Sunday, April 12, 2009

Our periodic crises of debt repudiation

NYT op-ed

Frederick Soddy was a Nobel Laureate chemist turned political economist. He conceived of the economy as a thermodynamic engine. His ideas lead to a view of the root cause of the financial problems.

....Debt, for its part, is a claim on the economy’s ability to generate wealth in the future. “The ruling passion of the age,” Soddy said, “is to convert wealth into debt” — to exchange a thing with present-day real value (a thing that could be stolen, or broken, or rust or rot before you can manage to use it) for something immutable and unchanging, a claim on wealth that has yet to be made.....

Problems arise when wealth and debt are not kept in proper relation. The amount of wealth that an economy can create is limited by the amount of low-entropy energy that it can sustainably suck from its environment — and by the amount of high-entropy effluent from an economy that the environment can sustainably absorb. Debt, being imaginary, has no such natural limit. It can grow infinitely, compounding at any rate we decide.

Whenever an economy allows debt to grow faster than wealth can be created, that economy has a need for debt repudiation. Inflation can do the job, decreasing debt gradually by eroding the purchasing power, the claim on future wealth, that each of your saved dollars represents. But when there is no inflation, an economy with overgrown claims on future wealth will experience regular crises of debt repudiation — stock market crashes, bankruptcies and foreclosures, defaults on bonds or loans or pension promises, the disappearance of paper assets.

It’s like musical chairs — in the wake of some shock (say, the run-up of the price of gas to $4 a gallon), holders of abstract debt suddenly want to hold money or real wealth instead. But not all of them can. One person’s loss causes another’s, and the whole system cascades into crisis. Each and every one of the crises that has beset the American economy in recent years has been, at heart, a crisis of debt repudiation. And we are unlikely to avoid more of them until we stop allowing claims on income to grow faster than income.

Soddy would not have been surprised at our current state of affairs. The problem isn’t simply greed, isn’t simply ignorance, isn’t a failure of regulatory diligence, but a systemic flaw in how our economy finances itself. As long as growth in claims on wealth outstrips the economy’s capacity to increase its wealth, market capitalism creates a niche for entrepreneurs who are all too willing to invent instruments of debt that will someday be repudiated. There will always be a Bernard Madoff or a subprime mortgage repackager willing to set us up for catastrophe. To stop them, we must balance claims on future wealth with the economy’s power to produce that wealth. (emphasis added)

And that leads to a prescription on how to avoid this.