recognize that if workers did not have to pay such high food prices, they could spend more on the products of industry – or, if they still earned only the subsistence wage (as Ricardo assumed), industrial profits would be higher at the expense of land rent. The real choice thus was between luxury consumption by the landed aristocracy or higher living standards for the rest of the population and more industrial investment. 1093
what Malthus described is best characterized as rentier demand by the One Percent. He was justifying what the late 19th-century cartoonist Thomas Nast depicted: Wall Street plutocrats dressed in finery and so fat from gluttonous over-eating that the buttons on their jackets nearly burst. 1100
defining economic rent as the excess of price over costs of production shaped subsequent conceptualization of rent theory. 1106
in the cheapest market leaves the economy dependent on foreign producers. The long-term risk of dependency on imported food and basic consumer goods escaped Ricardo’s attention, as did the problem of financing trade deficits 1111
As Parliamentary spokesman for his fellow financiers, he accused only landlords of draining income out of the economy, not creditors. So his blind spot reflects his profession and that of his banking family. (The Ricardo Brothers handled Greece’s first Independence Loan of 1824, for instance, on quite ruinous terms for Greece.) Seeing no parallel between paying interest to bankers and paying rents to landlords, Ricardo sidestepped Adam Smith’s warning about how excise taxes levied on food and other necessities to pay bondholders on Britain’s war debt drove up the nation’s subsistence wage level. His one-sided focus on land rent diverted attention from how rising debt service – the financial analogue to land rent – increases break-even costs while leaving less income available for spending on goods and services. Treating money merely as a veil – as if debt and its carrying charges were not relevant to cost and price levels – Ricardo insisted that payment of foreign debts would be entirely recycled into purchases of the paying-nation’s exports. There was no recognition of how paying debt service put downward pressure on exchange rates or led to domestic austerity. 1132
keeping debts on the books while prices decline enhances the value of creditor claims for payment. This polarization between creditors and debtors is what happened after the Napoleonic Wars, and also after America’s Civil War, crucifying indebted farmers and the rest of the economy “on a cross of gold,” as William Jennings Bryan characterized price deflation. The financial sector now occupies the dominant position that landlords did in times past. Debt service plays the extractive role that land rent did in Ricardo’s day. 1143
creditors recycle most of their receipt of interest into new loans. This increases the debt burden without raising output or living standards. 1148
Today, banking has found its major market in lending to real estate and monopolies, adding financial charges to land and monopoly rent overhead. The financial counterpart to diminishing returns that raise the cost of living and doing business takes two forms. Interest rates rise to cover the growing risks of lending to debt-strapped economies. And the “magic of compound interest” extracts an exponential expansion of debt service as creditors recycle their interest income into new loans. The result is that debts grow more rapidly and inexorably than the host economy’s ability to pay. 1153
The All-Devouring “Magic of Compound Interest”1158
overgrowth of debt is at the root of today’s economic crisis. Creditors make money by leaving their savings to accrue interest, doubling and redoubling their claims on the economy. This dynamic draws more and more control over labor, land, industry and tax revenue into the hands of creditors, concentrating property ownership and government in their hands. The way societies have coped with this deepening indebtedness should be the starting point of financial theorizing. 1163
Money is not a “factor of production.” It is a claim on the output or income that others produce. Debtors do the work, not the lenders. Before a formal market for wage labor developed in antiquity, money lending was the major way to obtain the services of bondservants who were compelled to work off the interest that was owed. Debtors’ family members were pledged to their creditors. In India, and many other parts of the world, debt peonage still persists as a way to force labor to work for their creditors. In a similar way, getting inducing landholders into debt was the first step to pry away their subsistence lands, beaching archaic communalistic land tenure systems. In this respect creditors are like landlords, obtaining the labor of others and growing richer in the way that J. S. Mill described: “in their sleep,” without working. 1166
The idea of such exponential growth is expressed in an Egyptian proverb: “If wealth is placed where it bears interest, it comes back to you redoubled.” A Babylonian image compared making a loan to having a baby. This analogy reflects the fact that the word for “interest” in every ancient language meant a newborn: a goat-kind (mash) in Sumerian, or a young calf: tokos in Greek or foenus in Latin. The “newborn” paid as interest was born of silver or gold, not from borrowed cattle (as some economists once believed, missing the metaphor at work). What was born was the “baby” fraction of the principal, 1/60th each month. (In Greece, interest was due on the new moon.) The growth was purely mathematical with a “gestation period” for doubling dependent on the interest rate. 1195
Sumer in the third millennium BC, which already had a term mashmash, “interest (mash) on the interest.” Students were asked to calculate how long it will take for one mina to multiply 64 times, that is, 26 – in other words, six doubling times of five years each. The solution involves calculating powers of 2 (22 = 4, 23 = 8 and so forth). A mina multiplies fourfold in 10 years (two gestation periods), eightfold in 15 years (three periods), sixteenfold in 20 years (four periods), and 64 times in 30 years. The 30-year span consisted of six fiveyear doubling periods. 1203
Martin Luther depicted usurers scheming “to amass wealth and get rich, to be lazy and idle and live in luxury on the labor of others.” The growing mass of usurious claims was depicted graphically as a “great huge monster … who lays waste all … Cacus.” Imbuing victims with an insatiable desire for money, Cacus encouraged an insatiable greed that “would eat up the world in a few years.” A “usurer and money-glutton … would have the whole world perish of hunger and thirst, misery and want, so far as in him lies, so that he may have all to himself, and every one may receive from him as from a God, and be his serf for ever. … For Cacus means the villain that is a pious usurer, and steals, robs, eats everything.” 1213
the 19th century German economist, Michael Flürscheim, cast this exponential doubling and redoubling principle into the form of a Persian proverb telling of a Shah who wished to reward a subject who had invented chess, and asked what he would like. The man asked only “that the Shah would give him a single grain of corn, which was to be put on the first square of the chess-board, and to be doubled on each successive square,” until all sixty-four squares were filled with grain. Upon calculating 64 doublings of each square from the preceding, starting from the first gain and proceeding 1, 2, 4, 8, 16, 32, 64 and so on. At first the compounding of grain remained well within the physical ability of the kingdom to pay, even after twenty squares were passed. But by the time the hypothetical chessboard was filled halfway, the compounding was growing by leaps and bounds. The Shah realized that this he had promised “an amount larger than what the treasures of his whole kingdom could buy.” The moral is that no matter how much technology increases humanity’s productive powers, the revenue it produces will be overtaken by the growth of debt multiplying at compound interest. The major source of loanable funds is repayments on existing loans, re-lent to finance yet new debts – often on an increasingly risky basis as the repertory of “sound projects” is exhausted. Strictly speaking, it is savings that compound, not debts themselves. Each individual debt is settled one way or another, but creditors recycle their interest and amortization into new interest-bearing loans. The only problem for savers is to find enough debtors to take on new obligations. 1224
The Rule of 72 A mathematical principle called the “Rule of 72” provides a quick way to calculate such doubling times: Divide 72 by any given rate of interest, and you have the doubling time. To double money at 8 percent annual interest, divide 72 by 8. The answer is 9 years. In another 9 years the original principal will have multiplied fourfold, and in 27 years it will have grown to eight times the original sum. A loan at 6 percent doubles in 12 years, and at 4 percent in 18 years. This rule provides a quick way to approximate the number of years needed for savings accounts or prices to double at a given compound rate of increase. 1238
The exponential growth of savings (= other peoples’ debts) One of Adam Smith’s contemporaries, the Anglican minister and actuarial mathematician Richard Price, graphically explained the seemingly magical nature of how debts multiplied exponentially. As he described in his 1772 Appeal to the Public on the Subject of the National Debt: Money bearing compound interest increases at first slowly. But, the rate of increase being continually accelerated, it becomes in some time so rapid, as to mock all the powers of the imagination. One penny, put out at our Saviour’s birth at 5% compound interest, would, before this time, have increased to a greater sum than would be obtained in a 150 millions of Earths, all solid gold. But if put out to simple interest, it would, in the same time, have amounted to no more than 7 shillings 4½d. 1246
In his Observations on Reversionary Payments, first published in 1769 and running through six editions by 1803, Price elaborated how the rate of multiplication would be even higher at 6 percent: “A shilling put out at 6% compound interest at our Saviour’s birth would … have increased to a greater sum than the whole solar system could hold, supposing it a sphere equal in diameter to the diameter of Saturn’s orbit.” 1254
Balances snowball in the hands of bankers, bondholders and other savers, as if there always will be enough opportunities to find remunerative projects and credit-worthy borrowers to pay the interest that is accruing. The moral is that the economy’s ability to produce and earn enough of a surplus to pay exponentially rising interest charges is limited. The more it is stripped to pay creditors, the less able it is to produce and pay as a result of unemployment, underutilization of resources, emigration and capital flight. 1265
