interview with ITulip.
Janszen: How do we fix this mess?
Hudson: Debt service is the major charge that is institutional rather than “real” and technologically necessary. Our tax system favors debt rather than equity financing. By encouraging debt it has prompted a tax shift onto the “real” economy’s labor and capital. The resulting interest charge and tax shift mean that we’re not as efficient and low-cost producers as we used to be. This makes it hard to work out way out of our foreign debt.
You want to phase out the “tollbooth” economy that adds unnecessary charges to the cost of living and doing business – charges that have no counterpart in actual necessary cost of production. You want to avoid monopoly rent of the sort that Mexicans have to pay Telmex. And you want to avoid having the tax collector lower property taxes, leaving more revenue available to be pledged to banks as interest on higher mortgage loans. To get a lower-cost world, you have to counter political pressure from real estate owners and their bankers to shift taxes off rent-yielding properties onto labor and capital. Income and sales taxes add to the price of doing business, and hence reduce their supply and competitiveness. Most economists – even Milton Friedman – recommend that the more efficient tax burden is one that collects economic rent – property rent, fees charged for using the airwaves, monopoly rent, and other income that is basically an access charge. If you tax land rent, for instance, this doesn’t raise the price of housing or office space. The rent-of-location is set by the market place. Taxes – or interest charges to buy such property – are paid out of the market price for using this space or natural resource.
“Rent-seeking” charges are paid out of prices. So taxing economic rent doesn’t add to prices. It simply collects what nature or public infrastructure spending have provided freely – site value, the broadcasting spectrum, the rights to access the internet or other technology in cases where prices exceed the reasonable cost of production. Unfortunately, despite what Milton Friedman said, the economy today is increasingly about how to get a free lunch of this sort – and how to get the government to avoid taxing it, and shift the tax onto labor and industry instead. This loads down the economy with unnecessary costs and higher prices, especially when rent-yielding assets are bid up on credit. That’s the essence of this decade’s real estate boom.
Eric [Janszen] (EJ): So let’s talk about the economy. The NBER finally announced in December that we’ve officially been in a recession for an entire year. What an odd recession it has been. There’s still an awful lot of lending going on. Clearly housing has been hammered but if you go to the malls they’re still busy. It just doesn’t seem like recessions what they were in the old days.
Michael Hudson (MH): One of the National Bureau’s leading indicators is the stock market. It’s supposed to turn up in recessions because companies aren’t investing in new production facilities. If you’re not buying capital goods or property, you’re putting your money into the financial system. Savings end up providing the credit to bid up stock prices.
That’s the past pattern, but stock prices aren’t been going up at all these days. This recession isn’t following the pattern that the National Bureau’s founder, Wesley Mitchell, was describing when he put together his set of leading and lagging indicators 70 years ago. So the NBER is at sea if it tries to find correlations with past business cycles. We’re not in a more or less automatic “cycle” at all – a cycle that will almost automatically turn into a boom like clockwork. The economy has hit a wall – in this case a debt wall. Each business upswing since World War II has taken off from a higher level of debt to income, profits and asset prices. It’s like trying to drive with the brakes on. Right now the financial debt-deflation brake has been pushed to the floor.
EJ: The definition they came up with was simply “two quarters of negative GDP growth.”
MH: That shows how superficial their approach is. The National Bureau was founded to make forecasts. Its staff fed in a mass of statistics, hoping that a pattern would emerge. The result became its leading and lagging indicators – average correlations from many cycles to get a “normal” pattern, assuming that the economy is a self-regulating system. That was Mitchell’s theory and Schumpeter had the same idea in his book on Business Cycles, drawing a smooth sine curve.
Popular wisdom and journalism in the 19th century talked about crashes, not cycles. A long upswing would end in a sudden downturn – a scalloped ratchet pattern. It takes a long time to save up money, but you can lose it in a hurry. But the National Bureau views the GDP and national income as being almost on automatic pilot, rising and ebbing in a consistent pattern. They follow a “one pattern fits all” logic. Instead of saying, “We’ve been a recession, what a surprise,” they should be explaining how this recession is different from others.
EJ: It discredits any institution to tell people things a year after it was obvious to everybody. Not forecasting something is bad enough, but not being able to look in the rear-view mirror and see things clearly is even worse.
MH: If we’re in a recession, what does it mean? We’re in a phase change where the economic relationships, proportions, leads and lags do not operate as they did in the past. So any mathematical model that’s based on this sequence is going to be junk mathematics. The last time we had junk mathematics we had the big financial crises that we’re bailing out today.
