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The Origins of Economic Distress: Apex and Foundation

Imagine our economy in three parts. The first is the foundation, upon which everything else rests. In the modern age, that foundation is energy- the vast enterprise by which resources are taken from the earth (and increasingly the sun and sky), refined, transported and used. The third, the apex, is the financial sector— the creation of capital and credit, and its exploitation. Everything feeds the apex, every credit card and check transaction, every major purchase (home, car, education) puts a percentage into the financial sector, however small. Finance is largely parasitic, feeding off value and trade created elsewhere. The middle ground between the apex and foundation is our productive economy, where labor and capital combine to create value and benefit.

This metaphor is purely subjective— there is no value judgement in putting banks at the top and oil drillers at the bottom and everyone else in the middle. But it is helpful to understand how these segments interact.

Most Americans don’t recognize this structure and the cracks that threaten the stability of the productive economy. Our leaders, when aware, won’t discuss it. Interests, from corporate, to labor, to environmental, to bureaucratic, fear a real debate about our common needs. The media, generally too depthless, won’t dare to tell the story. Academia is too fractured and secularized to grasp the long view round it.

Regardless, the problems are real. Some measures of it are visited upon the vast majority of American families. Real wages (adjusted for inflation) in the United States are stagnant over the last seven years, only 0.8% higher in January 2008 then March 2001.

Inflation is said to be contained. But the reality? Energy prices leap ever higher daily. Health care costs inflate at double digit rates. Even food prices threaten the effective standard of living. The dollar is so weak that it may not be the world’s reserve currency much longer, a possibility that could literally bankrupt the nation, leaving no buyers for the prodigious debt we create month in and month out.

At its peak, the apex, the American financial sector is in miserable shape, despite extraordinary efforts by the Federal Reserve to maintain stability. Highly leveraged in every market by speculation, from credit card debt to municipal bonds, we are seeing a gigantic house of cards crumble. American prosperity is an illusion of debt. We borrow, and create money through leverage, far in excess of the cumulative value of economic production (GDP). At every turn, from mortgages, to bonds, we put a fraction down and promise to pay later. A hedge fund, Carlyle Capital, related to the private equity fund the Carlyle Group, failed last month– it was leveraged 32 times to one. In plain language, it took $1,000 in collateral and purchased $32,000 worth of mortgages– good old government insured mortgages, to the tune of $27.1 billion. No bank or credit union could ever have done this 32-to-1 trick, but a variety of pseudo-banks have done the same, essentially creating phony money through leverage. And many of them, including the giant investment bank Bear Stearns have now failed. That phony money is now gone, taking some $18 billion in shareholder value with it.

We now have seen three financial bubbles arise and two burst in an astonishingly short period of time. The first was the internet/tech stock bubble, which blew up, vaporizing some $7 trillion. Next was the housing bubble, in which home valuations rocketed up 50% while GDP increased 14%. Eric Janzen, writing in Harper’s, put the inflated value of housing due to the bubble at $13 trillion, using the Federal Reserve’s Flow of Funds. One good way to recognize a bubble? When the cost of an item (like a home) is increasing far more quickly than people’s ability to buy the item. And now we are in the midst of a commodity bubble, with gold and oil leading the way, but also including grain, uranium and copper. The commodity bubble is currently being inflated by two factors– the plunging value of the dollar, which automatically creates price increases in commodities valued in dollars, and the massive asset rotation out of stocks and into commodities. Simply put, when stocks and bonds look risky and none-too-profitable, investors switch to another asset class or type of investment. The stock market has been flat for a decade, measured by the S&P 500, so investors have put their money into, or speculated with, oil, gold and the like. More buyers mean higher prices, yes?

Some observers, like William Fleckenstein, put the bubble blame squarely upon the Federal Reserve, and a sustained monetary policy that drove the cost of money to nearly zero for a fifteen year period. Cheap money also channels money from the productive sectors of the economy into financial speculation, widening the cracks in the apex. Fleckenstein’s book, Greenspan’s Bubbles, is a lengthy tour of the effects of the Fed’s actions. Speculation is fueled by cheap money and leverage, and while regulators have turned a blind-eye to widespread and creative use of leverage, cheap money is purely the result of monetary policy.

It seems, however, that bubbles and leverage are only a portion of the problems besetting the apex of the economy.

The Chinese are purchasing the debt of the United States at the rate of $1 billion daily, totaling some $1.5 trillion so far. As James Fallows has reported, that means the poor of China have purchased $4,000 in U.S. debt for every man, woman and child in America. Put on hold for a second what that means in geo-political terms. This represents a huge risk for both China and America. For the Chinese, this is an investment risk. As the dollar suffers, the commodities that they use for manufacture and the energy they import, get more expensive relative to their huge asset base. As some point, the Chinese will have to diversify (just like your 401k), and unwind this giant dollar position, or risk getting clobbered as everything they import goes sky high in pricing. For the U.S., this is a debtor’s risk. If the Chinese call our loan, or begin to sell off their devalued dollar investments, we will be badly hurt. They will be selling into a falling market, risking a run on Treasuries. Simply put, the interest cost to taxpayers will skyrocket, crippling our ability to deal with Social Security, Medicare, Medicaid, not to mention everything else the federal government spends money upon. This is an arrangement that simply can not be sustained.

China also invests in America through Sovereign Wealth Funds (SWF), and they buy much more than just treasury bonds. They are giant investors in private equity funds, which increasingly, own American corporations, including many companies you are a daily consumer of.

As the American financial sector cratered this January, Sovereign Wealth Funds from Singapore, China, Abu Dhabi and Oman raced to the rescue. Or was it a firesale? Merrill Lynch, Citigroup, Morgan Stanley, Bear Stearns and UBS, the cream of the American banking industry, took in a total of $30.5 billion from SWFs, according to CFO Magazine. It’s unclear exactly who all these investors are, and what their real stakes may total.

How active these SWFs will be as investors, we don’t know. But just as small businesses know, when hometown banks get gobbled up and decision-makers move to far away cities, loans get harder to come by. If Americans believe that folks in Abu Dhabi and Singapore have their best interests at heart, they may be in for a nasty surprise down the road. But what we do know is that the American economy no longer has the strength or the flexibility to support its own banks and brokers.

Increasingly, the dollar is creating a new set of hazards for our financial apex. The weak dollar hampers our competitive position in the financial sector. No one wants to buy assets valued in dollars when those dollars will be worth less tomorrow than today, an almost guaranteed outcome given the Federal Reserve’s rapid cuts in interest rates. At some point, the world will no longer need the dollar, at least as a reserve currency (the currency assets are held in). And since America has outsourced its manufacturing base, increasingly outsource it high-value service industry, and is eroding its status as financial titan, what will be left? Hollywood? Video games? Not a very pretty prospect. With our low savings rate and high consumer debt levels, we will be hard pressed to find the funds to invest in technology, the area we still hold a global edge in.

Next month, the cracks in the foundation and what you can do.

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