In the two thousand years since the birth of Christ, the European economy has grown at a compound annual rate of 0.2 percent, far lower than the level at which interest rates have stood. Yet financial fortunes have crashed again and again – in part because interest payments have absorbed the revenue that otherwise would have been available for new direct investment. The inability of productive investment opportunities to keep pace with the expansion of credit is the Achilles heel of finance-based growth. How can compound interest be paid? Who will end up paying it? Who will receive it, and what will they do with it? If banks and a creditor class receive this money, will they spend it domestically to maintain balance, or will they drain the economy’s income stream and shift it abroad to new loan markets, leaving the economy strapped by the need to pay interest on the growing debt? If the state accrues this money, how will it recirculate it back into the economy? 1270
“The Magic of Compound Interest” vs. The Economy’s Ability to Pay 1. Neither money nor credit is a factor of production. Debtors do the work to pay their creditors. This means that interest is not a “return to a factor of production.” Little credit is used to expand production or capital investment. Most is to transfer asset ownership. 2. If loan proceeds are not used to make gains sufficient to pay the creditor (productive credit), then interest and principal must be paid out of the debtor’s other income or asset sales. Such lending is predatory. 3. The aim of predatory lending in much of the world is to obtain labor to work off debts (debt peonage), to foreclose on the land of debtors, and in modern times to force debt-strapped governments to privatize natural resources and public infrastructure. 1278
Most inheritance consists of financial claims on the economy at large. In antiquity, foreclosure for non-payment was the major lever to pry land away from traditional tenure rights inheritable within the family. (Early creditors got themselves adopted as Number One sons.) Today, most financial claims are on the land’s rent, leaving ownership “democratized” – on credit. 5. Most interest-bearing debt always has been predatory, apart from lending for commerce. Carrying a rising debt overhead slows material investment and economic growth.1286
The rate of interest never has reflected the rate of profit, the rise in physical productivity or the borrower’s ability to pay. The earliest interest rates were set simply for ease in mathematical calculation: 1/60 per month in Mesopotamia, 1/10 annually in Greece, and 1/12 in Rome. (These were all the unit fractions in their respective fractional systems.) In modern times the rate of interest has been set mainly to stabilize the balance of payments and hence exchange rates. Since 2008 it has been set low to re-inflate asset prices and bank profits. 7. Any rate of interest implies a doubling time for money lent out. See the Rule of 72 (e.g., five years in Mesopotamia).1291
Modern creditors avert public cancellation of debts (and making banks a public utility) by pretending that lending provides mutual benefit in which the borrower gains – consumer goods now rather than later, or money to run a business or buy an asset that earns enough to pay back the creditor with interest and still leave a profit for the debtor. 9. This scenario of productive lending does not typify the banking system as a whole. Instead of serving the economy’s production trends, the financial sector (as presently organized) makes the economy top-heavy, by transferring assets and income into the hands of an increasingly hereditary creditor class.1297
The exponential growth of debt shrinks markets and slows and investment, reducing the economy’s ability to pay debts, while increasing the debt/output and debt/income ratios. 11. The rising volume of debt changes the distribution of property ownership unless public authorities intervene to cancel debts and reverse expropriations. In antiquity, royal “Jubilee” proclamations liberated bondservants and restored lands that had been foreclosed. 12. Cancelling debts was politically easiest when governments or public institutions (temples, palaces or civic authorities) were the major creditors, because they were cancelling debts owed to themselves. This is an argument for why governments should be the main suppliers of money and credit as a public utility.1303
Gustavus Myers’ History of the Great American Fortunes. In 1895, J. W. Bennett warned of a rentier caste drawing the world’s wealth into its hands as the inventive powers of industry were outrun by the mathematics of compound interest, “the principle which asserts that a dollar will grow into two dollars in a number of years, and keep on multiplying until it represents all of the wealth on earth.” Although not much noticed at the time, Bennett was one of the first to recognize that financial recycling of interest receipts into new lending was the driving force of the business cycle. Despite the rising role of industry, “financial systems are founded on rent and interest-taking,” and “interest-bearing wealth increases in a ratio which is ever growing more and more rapid,” leaving few assets unattached by debt. The exponential growth of debt makes business conditions more risky, because “there are not available assets to meet [creditor] demands and at the same time keep business moving.” Bankers call in their loans, causing a crash followed by “a trade depression every ten years or oftener and panics every twenty years.” 1319
The mathematics of compound interest explain “the extremely rapid accumulation of wealth in the hands of a comparatively few non-producers,” as well as “the abject poverty of a large percentage of the producing masses.” Non-producers receive “much the largest salaries,” despite the fact that their “income is often in inverse ratio to the service which [they do for their] fellow men.” As a result, Bennett concluded: “The financial group becomes rich more rapidly than the nation at large; and national increase in wealth may not mean prosperity of the producing masses.” All this sounds remarkably modern. The same basic criticisms were made after the 2008 crash, as if the discovery of predatory finance was something new. 1328
Bennett’s contemporary John Brown (not the abolitionist) argued that compound interest “is the subtle principle which makes wealth parasitic in the body of industry – the potent influence which takes from the weak and gives to the strong; which makes the rich richer and the poor poorer; which builds palaces for the idle and hovels for the diligent.” Only the wealthy are able to save up significant amounts and let sums simply accumulate and accrue interest over time. Small savers must live off their savings, drawing them down long before the mathematics of compound interest become truly significant. What is remarkable is that this principle of compound interest has come to be viewed as a way to make populations richer rather than poorer. It is as if workers can ride the exponential growth of financial debt claims, by saving in mutual funds or investing in pension funds to financialize the economy. This rosy scenario assumes that the increase in debt does not dry up the growth in markets, investment and employment in much the way that Ricardo imagined landlords and their rent would stifle industrial capitalism. 1334
How the One Percent Holds the 99 Percent in Exponentially Deepening Debt [W]hat Smith and Marx shared, critically, was the belief that it was entirely possible for an activity to be revenue- and profit-generative without actually contributing to the creation of value. There was no paradox. (Or rather, for Marx at any rate, the paradox was not that banks made profits without producing value, but that industrial capitalists allowed them to do so.) J. P. Morgan and John D. Rockefeller are said to have called the principle of compound interest the Eighth Wonder of the World. For them it meant concentrating financial fortunes in the hands of an emerging oligarchy indebting the economy to itself at an exponential rate. This has been the key factor in polarizing the distribution of wealth and political power in societies that do not take steps to cope with this dynamic. The problem lies in the way that savings and credit are lent out to become other peoples’ debts without actually helping them earn the money to pay them off.1343
the financial sector this poses a banking problem: how to prevent losses to creditors when loan defaults occur. Such defaults prevent banks from paying their depositors and bondholders until they can foreclose on the collateral pledged by debtors and sell it off. But for the economy at large, the problem is bank credit and other loans loading the economy down with more and more debt, “crowding out” spending on current output. Something has to give – meaning that either creditors or debtors must lose. Politicians thus face a choice of whether to save banks and bondholders or the economy. Do they simply reward their major campaign contributors by giving banks enough central bank or taxpayer money to compensate losses on bad loans? Or do they restructure debts downward, imposing losses on large bank depositors, bondholders and other creditors by writing down bad debts so as to keep debt-strapped families solvent and in possession of their homes? It is politically convenient in today’s world to solve the banking dimension of this problem in ways that please the financial sector. After the 1907 crash hit the United States harder than most economies, the Federal Reserve was founded in 1913 to provide public back-up credit in times of crisis. The assumption was that debt problems were merely about short-term liquidity for basically solvent loans whose carrying charges were temporarily interrupted by crop failures or a major industrial bankruptcy. The exponential growth of debt was not anticipated to reach a magnitude that would bring economic growth to a halt. That worry has faded almost entirely from mainstream discussion for the past century. 1352
The Glass Steagall Act, also passed in 1933, separated normal banking from the risky speculation until 1999, when its provisions were gutted under Bill Clinton. Banks were regulated to make loans to borrowers who could provide sound collateral and earn enough to carry their debts. 1372
The economy was idealized as rising and falling fairly smoothly around a steady upward trend. The mathematics of compound interest should have alerted regulators to the need “to take away the punch bowl just as the party gets going,” as McChesney Martin, long-term Federal Reserve Chairman (1951-70) famously quipped. But the combination of New Deal reforms and soporific economic theory (assuming that economies could carry a rising debt burden ad infinitum) led regulators to lower their guard against the strains created by banks and bondholders lending on increasingly risky terms at rising debt/income and debt/asset ratios. Alan Greenspan promised the public before the 2008 crash that a real estate implosion was impossible because such a decline would be only local in scope, not economy-wide. But by this time the pro-Wall Street drive by the Clinton Administration’s orchestrated by Treasury Secretary Robert Rubin (later to chair Citibank, which became the most reckless player) had opened the floodgates that led rapidly to widespread insolvency. Nearly ten million homes fell into foreclosure between 2008 and mid-2014 according to Moody’s Analytics. Cities and states found themselves so indebted that they had to start selling off their infrastructure to Wall Street managers who turned roads, sewer systems and other basic needs into predatory monopolies. 1377