EJ: When people think of recessions, they typically think of a couple of things. First of all, they imagine inflation going down, and that has finally happened over the last quarter or so. There has been a precipitous decline in inflation, but it seems to me the spike in inflation we saw a year ago is probably one of the things that precipitated this recession in the first place.
MH: You mean the oil spike?
MH: Coming to the airport to get up to Boston yesterday, they raised the limousine price from $22 to $28 two months ago, ostensibly because of the oil spike. I called and they said it was still $28. They’re never going to come down. Just like when the European currencies went into the euro started everybody rounded off the price of bread and there was a huge jump in many prices. That didn’t come down. So yesterday I took the subway and bus.
EJ: So why are the prices ticking upward then? Wouldn’t it make sense for falling demand to start bringing down prices? If the input cost to run your restaurant, taxi service or whatever you’re doing is now lower, why not lower prices to meet the new lower demand? Or are they raising prices to compensate for lower unit volume?
MH: The pricing system is like that of electric utilities. Long Island Power in New York said there is much less consumer demand for electricity, so they need to raise their rate in order to stabilize our revenue flow–because if we don’t stabilize our revenue flow, we can’t pay our employees. Con Ed had a similar policy in selling steam: Total revenue was fixed, and divided by the number of steam customers. Each time a customer withdrew from the old steam system, prices rose for the remaining customers.
So you now have a business model that is not the marginal pricing model you find in textbooks. The aim is indeed to stabilize your income flow in the face of falling demand. Imagine running an economy like this. Now, imagine that the debt overhead grows exponentially, divided over the population. You’ll have its carrying charges (interest and amortization) spread over an economy that is shrinking as debt service “crowds out” spending on goods and services, shrinking investment and employment. And taxes will rise to pay interest on the Treasury bonds issued in “cash for trash” swaps to bail the banking system out of its bad loans and derivatives gambles. Shrinking loan volume, but rising bailout and other financial costs.
Let’s look at the hapless sectors of society that aren’t in a monopolistic position to administer prices in this way. Restaurants are said to be cutting back food portions as a means of holding prices or income stable as fewer people can afford to eat out. Retail trade is shrinking, and stores are going bankrupt. Starbucks is closing shops around the country. Auto demand is falling. Nortel just went under and its business plan is basically like that of the rest of the telecom sector.
EJ: That is pretty much what we told our readers about six months ago when this recession arose and everybody was expecting a goods-price deflation. We told them to not expect that. Even though demand will fall, supply will fall more quickly. So what would happen is a new equilibrium price between smaller demand and smaller supply at the same or higher prices.
MH: They’ve built in all these break-even costs that the Chicago School dismisses so trivially as “sunk costs.” The economy has a legacy of much higher break-even expenditures built into its cost of living and doing business. This is what I meant when I said above that every U.S. business recovery since WWII has taken off with a higher level of debt. That means debt service – the monthly “nut” you have to cover – has become much higher with each recovery.
EJ: At some point in this conversation I’d like to talk about what’s going to happen to private sector debt. It appears that we have reached a point where there isn’t enough cash flow to service the debt, and that we can’t create more credit to continue to generate more demand to create more cash flow to pay the old debt. In other words, we finally seem to be in a real debt deflation, as you, Steve Keen and others have talked about over the years.
MH: Adam Smith said no county ever has repaid its national debt. He was referring to government debt, which was the major form of debt in his day, but now you can say the same thing for private sector debt as well. If you look at the exponential growth of debt, no economy can simply grow by the purely mathematical principle of compound interest. So this “magic of compound interest” that is supposed to make the economy rich by doubling one’s savings works to double the debt just as well. One party’s saving becomes another’s debt. Well into Volume III of Capital, Marx sketched the history of writings on compound interest (Martin Luther, Richard Price and his sinking-fund proposal, etc.) to show that this purely mathematical law was incompatible with industrial capitalism. Engels wrote a footnote to say the reason Marx put all these notes together for Vol. III (he died before he could complete it) was that he was a follower of St. Simon, the French reformer who said we have to replace banking based on interest-bearing debt with a shift of banking toward essentially a mutual fund that would invest in stocks. That way, returns to savers would be paid out of earnings rather than growing faster than the economy’s overall ability to pay.
EJ: Equity based banking…
MH: Yes, because equity-based banking can go up and down. But when they did that in France, the first example was the Credit Mobilier, which went bankrupt under Louis Napoleon, for the same reason that the John Law’s bank went bankrupt: corruption by government insiders at the top.
EJ: Good idea, bad execution.