Across the board, the U.S. and European economies were “loaned up” and could not sustain living standards and public spending programs simply by borrowing more. Repayment time had arrived. That meant foreclosures and distress sales. That is the grim condition that the financial sector historically has sought as its backup plan. For creditors, debt produces not only interest, but property ownership as well, by indebting their prey. 1388
Wages and profits rose steadily from 1945 to the late 1970s. So did savings. Banks lent them to fund new construction, as well as to bid up prices for housing already in place. This recycling of savings plus new bank credit into mortgage lending obliged homebuyers to borrow more as interest rates rose for 35 years, from 1945 to 1980. The result was an exponential growth of debt to buy housing, automobiles and consumer durables. Financial wealth – what the economy owes bankers and bondholders – increases the volume of debt claims from one business cycle to the next. Each business recovery since World War II has started with a higher debt level. Adding one cyclical buildup on top of another is the financial equivalent of driving a car with the brake pedal pressed tighter and tighter to the floor, slowing the speed – or like carrying an increasingly heavy burden uphill. The economic brake or burden is debt service. The more this debt service rises, the slower markets can grow, as debtors are left with less to spend on goods and services because they must pay a rising portion of income to banks and bondholders. Markets shrink and a rising proportion of debtors default. New lending stops, and debtors must start repaying their creditors. This is the debt deflation stage in which business upswings culminate. By the mid-1970s entire countries were reaching this point. New York City nearly went bankrupt. Other cities could not raise their traditional source of tax revenue, the property tax, without forcing mortgage defaults. 1400
Deterioration of loan quality to interest-only loans and “Ponzi” lending Hyman Minsky has described the first stage of the financial cycle as the period in which borrowers are able to pay interest and amortization. In the second stage, loans no longer are self-amortizing. Borrowers can only afford to pay the interest charges. In the third stage they cannot even afford to pay the interest. They have to borrow to avoid default. In effect, the interest is simply added onto the debt, compounding it. Default would have obliged banks to write down the value of their loans. To avoid “negative equity” in their loan portfolio, bankers made new loans to enable Third World governments to pay the interest due each year on their foreign debts. That is how Brazil, Mexico, Argentina and other Latin American countries got by until 1982, when Mexico dropped the “debt bomb” by announcing that it could not pay its creditors. Leading up to the 2008 financial crash, the U.S. real estate market had entered the critical stage where banks were lending homeowners the interest as “equity loans.” Housing prices had risen so high that many families could not afford to pay down their debts. To make the loans work “on paper,” real estate brokers and their banks crafted mortgages that automatically added the interest onto the debt, typically up to 120 percent of the property’s purchase price. Bank credit thus played the role of enticing new subscribers into Ponzi schemes and chain letters. Over-lending kept the economy from defaulting until 2008. 1414
These are paid out of the proceeds from more and more new players joining the scheme, e.g., by new homebuyers taking out ever-rising mortgage loans to buy out existing owners. The newcomers hope that returns on their investment (like a chain letter) can keep on expanding ad infinitum. But the scheme inevitably collapses when the inflow of new players dries up or banks stop feeding the scheme. 1430
Higher prices for the houses being borrowed against seemed to justify the process, without much thought about how debts could be paid by actually earning wages or profits. Banks created new credit on their keyboards, while the Federal Reserve facilitated the scheme by sustaining the exponential rise in bank loans (without anyone having to save and deposit the money). However, this credit was not invested to increase the economy’s productive powers. Instead, it saved borrowers from default by inflating property prices – while loading down property, companies and personal incomes with debt. The fact that price gains for real estate are taxed at a much lower rate than wages or profits attracted speculators to ride the inflationary wave as lending standards were loosened, fostering lower down payments, zero-interest loans and outright fictitious “no documentation” income statements, forthrightly called “liars’ loans” by Wall Street. But property prices were bound to crash without roots in the “real” economy. Rental incomes failed to support the debt service that was owed, inaugurating a “fourth” phase of the financial cycle: defaults and foreclosures transferring property to creditors. On the global plane, this kind of asset transfer occurred after Mexico announced its insolvency in 1982. Sovereign governments were bailed out on the condition that they submit to U.S. and IMF pressure to sell off public assets to private investors. Every major debt upswing leads to such transfers. These are the logical consequence of the dynamics of compound interest. 1437
Table B.100 from the Federal Reserve’s flow-of-funds statistics shows the consequences of U.S. debt pyramiding. By 2005, for the first time in recent history, Americans in the aggregate held less than half the market value of their homes free of debt. Bank mortgage claims accounted for more than half. By 2008 the ratio of home equity ownership to mortgage debt had fallen to just 40 percent. Bank mortgages now exceed homeowners’ equity, which fell below 40% in 2011. 1450
What happens when the exponential buildup of debt ends During the financial upswing the financial sector receives interest and capital gains. In the fallback period after the crisis, the economy’s private- and public-sector assets are expropriated to pay the debts that remain in place. A “Minsky moment” erupts at the point when creditors realize that the game is over, run for the exits and call in their loans. The 2008 crash stopped bank lending for mortgages, credit cards and nearly all other lending except for U.S. government-guaranteed student loans. Instead of receiving an infusion of new bank credit to break even, households had to start paying it back. Repayment time arrived. This “saving by paying down debt” interrupts the exponential growth of liquid savings and debt. But that does not slow the financial sector’s dominance over the rest of the economy. Such “intermediate periods” are free-for-alls in which the more powerful rentiers increase their power by acquiring property from distressed parties. 1455
Financial emergencies usually suspend government protection of the economy at large, as unpopular economic measures are said to be necessary to “adjust” and restore “normalcy” – finance-talk for a rollback of public regulatory constraints on finance. “Technocrats” are placed in control to oversee the redistribution of wealth and income from “weak” hands to strong under austerity conditions. 1464
reverse mortgages. Retirees and other homeowners signed agreements with banks or insurance companies to receive a given annuity payment each month, based on the owner’s expected lifetime. The annuity was charged against the homeowner’s equity as pre-payment for taking possession upon the owner-debtor’s death. The banks or insurance companies ended up with the property, not the children of the debtors. (In some cases the husband died and the wife received an eviction notice, on the ground that her name was not on the ownership deed.) The moral is that what is inherited in today’s financialized economy is creditor power, not widespread home ownership. So we are brought back to the fact that compound interest does not merely increase the flow of income to the rentier One Percent, but also transfers property into its hands. 1469
economies veer out of balance as revenue is diverted to pay bankers and bondholders instead of to expand business. Yet this has not discouraged economists from projecting national income or GDP as growing at a steady trend rate year after year, assuming that productivity growth will continue to raise wage levels and enable thrifty individuals to save enough to retire in affluence. The “magic” of compound interest is held to raise the value of savings as if there are no consequences to increasing debt on the other side of the balance sheet. The internal contradiction in this approach is the “fallacy of composition.” Pension funds have long assumed that they and other savers can make money financially without inflicting adverse effects on the economy at large. Until recently most U.S. pension funds assumed that they could make returns of 8.5 percent annually, doubling in less than seven years, quadrupling in 13 years and so forth. This happy assumption suggested that state and local pension funds, corporate pension funds and labor union pension funds would be able to pay retirees with only minimal new contributions. The projected rates of return were much faster than the economy’s growth. Pension funds imagined that they could grow simply by increasing the value of financial claims on a shrinking economy by extracting a rise in interest, dividends and amortization. 1478
It is as if savings can keep accruing interest and make capital gains without shrinking the economy. But a rate of financial growth that exceeds the economy’s ability to produce a surplus must be predatory over time. Financialization intrudes into the economy, imposing austerity and ultimately forcing defaults by siphoning off the circular flow between producers and consumers. To the extent that new bank loans find their counterpart in debtors’ ability to pay in today’s bubble economies, they do so by inflating asset prices. Gains are not made by producing or earning more, but by borrowing to buy assets whose prices are rising, being inflated by credit created on looser, less responsible terms. Today’s self-multiplying debt overhead absorbs profits, rents, personal income and tax revenue in a process whose mathematics is much like that of environmental pollution. 1490
The twenty-ninth day,” that is, one day before the half the pond’s lilies double for the final time, stifling its surface. The end to exponential growth thus comes quickly. The problem is that the pond’s overgrowth of vegetation is not productive growth. It is weeds, choking off the oxygen needed by the fish and other life below the surface. This situation is analogous to debt siphoning off the economic surplus and even the basic needs of an economy for investment to replenish its capital and to maintain basic needs. Financial rentiers float on top of the economy, stifling life below. Financial managers do not encourage understanding of such mathematics for the public at large (or even in academia), but they are observant enough to recognize that the global economy is now hurtling toward this pre-crash “last day.” That is why they are taking their money and running to the safety of government bonds. Even though U.S. Treasury bills yield less than 1 percent, the government can always simply print the money. The tragedy of our times is that it is willing to do so only to preserve the value of assets, not to revive employment or restore real economic growth. Today’s creditors are using their gains not to lend to increase production, but to “cash out” their financial gains and buy more assets. The most lucrative assets are land and rent-yielding opportunities in natural resources and infrastructure monopolies to extract land rent, natural resource rent and monopoly rent. 1500
Finance has converted its economic power into the political power to reverse the classical drive to tax away property rent, monopoly rent and financial income, and to keep potential rent-extracting infrastructure in the public domain. Today’s financial dynamics are leading back to shift the tax burden onto labor and industry while banks and bondholders have obtained bailouts instead of debts being written down. This is the political dimension of the mathematics of compound interest. It is the pro-rentier policy that the French Physiocrats and British liberals sought to reverse by clearing away the legacy of European feudalism. 1515
the forefront of the news by the statistical research of Thomas Piketty 1529
statistical research of Thomas Piketty and Emmanuel Saez showing the increasing concentration of income in the hands of the richest One Percent. The main remedies they propose are a wealth tax (especially on inherited estates) and a return to steeper progressive income taxation. The idea of taxing higher income brackets more without regard for whether their gains are earned “productively” or in extractive rentier ways represents a victory in dissuading critics from focusing on the policy aim of Adam Smith and other classical economists: preventing “unearned” income from being obtained in the first place. As Chapter 3 has described, they recognized not only that rentier revenue (and capital gains) is earned in a predatory and unproductive way, but also that land rent, monopoly rent and financial charges are mainly responsible for the rising wealth of the One Percent as compared to that held by the rest of society. 1530
FIRE sector revenue appears as a cost of producing an equivalent amount to Gross Domestic Product (GDP), not as unearned income or “empty” pricing. And neither the NIPA nor the Federal Reserve’s flow-of-funds statistics recognize how the economy’s wealthiest financial layer makes its fortunes by land-price gains and other “capital” gains. A cloak of invisibility thus is drawn around how FIRE sector fortunes are amassed. 1546
The foundation myth of pro-rentier economics is that everyone receives income in proportion to the contribution they make to production. This denies that economic rent is unearned. Hence, there is no exploitation or unearned income, and no need for the reforms advocated by classical political economy. 1550
Robber barons, landlords and bankers are depicted as part of the production process, and prices are assumed to settle at their cost of production, defined to include whatever rentiers manage to obtain. This closed logical circle excludes any criticism that markets may work in an unfair way. To Clark and other “free market” economists, “the market” is simply the existing status quo, taking for granted the existing distribution of wealth and property rights. Any given distribution of property rights, no matter how inequitable, is thought of as part of economic nature. The logic is that all income is earned by the recipient’s contribution to production. It follows that there is no free lunch – and also that There Is No Alternative to the extent that the existing distribution of wealth is a result of natural law. 1566
Treating any revenue-yielding asset as capital conflates financial and rentier claims on production with the physical means of production. The vantage point is that of financiers or investors buying land and real estate, oil and mineral deposits, patents, monopoly privileges and related rent extraction opportunities without concern for whether economists classify their returns as profit or as rent. Today’s tax laws make no such distinction. 1575
failure to distinguish manmade capital from property rights that did not involve any necessary or intrinsic cost of production. The result, Patten said, was to conflate profits earned on tangible industrial capital investment with land and monopoly rent. To real estate investors or farmers buying properties on mortgage, the financial and monopoly charges built into their acquisition price appear as an investment cost. “The farmer thinks that land values depend on real costs” because he had to pay good money for his property, explained Patten, “and the city land speculator has the same opinion as to town lots.” This individualistic view is antithetical to the socialist and Progressive Era reforms being introduced in the late 19th century. That is what makes classical concerns with the economics of national development different from the financialized investor’s-eye view of the world. At issue was what constitutes the cost of production in terms of real value, as distinct from extractive rentier charges. Freeing economies from such charges seemed to be the destiny of industrial capitalism. 1581
“Institutionalist” and sociological reformers retained rent theory Patten pointed out that land sites, like mineral rights provided by nature and financial privileges provided by legal fiat, do not require labor to create. But instead of describing their economic rent as an element of price without real cost or labor effort, Clark viewed whatever amount investors spent on acquiring such assets as their capital outlay and hence as a market cost of doing business. “According to the economic data he presents,” Patten wrote, “rent in the economic sense, if not wholly disregarded, at least receives no emphasis. Land seems to be a form of capital, its value like other property being due to the labor put upon it.” But its price simply capitalizes property rights and financial charges that are not intrinsic. 1590
For national economies, the problem is that and land rent and natural resource rent are taken at the expense of wage earnings as well as from industrial profits. “It seems to me,” Patten wrote, that the doctrine of Professor Clark, if carried out logically, would deny that the laborers have any right to share in the natural resources of the country. … All the increase of wealth due to fertile fields or productive mines would be taken gradually from workmen with the growth of population, and given to more favored persons … When it is said that the workingman under these conditions gets all he is worth to society, the term ‘society,’ if analyzed, means only the more favored classes … They pay each laborer only the utility of the last laborer to them, and get the whole produce of the nation minus this amount. This is why Patten’s contemporary reformers urged that land, natural resources and monopolies be kept in the public domain, so as to minimize the rake-off of national patrimony “given to more favored persons.” The idea of unearned income as a subtraction from the circular flow of income available for labor and industry as wages and profits has vanished from today’s post-classical NIPA. Now, whatever is paid to rentiers is considered a bona fide cost of doing business as if it embodies intrinsic value for a product. 1606
Clark’s claim that no income is unearned defines all economic activities as being productive in proportion to how much income they obtain. No one way of making money is deemed more or less productive than any other. 1617
Everyone earns just what he or she deserves. Natural law will proportion income and wealth to their recipients’ contribution to production, if not “interfered” with. Today’s highest paying occupations are on Wall Street, running banks, hedge funds or serving as corporate Chief Financial Officers. In Clark’s view they earn everything they get, and everyone else only deserves whatever is left over. Gary Becker, the University of Chicago economist, followed this logic in justifying such incomes as being earned productively, warning that progressive taxation would discourage their enterprise and hence productivity: “A highly progressive income tax structure tends to discourage investment in human capital because it reduces take-home pay and the reward to highly skilled, highly paid occupations.” Rentier income, inherited wealth, landlords and monopolies making money off the economy is thus interpreted as “earnings” on one’s “human capital,” the neoliberal catchall residual to absorb whatever cannot be explained in terms of actual labor effort or cost. It replaces what former economists called unearned income. It is as if the One Percent and the FIRE sector do not make money off the property they have (either inherited or built up far beyond what anyone’s individual labor and enterprise could explain), but out of their own human talents. Finance capital, rentier capital, land and monopoly rights are all conflated with “capital.” 1619
Keynes worried that as economies grew richer, people would save a larger proportion of their income instead of spending on consumption. This drain from the circular flow would lead to depression, unless governments compensated by infusing money into the economy, hiring labor for public works. Keynes depicted saving simply as hoarding – withdrawing revenue from the spending stream of production and consumption. 1647
There always is an economic gain for some party in sponsoring bad theory. Many erroneous economies can be traced to policies endorsed by the bad theorists. Leaving rentier income and spending out of the equation enables anti-labor economists to demand monetary austerity and a balanced government budget as their knee-jerk policy response. The narrow-minded MV=PT tautology enables economists to blame wages for inflationary pressures, not the cost of living being pushed up by debt-leveraged housing prices and other FIRE sector expenses, or by the rising corporate debt service built into the pricing of goods and services. In reality, asset prices rise or fall at a different rate from commodity prices and wages. This is a result precisely of the fact that the Federal Reserve and other central banks “inject” money into the economy via Wall Street, the City of London or other financial centers, by buying and selling Treasury securities or providing commercial bank reserves, e.g., in the post-2008 waves of Quantitative Easing. 1666
The assumption is that people only receive income for what they produce. This assumption rests on a tunnel vision that reflects the ideological victory that landlords and vested financial interests achieved in the late 19th century against the classical drive to tax economic rent. The effect of excluding land rent, natural resource rent and monopoly rent – the drain of income from producers and consumers to pay landlords, privatizers, monopolists and their bankers – is to deter measurement of what I call rent deflation. That is the analogue to debt deflation – the diversion of income to pay debt service. 1687