MH: But the German and Central European banks did apply this concept before World War I. They took a heavy equity position in the companies they financed.
EJ: We have a model for that in this country. It’s called Venture Capital.
EJ: It’s a form of banking. It funds losses. Typically we use equity financing in this country to finance companies that are not yet economical, the theory being that if you finance them through equity rather than debt, you have a much better chance of getting a decent return for the risk you’re taking.
MH: That’s right, like Amazon for all these years before it made any money.
EJ: Why wouldn’t the equity banking model work for companies that finance purchases of property?
MH: That certainly would be a better model. Unfortunately, what we’re getting is a bastardized version. The Treasury is talking about refinancing the existing mortgage debt in a way that the banks that have made these bad loans will have an equity kicker, much like the S&Ls asked for in the booming 1980s. The problem with this is that most American families have seen their net worth rise mainly through the price appreciation of their homes. That’s what created the middle class here. If you leave the creditor with the equity return, you will turn over to the financial sector this land-price inflation that has made the middle class rich. The system really would only work if you have a full site-value tax on the land’s rental value.
EJ: Well, until recently.
MH: Right. The financial sector translates its economic power into the political power to cut back real estate taxes. What has really been fueling the rise in property prices in this country has been the fact that real estate has been untaxed. What the tax collector relinquishes is now free to be capitalized into debt service on higher loans to bid up real estate prices. In 1930 about 75% of state and local finances came from the property tax. Last year it was down to 16%, so that’s from 3/4ths down to 1/6. Cities have shifted the property tax onto wages and salaries – income and sales taxes that increase the price of business. Taxes used to fall on property and hence were progressive, but now have turned regressive. The result is that “tax deflation” now reinforces debt deflation. This threatens to aggravate the depression we’re entering.
The venture-capital model that you’re talking about applies to enterprises that create new goods and services, especially products that weren’t produced before. But in real estate what you have is not so much a profit as “economic rent” and the free lunch of land-price gains that John Stuart Mill said landlords make in their sleep. The rental value of their property is determined by economic conditions and by local infrastructure spending to raise the rent-of-location, not by their own efforts and enterprise. Land and natural resources therefore should be the basis of taxation, because a real estate tax keeps down house prices and makes them more affordable. Homeowners may imagine that they are benefiting when property is un-taxed. But this simply leaves more rental income available to be pledged to the banks and capitalized into larger mortgage loans. So people end up paying the same amount of income to carry property as they did when real estate taxes where higher, but now they pay the banker instead of the tax collector. In fact, not only do they have to pay the same amount – but in the form of mortgage interest instead of taxes –they still have to carry the tax burden. This tax burden now takes the form of income tax and sales taxes. So you double the sum of taxes plus debt charges.
EJ: You’re probably familiar with Professor Robert Shiller’s work.
MH: Of course.
EJ: To make a long story short, his analysis is that U.S. housing prices for the last 100 years with two exceptions – after World War II and today’s housing bubble – have only kept up with the rate of inflation. No more, no less. Pretty much kept up with inflation in the US. It really is the land value that has been inflating.
MH: I prefer to say land price rather than land “value,” because in classical economics value is created by labor and direct costs of production. Land rent and other economic rent is income without corresponding cost of production, and hence price in excess of value.
EJ: Yes, very good. But Shiller’s point is that until recently, people didn’t view the building on the land as an investment, but as an expense. Unless they could charge more rent on the building than it cost to operate.
MH: Yes. That’s how the construction industry views it. There’s a tax distortion here too. Buildings can be depreciated as a tax write-off as if the property is losing market price, despite the long-term rise in real estate prices. Buildings can be depreciated again and again, at a higher price each time they change hands. The national income and product accounts (NIPA) show that this depreciation – along with the tax-deductibility of interest – made the real estate sector exempt from having to pay an income tax from about 1945 through 2000. The result has been to divert investment away from industry into real estate – largely to get a tax break while riding the wave of land-price inflation. To cap matters, capital gains now are taxed at a much lower rate than “earned” income (wages and profits), and don’t even have to be paid when property owners turn around and plow their gains into yet more property accumulation, or when they die or make use of other “small print loopholes” that the property and financial lobbies have inserted into the tax code.
EJ: But for some reason people got the idea that it’s the house sitting on the land that actually is inflating in price and creating wealth for them.