There also is no measure of criminal income, smuggling or fictitious accounting for tax avoidance. No category of spending is counted as overhead, not even pollution cleanup costs or crime prevention, not to mention financial bailouts. Economists dismiss these as “externalities,” meaning external to the statistics deemed relevant. Yet despite the rising proportion of spending that takes the form of rent extraction, environmental pollution cleanup costs, debt pollution and its bailout costs, GDP is treated as a an accurate measure of economic welfare. The result confuses healthy growth with that of a tumor on the body politic. Taken together, these omissions deter the kind of systemic analysis that would have alerted policy makers and voters to the distortions leading up to the 2008 crash. 1693
Rental income obtained by commercial investors and natural resource owners is called “earnings” on a par with profits and wages. This diverts attention away from how fortunes are made without labor or out-of-pocket production costs. It also requires a convoluted reorganization of statistics to discover how large the actual cash-flow return to absentee real estate ownership is, given the heavy component of interest and the “just pretend” economic category of over-depreciation. 1704
Land rent appears to have disappeared into the Orwellian memory hole. It is as if commercial real estate investors and owners receive no land rent at all. This terminological sleight of hand helped divert attention from how bank over-lending led to the real estate bubble that burst in 2008. It also trivializes international trade theory, by failing to recognize how capitalizing land rent into mortgage loans raises the cost of housing and other debt-leveraged prices. What the NIPA do make clear is that most real estate rental income is paid to the banks as interest. NIPA accountants find real estate and banking are so intertwined in the symbiotic FIRE sector that for many years financial and real estate income was not separated in the statistics. The activities of mortgage brokers and real estate agents seem to belong to Finance, Insurance or Real Estate in common. 1715
The NIPA also show how the tax fiction of over-depreciation (writing off a building more than once, over and over again) offsets otherwise taxable earnings for commercial real estate, enabling commercial real estate, oil and mining companies to operate decade after decade without a reportable taxable profit. An army of accountants has been backed by political lobbyists to write “loopholes” (a euphemism for distorting economic reality) into the tax code to make it appear that landlords and oil companies lose money, not make it! According to the NIPA, real estate earnings do not cover the rate at which landlords pay interest as a cost of production and buildings depreciate. Depreciation and the rate of return For industrial capital that wears out or obsolesces (becoming high-cost as a result of improving technology, e.g., computers that quickly get out of date even though they remain in working order), depreciation is a return of capital, and hence not part of surplus value strictly speaking. But this is not the case in the real estate, because buildings do not wear out – and rather than their technology becoming obsolete, older buildings tend to have much more desirable construction, or else have been renovated as a result of the ongoing maintenance repairs that typically absorb about 10 percent of rental income (or a property’s equivalent rental value). So for real estate, depreciation is largely a fictitious category of income designed to make rental revenue tax-free. The same building can be depreciated all over again – at a rising price – each time the property is sold to a commercial investor. (Homeowners are not allowed this tax subsidy.) 1723
Thus, despite the pretense by accountants that real estate is losing its value, the land’s site value (and the decline in interest rates) actually is increasing its value. Reality and seemingly empirical statistics tell opposite stories. No wonder the wealthiest One Percent have widened their wealth gap over the rest of the economy, defending this just-pretend statistical picture as if it is empirical science and therefore objective simply because its deception has decimal points. 1737
What actually happens is that landlords, oil and gas companies, mining companies, monopolies and banks charge rents for access to the land, natural resources and credit needed for production to take place. These payments drain the circular flow of spending between producers and consumers, shrinking markets and causing unemployment. Rentiers spend their income not only to hire labor and buy its products (as Malthus described, and as Keynes applauded) but also to buy financial assets and more property. Banks use their revenue to make more loans. This creates yet more debt while bidding up asset prices, obliging new homebuyers to borrow even more for ownership rights. 1742
the NIPA provide a cloak of invisibility for rent-extracting activities. The vested interests have won the fight against creating more relevant statistical categories. Their hope evidently is that if exploitative activities are not seen or quantified, they are less likely to be taxed or regulated. 1753
Today’s major rentier sector is banking and high finance. Most bank loans are geared not to produce goods and services, but to transfer ownership rights for real estate, stocks (including those of entire companies) and bonds. This has led national income theorists to propose treating the revenue of such institutions as transfer payments, not payments for producing output or “product.” 1757
Thorstein Veblen 2117
the Paris Bourse and Frankfurt, instead of in public hands as socialists 2141
Most U.S. and European corporations pay for their capital investment out of their current earnings, not by borrowing from bondholders or banks. The financial system extends credit mainly to buy property already in place, from real estate (the focus of most bank lending today) to entire companies. This shift in ownership adds to debt without increasing output, merely transferring ownership. Existing stockowners are bought out by new owners who issue high-interest bonds and borrow takeover loans from banks. And corporations borrow increasingly to buy up their own stock, and even to pay dividends, creating gains by inflating asset prices. 2173
As early as 1910, Rudolf Hilferding’s Finanzkapital described high finance as extractive: “Property ceases to express any specific relation of production and becomes a claim to the yield, apparently unconnected with any particular activity.” 2322
The tax subsidy for debt over stock market financing is a major catalyst to debt-leveraged buyouts (LBOs) and share buybacks. The new breed of corporate raiders and “financial engineers” pay themselves interest and produce capital gains with the profits hitherto shared with federal, state and local tax collectors. The government budget deficits deepens, and the Treasury issues more bonds (and looks to raise taxes from labor and consumers). The entire economy becomes more debt-leveraged, paying income to creditors – headed by the One Percent – instead of investing it or spending to raise living standards. This phenomenon is the major theme of this book. 2346
Debts require interest to be paid at a stipulated pace without regard for what the debtor earns. If a payment is missed, creditors have the right to foreclose on whatever assets are pledged as collateral. To protect themselves, debtors keep a liquid savings cushion on hand to cover the risk of declining income. Paying interest and amortization thus leaves less available to spend. 2356
Banks hesitate to finance new ventures. They prefer to lend against collateral on which they can foreclose if debtors cannot meet their scheduled payment. This obliges debtors to keep liquid savings on hand, leaving less for current spending. In antiquity, debtors who could not pay fell into bondage to their creditors. That is the original literal meaning of bond: a fetter imprisoning the debtor. Now that debtors’ prisons have been phased out, creditors have recourse to the debtor’s property and future earnings. Homeowners pledge their real estate to back their mortgage debts, companies pledge their assets, and clients of payday loan sharks pledge their kneecaps. 2363
The problem is that instead of raising capital to fund new capital investment and avoid debt, the stock market has been turned into a vehicle for debt-financed takeovers, replacing equity with debt. Starting with the high-interest “junk” bonds issued from 1977 onward, a class of raiders and “buyout kings” like Carl Icahn emerged to become Wall Street’s most lucrative market. Financial empire builders borrowed from banks and institutional bond buyers to buy out existing stockholders. Takeover financing pays an interest rate premium because of the relatively high risk that the process will drive targeted companies bankrupt, or at least will strip their capital and slow their growth by raising their debt/equity ratio. The process is called debt leveraging. It has been welcomed as “wealth creation,” as if it enriches the economy rather than leaving less for new investment and hiring. 2368
Researchers at Stanford University have concluded that pressure to meet quarterly earnings targets may be reducing research and development spending, and cutting US growth by 0.1 percentage points a year. Others have found that privately held companies, free to take a longer-term approach, invest at almost 2.5 times the rate of publicly held counterparts in the same industries. This persistent lower investment rate among America’s biggest 350 listed companies may be reducing US growth by an additional 0.2 percentage points a year. Much of the problem stems from the way the vast majority of asset owners pay the people who manage their money. On average, 74 per cent of remuneration is paid in cash, and tied to outperforming an annual stock market benchmark. The result is an obsession with next quarter’s earnings rather than the next 10 years’. — Financial Times, April 1, 2015 2380
The origins of banking, financial partnerships and shares in enterprises are to be found in the temples and palaces of the ancient Near East at the inception of the Bronze Age (3200-1200 BC). From the time interest-bearing debt was innovated in Mesopotamia to finance commerce and provide agricultural credit around 3000 BC, there is no trace of borrowing to manufacture goods in workshops, and rarely to buy land. Business credit came into the picture initially to consign temple handicrafts or commodities to seafaring merchants and caravans for long-distance commerce. 2393
The wealthy used their profits from this commerce and money lending to buy land, which was the major determinant of social status and economic patronage throughout antiquity. (What modern historians call “banks” were family or public lenders using mainly their own money, not deposits.) Purchases of real estate and other assets were for cash. Even in modern times it has been rare for banks to finance investment in industrial production. Until the 19th century most business loans were to fund the sale (usually exportation) of goods after they were produced, not to put workshops and factories in place. Banks thus found their major market in international trade, which helps explain why the British bank spokesman David Ricardo advocated an international specialization of labor instead of national self-sufficiency in food and other basic needs. 2399
Historically, most lending to governments has focused on war borrowing. When the Habsburgs and other rulers had trouble paying their debts, bankers pressed for payment in the form of a transfer of ownership of mines and other natural resources in the public domain. Rulers also created commercial monopolies to privatize: the East and West Indies Companies of Holland, Britain and France, and similar exclusive privileges (literally “private law”) to trade with specific regions or similar. These Crown Corporations paid dividends out of monopoly rent extraction, not profits from industrial manufacturing. 2423
To maximize what they received for these monopolies, governments promoted stock markets as a speculative vehicle. 2432
To dispose of France’s royal debt, he created the Mississippi Company to develop plantation slavery in what later was called the Louisiana territory (named for Louis XIV). Britain emulated the scheme, hoping to retire its war debts by privatizing the asiento slave trade monopoly its navy had won from Spain. This treaty became the sole asset of the newly incorporated South Sea Company, named for the South Atlantic across which slaves were shipped from Africa to the New World. Together, these two government-sponsored bubbles promised enormous wealth from 18th century’s the major growth sector: the African slave trade, that century’s version the dot.com bubble of the 1990s. The beneficiaries were the French and British governments, along with insiders who became part of what today is called a pump and dump operation. 2439
The French and British governments accepted payment for stock in these companies in their own bonds – at full par value. This provided a giveaway to bondholders, because the bonds could be bought at a steep discount, reflecting widespread doubt that they could actually be paid. Bond prices rose as new buyers used them to buy shares in the Mississippi and South Sea companies. Almost no money raised by these companies was actually invested to undertake business and generate a profit. What was sold was hope – shares in purely potential gains. Investors only needed to put down about 10 percent of the purchase price of the stock to subscribe. By the time the second payment was due, the stock price may have been bid up by at least that amount, doubling the initial down payment. This debt leveraging – buying on credit with only a small down payment – magnifies gains and losses in asset prices on both the upside and downside. It was the strategy Margaret Thatcher used to popularize the privatization of British Telecom and subsequent selloffs of government assets, providing quick speculative gains to early buyers with small down payments. 2446
The government tactic was to sell stocks in order to retire its bonds instead of defaulting on them, by persuading bondholders to swap their bonds for shares in the new companies. When the swap was completed, the stock price was allowed to plunge. The government shed crocodile tears at the “madness of crowds” that it itself had encouraged! It was a carefully orchestrated madness. Insiders avoided loss by selling out in time. 2455
Making stock market gains from financial leverage and rent extraction The privatization of monopolies, canals or national railroad systems always has been associated with insider dealing and fraud, ending with latecomer buyers holding a collapsing financial bag. Yet despite insider manipulations and subsequent collapse, the idea of making capital gains while putting down only a fraction of the purchase price seized the public imagination. It offered the temptation of outsiders making the huge gains that insiders tended to monopolize. 2459
The irony of the stock market is that corporations were created to replace short-term partnerships for voyages and other such ventures. Instead of having to divide up profits at the end of each voyage or upon the death of major partners, corporations have been given a permanent existence, divided into shares that were transferable. Yet the financial time frame is still short-term. This is especially true of bankers, who did little to finance the Industrial Revolution. The economic historian George W. Edwards has found that Britain’s “investment banking houses had little to do with the financing of corporations or with industrial undertakings. The great investment houses bitterly opposed the numerous corporate issues which were floated in 1824 and 1825,” hoping to control industry by bank credit. “The investment houses for a long time refused to take part even in the financing of the British railways.” Banks and other lenders advanced credit to industry only if proprietors could show orders for their products, or bills falling due for sales. Most of all, banks financed shipments of goods, spanning the time gap between production, delivery and receipt of payment by the customer, usually payable after 90 days. This financing involved foreign exchange fees for the banks as well as interest. But it was a short-term business. 2465
the Industrial Revolution’s leading entrepreneurs could obtain bank credit only after investing their own funds to get production underway. From James Watt’s steam engine in the late 18th century to Henry Ford’s automobile in the early 20th century, banks were not in the foresight business. Stock markets really began to take off in the 19th century for railroads and canals, other basic infrastructure, monopolies and trusts. These undertakings were rife with financial fraud, headed by the Panama and Suez Canal schemes. America’s stock market consisted mainly of railroad stocks during its early years, which transferred enormous sums of British and other European savings to the United States. Wall Street operators skimmed off much of the inflow. A favorite tactic was “stock watering,” a practice of proprietors issuing stock to themselves, “diluting” the ownership of existing shareholders. Banks favored railroads and public utilities whose income streams could be easily forecast, and large real estate borrowers with land pledged as collateral. Manufacturing enterprises only obtained significant bank and stock market credit after companies had grown fairly large with stable earnings. Growth potential hardly qualified. By the 1920s, Britain’s banks were broadly criticized for their failure to finance industry, and for favoring international clients rather than domestic ones. 2477
Apart from infrastructure speculation, the stock market was mainly a vehicle for manipulators to buy ownership rights of natural monopolies and rent-seeking privileges, especially to create large trusts such as U.S. Steel and Standard Oil. Banks, pension funds and other financial institutions have lent increasingly for speculation in stocks and bonds, including today’s debt-leveraged buyouts for mergers, acquisitions and outright raids. Trade financing was evolving into investment banking, focusing on real estate, oil and other natural resources, and funding speculation in stocks, foreign bonds and currencies. These high-risk activities held consumer and business deposits hostage to financial gambling and raiding, leading to the 1929 crash and the Great Depression. 2490
The economic wreckage made it obvious that the U.S. financial system needed to be insulated from such speculation. Congress passed the Glass-Steagall Act in 1933 to isolate financial speculation from personal and basic business banking. Other New Deal reforms included creation of the Securities and Exchange Commission (SEC), the Federal Deposit Insurance Corp. (FDIC) and a shift to 30-year home mortgages instead of the short three-year time frame. These reforms succeeded in stabilizing banking through the 1940s up to the 1970s. 2496
high finance has promoted debt at the expense of equity, and used it to make short-term financial returns rather than funding new capital investment. 2510
The result is that despite 20th-century reformers’ hopes to see the stock market promote industrial capital formation, it has become a vehicle for loading companies down with debt and cutting back their long-term investment. Unlike dividends to shareholders, interest charges on debt cannot be reduced when sales and earnings turn down. 2512
Companies that replace equity with debt lose economic flexibility and must live on short financial leashes. 2515
The term “junk bonds” was coined to reflect high-interest bonds issued to corporate raiders and takeover kings to buy companies with borrowed credit (or, less negatively, to finance smaller new business without a track record or deemed too risky to obtain normal bank credit). 2518
Adam Smith long ago remarked that profits often are highest in nations going fastest to ruin. There are many ways to create economic suicide on a national level. The major way throughout history has been by indebting the economy. Debt always expands to reach a point where it cannot be paid by large swaths of the economy. That is the point where austerity is imposed and ownership of wealth polarizes between the One Percent and the 99 Percent. Today is not the first time this has occurred in history. But it is the first time that running into debt has occurred deliberately, applauded as if most debtors can get rich by borrowing, not reduced to a condition of debt peonage. 2664
Finance vs. Industry: Two Opposite Sides of the Balance Sheet Last year, the corporations in the Russell 3000, a broad U.S. stock index, repurchased $567.6 billion worth of their own shares – a 21% increase over 2012 … That brings total buybacks since the beginning of 2005 to $4.21 trillion – or nearly one-fifth of the total value of all U.S. stocks today. — Jason Zweig, “Will Stock Buybacks Bite Back?” Wall Street Journal, March 22, 2014. Today’s financial sector is raiding what was expected a century ago to be the social functions of capital: to expand output and employment. Economies are slowing in the face of exponentially growing financial claims (bank loans, stocks and bonds) that enrich the One Percent at the expense of the 99 Percent. This polarization leads to unemployment and also to corporate underinvestment by leaving companies too cash-strapped to undertake new capital spending to raise productivity.2679
Business schools teach today’s new breed of managers that the proper aim of corporations is not to expand their business but to make money for shareholders by raising the stock price. Instead of warning against turning the stock market into a predatory financial system that is de-industrializing the economy, they have jumped on the bandwagon of debt leveraging and stock buybacks. Financial wealth is the aim, not industrial wealth creation or overall prosperity. The result is that while raiders and activist shareholders have debt-leveraged companies from the outside, their internal management has followed the post-modern business school philosophy viewing “wealth creation” narrowly in terms of a company’s share price. The result is financial engineering that links the remuneration of managers to how much they can increase the stock price, and by rewarding them with stock options. This gives managers an incentive to buy up company shares and even to borrow to finance such buybacks instead of to invest in expanding production and markets. 2688
Conventional wisdom throughout the 20th century described low interest rates as spurring new investment and employment by lowering the cost of borrowing, and hence supposedly the cost of new investment. But few bank loans or bonds are for this purpose. Instead, low interest rates provide easier credit for raiders to attack companies, or simply for mergers and acquisitions. 2707
The effect of financial interlopers buying a company and making it appear more profitable in the short run by “bleeding” its balance sheet (hoping to find a buyer who will believe that the company has been “streamlined,” not depleted) is like a landlord stinting on maintenance and repairs, paying bills more slowly, and letting the property deteriorate by laying off doormen and other niceties. The property is left debt-ridden, with a stagnating rent roll unable to cover the mortgage. If we view industry as part of the economic and social environment, today’s breed of corporate raiders and shareholder activists are strip-mining companies, causing debt pollution, clear-cutting industry and leading to economic drought. Such short-termism is much like a debt-strapped family having to rely on a junk-food diet in order to make ends meet, leading to long-term medical costs and shorter lifespans. Living in the short run does not help make economies lower-cost and more productive. The aim is simply to report bigger profits so that managers and stockholder “activists” can exercise their stock options at a higher price. 2764
Even the public sector has adopted financial management criteria to squeeze out a positive cash flow. Governments are reducing their budget deficits by cutting back on maintenance and repair of bridges, roads and other infrastructure, and selling off public real estate and other assets. The effect is to inject less purchasing power and employment to support economic recovery. 2807
The financial sector promised to inaugurate a postindustrial economy in which bank customers could make money from borrowed credit created on computer keyboards without a need for industrial capital formation or employment. 2821
banking was on its way to becoming a public utility in the years leading up to World War I. 2830
public banking would be less likely to extend credit for the asset-stripping and asset-price inflation that characterizes today’s financial system. 2833
Most futurists a century ago believed that public regulation was needed to keep predatory finance and rent-seeking in check. But bankers and financiers successfully instituted a deregulatory economic philosophy and have seized control of governments to use its money-creating power to subsidize high finance, while leaving creditors “free” to stifle the economy’s real growth with debt deflation. 2834
Today’s financial interests denounce public regulation and rentier taxes as socialism. But “socialism” was not initially a term of invective for classical theorists. John Stuart Mill was called a Ricardian socialist because classical economists were moving toward reforms they themselves characterized as social – and hence, as socialist. Most reformers referred to themselves as socialists of one kind or another, from Christian socialists to Marxist socialists and reformers across the political spectrum. The question was what kind of socialism “free market” capitalism would evolve into. 2838
The resulting financial overhead consists of claims on the economy’s actual means of production. Yet most people think of these bonds, bank loans and stocks and creditor claims as wealth, not its antithesis on the debit side of the balance sheet. This inside-out doublethink is a precondition for the bubble economy to be applauded by the mass media, keeping its corrosive momentum expanding. 2881
Most capital investment in the U.S. and other economies normally is self-financed out of retained corporate earnings, not by borrowing from banks or bondholders. During the 35-year upswing spanning the return to peace after World War II until the late 1980s, “profits and overall net investment in the US tracked each other closely … with both about 9 per cent of gross domestic product,” noted a recent Financial Times report. But this correlation between capital investment and corporate profits “began to break down” in the Reagan/Thatcher era. By 2012 the National Income and Product Accounts (NIPA) were reporting that pre-tax corporate profits had risen to a record 12 per cent-plus of GDP, “while net investment is barely 4 per cent of output.” Although corporate profits have soared in recent years, they are not leading to new tangible investment, output or employment. The explanation for this disconnect is financialization. 2891
Some 40 percent of profits are now registered by the banking and financial sector, not industry. In the manufacturing sector, managers increase reported profits by cutting back basic spending, letting their physical investment run down, and replacing long-term skilled employees with less highly paid new recruits, while using the remaining corporate profits increasingly for share buybacks and higher dividend payouts. These practices have decoupled financial management from investment in new means of production. The idea that economies can get rich mainly from the debit side of the national balance sheet reflects the degree to which creditor interests have taken over the economy’s brain. 2899
Mainstream economists called the 1990-2007 era the Great Moderation. But then, bankers were in charge of naming it (in this case, David Shulman of Salomon Brothers). In reality it was the Great Indebtedness, leading to the Great Polarization that paved the way for today’s Great Austerity. When the bubble crashed, Wall Street blamed “the madness of crowds.” This blame-the-victim view depicted borrowers as being immoderate and greedy, and it seemed only moral that the “mad crowd” should now pay the price for its reckless indebtedness, not the creditors. So the most reckless banks were bailed out, as if it were not they and the Federal Reserve that were mad and immoderate. What made this period immoderate was deregulation of the financial sector. 2919
To new homebuyers, housing prices rose so high that by 2008 taking out a mortgage to buy a home meant cutting back consumption and living standards – unless one ran up credit-card debt and other borrowing. Many homeowners took out home equity loans (“second mortgages”), using their homes as an ATM to draw against a bank account. 2930
Every economic recovery since 1945 has started with a higher debt level than the one before it, and each successive recovery has been weaker. The rising debt overhead explains why the bank bailout that resolved the 2008 financial crisis has failed to yield a real “recovery.” To banks and other creditors, recovery means keeping the debts on the books, and indeed, re-inflating prices for homes by creating yet new debt. The bankers’ “solution” is to extend a new wave of credit to bid real estate, stock and bond prices back up. But debt is the problem. What is depressing today’s economies is that the debts have been kept in place, acting as a financial brake blocking a business upswing. The “solution” that banks offer is austerity: Most of the economy is geared to work off its debts, not write them down to levels that can be paid without pushing the economy into austerity. Austerity is Wall Street’s (and the Eurozone’s) new definition of “moderation.” 2933
Creditors and debtors thus have naturally opposing worldviews. Labor (“consumers”) and industry are obliged to pay a rising proportion of their income in the form of rent and interest to the Financial and Property sector for access to property rights, savings and credit. This leaves insufficient wages and profits to sustain market demand for consumer goods and investment in new means of production (capital goods). The main causes of economic austerity and polarization are rent deflation (payments to landlords and monopolists) and debt deflation (payments to banks, bondholders and other creditors). To the banks, “moderation” simply means not defaulting. From the 1990s to 2007, this eventuality was postponed by consumers running deeper into debt to pay their scheduled debt service and other rentier charges. Banks created enough new credit to finance rising personal budget deficits by lending mortgage credit and home equity loans to a widening segment of the population, without much regard for their ability to pay. Supplemented by soaring credit-card debt, this bank credit enabled consumers to support the living standards that their wages were unable to cover. The hope was that somehow they would come out ahead, as long as bank credit continued to bid up prices for real estate, stocks and bonds. 2941
Government deficits are deemed “good” as long as they are spent to bail out banks and bondholders. They are only “bad” when they are spent on labor and the “real” economy. Federal Reserve credit (“Quantitative Easing”) is good if it helps inflate asset prices for the One Percent and improves bank balance sheets. But public money creation is deemed “irresponsible” if it spurs recovery in employment and wages, helping the 99 Percent break even and recover its former share of national income and wealth. Rising asset prices for real estate, stocks and bonds are “good” because they increase the power of the One Percent over the rest of the economy. Rising wages and commodity prices are deemed bad, because they threaten to erode this power of debt over the economy. 2958
The reality is that bank loans do not fund direct investment and employment. They extract debt service while inflating asset prices to provide “capital” gains. This makes homes more expensive to buy, requiring new owners to take out larger mortgage loans. That is the Asset-Price Inflation phase of the financial cycle. At some point, repayment time arrives. Paying off debts absorbs income that otherwise would be available for spending on the goods and services that labor produces. This is the Debt Deflation phase. Each business upswing leaves a higher level of debt, diverting a rising proportion of income to pay debt service. The post-2008 bailout and imposition of austerity aimed to squeeze out enough income to carry the debt claims. But austerity generates even more defaults and a deeper crash. 2985
In contrast to industrial profits, capital gains are the product largely of the wave of asset-price inflation – that is, the wave of bank credit on easier terms for debt leveraging. Since interest rates began their 30-year decline in 1980, a financial wave of credit has enabled borrowers to buy these assets and their flow of incomes with higher amounts of low-interest credit. Price/earnings ratios rise when interest rates fall (described below). Making such gains therefore is different from earning them by labor and enterprise. These profits are what 19th-century writers called the “unearned increment,” especially when they accrue for the land’s rising site value. 3011
Public investment in roads and other transportation, schools and parks, water and other infrastructure is provided freely or at prices subsidized by taxpayers as a whole. The result is that taxpayers as well as rent-payers end up paying to create wealth for landlords – enabling them to borrow more or obliging new homebuyers to borrow more to obtain ownership of such sites. To the extent that rental values are paid to the banks as interest, landlords as well as taxpayers end up creating revenue and wealth for the financial sector. 3036
Capital gains are fueled mainly by debt leveraging – buying with as little of one’s own money as possible. As financial wealth mounts up, banks compete for new business by loosening their lending terms. The process becomes self-feeding as property prices rise. Speculators and homeowners are willing to pay their banks the rental value, hoping to get a capital gain. The logical end is reached at the point where the financial carrying charges absorb all the rental income or profits. This willingness of borrowers to pay all the rental income to creditors is the driving force behind asset-price bubbles. 3041
Pension funds diversified into junk bonds in the 1980s, and into packaged mortgages after the dot.com bubble burst in 2000. Mortgages became the highest-yielding form of security, steering pension savings into the real estate market by providing banks with a market for loans they originated. Tax favoritism for capital gains and inherited wealth When the U.S. income tax was inaugurated in 1913, capital gains were taxed as normal income. The logic was that a price gain for a stock, bond or real estate builds up the owner’s net worth just as do savings out of wages or profits. 3052
The Reagan-Bush Administration eased it yet more, especially for real estate. Landlords were allowed to pretend that their buildings depreciated in just over seven years, creating a fictitious charge that offset the rental income. This made commercial and absentee real estate basically income-tax free. Real estate gains are not taxed if they are re-invested in new property acquisition. Many European countries do not tax capital gains at all. British landlords can evade taxes by holding their property in an Isle of Man account or other tax-avoidance enclave. This favoritism has enabled real estate fortunes to be built up largely free of income and capital gains taxes. When owners die, all tax liability is forgiven and the heirs can continue the buildup. No wonder the One Percent now controls the lion’s share of U.S. wealth and income! 3059
selling the mortgage loans it has originated 3093
Together these payments to the FIRE sector (and the tax shift off it onto consumers) absorb roughly two-thirds of many blue-collar family budgets, leaving only about a third available to spend on current output: Rent or home ownership costs (incl. property tax): 35 to 40% Other debt service (credit cards, student loans etc.): 10% FICA wage withholding (Social Security and Medicare): 7.5% Other taxes (income and sales taxes and health insurance): 10 to 15% TOTAL: about 67% There is no way for an economy with such high debt service, real estate and tax charges to compete with less financialized economies where housing is not so debt-leveraged, where family budgets do not have such high debt carrying charges, and where taxes have not been shifted so regressively off the FIRE sector onto labor and industry. Debt Deflation Meanwhile, the rentier overhead leaves consumers with less to spend on current output. This imposes deepening austerity as asset-price inflation gives way to debt deflation: 3110
(Phase 1) Consumer Demand = wages + new borrowing (that is, increase in debt) Paying back the rising debt taken on prior to 2008 led to the Debt Deflation phase of the credit cycle: (Phase 2) Demand = wages minus debt service. Asset-price inflation turns into debt deflation when paying amortization and interest (not to mention late fees) drains income from the economy’s circular flow of production and consumption spending (“Say’s Law” discussed in Chapter 3). This slows growth. The economy tapers off while the volume of credit and debt grows exponentially. Carrying this rising debt leaves less available to spend on goods and services, while government tax revenues and new money creation are paid to bondholders instead of being spent on public infrastructure, education, health and other social programs. 3121
Bernanke’s denial that rising debt levels do not reduce overall market demand for goods and services is reminiscent of Malthus’s argument that landlords spend their rents back into the economy. In trying to absolve the financial sector from causing austerity, Bernanke claimed that “debt-deflation represented no more than a redistribution from one group (debtors) to another (creditors). Absent implausibly large differences in marginal spending propensities among the groups, it was suggested, pure redistributions should have no significant macroeconomic effects.” In other words, if creditors (or real estate moguls) spend the same proportion of their income and capital gains on consumer goods and investment goods as do average wage earners, there would be no debt deflation or general spending shortfall, but simply a transfer of purchasing power from debtors to creditors and their fellow rentiers. 3139
But the whole point is that “spending propensities” do differ between the One Percent and the 99 Percent, between rentiers on the one hand, and consumers and producers on the other. 3145
when today’s Wall Street financiers do spend their multi-million dollar salaries and bonuses money on themselves, it is largely on fine art trophies, luxury apartments that already have been built, on yachts and high fashion – largely imported, as was noted already in Malthus’s day. But most important, the super-rich lend out most of their gains, indebting the rest of the economy to themselves. 3148
President Obama and Republicans sought to reduce the government’s budget deficit, not spend more money into the economy. For Bernanke, monetary inflation after 2008 was limited to providing easy Federal Reserve credit money for banks. He expressed the hope that they would extend credit to the real estate, stock and bond markets to re-inflate asset prices. The “real” economy was left to suffer debt deflation. But more debt overhead involves carrying charges that drain consumption and investment spending. And paying down the debt overhead intensifies the austerity. This transforms the character of “saving” to mean a pay-down of debt, not money in the bank. 3155
The “saving” in question was an accounting entry in the national income accounts – a negation of a negation, and hence a positive. The only way these savings were “money in the bank” was that they were paid by debtors to their banks and credit card companies. This debt deflation shows how false the image is of using one’s home like the proverbial piggy bank. Running up a debt is not at all like withdrawing cash from a savings account. Bankers euphemize taking out equity loans (borrowing more against the property’s rising market price) as “cashing out” on one’s equity, as if this does not leave a legacy of debts, which constrain future spending by diverting more income to pay creditors. The more the “savings rate” rose in the post-2008 world, the less money “savers” had to spend. Debtors ate cheaper foods and ran down whatever liquid savings they had. This “upside down” saving led to debt deflation. 3178
To restore prosperity, the way the economy operates must be changed – mainly by writing down the debt overhead. Piketty and Saez have documented the extent to which just One Percent of the population owns most of the stocks and bonds in the banks and other firms, and receive their surplus in the form of dividends, profits, interest, rent and capital gains. A realistic model or picture of how the economy operates would require separating the “wealthy” households from the wage earners that live by their own labor rather than on dividends, rents, interest and capital gains. There is no way for markets to maintain full employment and grow in the face of debt deflation and regressive tax systems that have reached today’s magnitudes. 3190
at the heart of Citigroup’s loss. Nobody could know in advance precisely 3264
mainstream economics has become a lobbying effort to dismantle government power to regulate and tax rentiers. Well-subsidized models promote a trickle-down rationalization for the status quo, as if it were produced by inexorable economic laws. “Free market” ideologues then reason backward to construct a logic “proving” that economies become lower-cost and more efficient by lowering wage levels, removing taxes on wealth, cutting back public spending and privatizing infrastructure monopolies. In the resulting symbiosis between bankers and other rentiers, debt is created mainly to purchase rent-extracting privileges and other rent-yielding properties, turning their economic rent into interest and related financial fees. Nearly all new credit since 1980 has been extended to the FIRE sector – credit to transfer ownership of assets while running the economy into debt, not to create new wealth. 3288
The intended effect is to leave financial management to “technocrats,” who turn out to be bank lobbyists toting around a few academics as useful idiots embedded in well-subsidized “think tanks.” Much as the oil industry subsidizes Junk Science to deny how carbon emissions contribute to global warming, so Wall Street subsidizes Junk Economics to deny that debt pollution plunges economies into chronic austerity and unemployment. Their conclusion is that no public regulation is needed, and no cleanup charges to compensate for the damage being caused. 3297
Much as the oil industry subsidizes Junk Science to deny how carbon emissions contribute to global warming, so Wall Street subsidizes Junk Economics to deny that debt pollution plunges economies into chronic austerity and unemployment. 3298
Questions that a relevant economic theory needs to answer Today, years after the 2008 financial crisis, the most pressing task for economic theory should be to explain why employment and consumption spending have not recovered. The Federal Reserve has given banks $4 trillion and the European Central Bank €1 trillion in Quantitative Easing to help the financial layer atop the economic pyramid, not to write down debts or revive the “real” economy by public spending. This enormous act of money creation could have enabled debtors to free themselves of debt so that they could resume spending to keep the circular flow of production and consumption in motion. Instead, governments have left the economy debt-strapped, creating money only to give to financial institutions. Orwellian rhetoric is invoked to describe governments running budget deficits and creating central bank credit to help banks and bondholders but not employment and production. This is called “preserving the system.” However, what is intended to be preserved is not the indebted economy, but the debt overhead owed to the financial sector. Central banks assiduously avoid any attempt to quantify how far wages, profits and tax revenue can be diverted to pay creditors without causing economic collapse and insolvency. 3301
through the early 1970s, wages had risen faster than overall prices. But since the late 1970s, they have hardly moved. Consumer prices also have stabilized over the past thirty years. What have risen are asset prices, fueled by a tidal wave of bank credit inflating the greatest bond market rally in history. More money has been made in the stock market, bonds and real estate than by employing labor to produce goods for sale. 3320