MH: This illusion is sponsored by the Federal Reserve Board. If you look at its real estate statistics in Table Z of the Fed’s quarterly Flow of Funds report, it lists the overall value of real estate. The figure comes mainly from the Census Department and is based largely on local property assessments. The problem is that it uses the land residual method, not the building residual. The logical thing to do would be to make a smooth land-price map, rising toward the center and falling away as you move away from the transport nodes. But the Federal Reserve has given in to the real estate lobbyists, who want to create a justification for raising depreciation write-offs as if the building itself is rising in value. If you look at how commercial investors make money on their real estate, until about five years ago when the real estate prices took off, from World War II to 2000, the sector as a whole didn’t pay income tax, because it didn’t have a declarable income! Investors were allowed to expense most of their ebitda (earnings before interest, taxes, depreciation and amortization) on interest and depreciation. Absentee owners could pretend that the building actually was losing value, and hence that their property was losing market price because the building was being “used up.” The same building could be depreciated again and again and again – and in fact, the older the building was, the better built it was and usually the better location it had, so the rental value and market price actually was rising.
EJ: When it changed ownership.
MH: When it changed ownership you could start depreciating it from scratch all over again. That’s called over-depreciation.
What’s ironic is that the role of depreciation was developed in classical economics by Karl Marx. His Theories of Surplus Value criticized Quesnay’s Tableau Economique, pointing out that it didn’t have a figure for replenishing the seed needed to grow next year’s crop. He said the same for industry: An industrial investor must recapture the capital he has put in, just as a bondholder gets back the principal, not only the interest. Marx added that for industry we are talking not only about physical depreciation of machinery, but about technological obsolescence. Then Schumpeter elaborated this with his theory of technology, innovation and creative destruction. But that doesn’t happen much in real estate. The older the building, the more valuable it is because new construction standards are going down and properties are more shoddy.
What the Federal Reserve statisticians do is take the original cost of the building, and then factors in the construction price index to calculate its replacement cost. This makes it appear as if buildings are rising in value. In fact, the rise that the Fed has imputed year after year is that by 1994, the replacement costs of all the buildings owned by all the corporations in America was so large that it left a land residual of negative $4 billion dollars. This was like saying to someone, “I’ll give you $4 billion, but there’s a catch. You’ll have to take ownership of all the corporate-held land in the United States.”
The result was nonsensical, of course. So the Fed had to do something. But it didn’t change its methodology. What it did instead was simply to publish the overall value of real estate held by corporations, partnerships and individuals, and the values of the buildings. It just publish the calculation for the land residual. It didn’t want the embarrassment of having a negative land figure, and I guess it hoped that nobody would look and subtract “buildings” from “total” to see how silly the result was.
About two years ago the Fed came out once again with another lobbying effort trying to rationalize why it was appropriate to use land residual instead of a building residual. Fortunately, it’s not too hard to unwind what the Fed has done. It also publishes as a footnote more realistic calculations for some sectors. The actual value of land in America a few years ago was about $11 trillion, but according to the Fed’s figures it was only about $5.5 trillion. The figures probably were double last year. In other words, a false rate of building cost inflation has been built in.
The bottom line here is that you’re right, it is all about the rising site value of land and the rent of location. From the builder’s and investor’s perspective, buildings are like what in New York are called “taxpayers”: a one-story building just big enough to rent out as a storage facility lot or even a parking lot to cover the tax costs while the owner waits for the site to appreciate. There was a debate about this in the 1890s and the early 1900s by Professor Ely of Columbia and others. The claim was that slumlords and speculators play a productive role because he is waiting for the land to “mature” or “fructify” like a crop or fine wine.
EJ: Let’s get back to the current economy. We started off by talking about expectations that there will be a general price deflation. There are some that say that the U.S. is already in a deflation.
MH: I believe that.
EJ: Not only a debt deflation, but a self-reinforcing downward price spiral.
MH: Yes. And the prices falling fastest are asset prices, not wages and product prices.
EJ: Bernanke came out in December and said, “let’s put out of our minds this idea that we can have a deflationary spiral like we had in the 1930s. That can’t happen any more.” Do you agree with his assertion?
MH: No. For starters, he’s talking about the wrong thing. The economy actually consists of two sectors: the “balance sheet” or FIRE sector – finance, insurance and real estate – and the “real” sector producing goods and services. There has been enormous inflation in the United States in recent years, but its been constrained in the asset market: stocks, bonds and real estate. There has not been wage inflation, and little commodity price inflation. So the “deflation” he’s talking about isn’t the deflation that most people think about – the prices they pay, and what they earn. It’s been contained in real estate, stocks and bonds – bought on credit. So yes, there is going to be a deflation, as debt payments divert income away from being spent on goods and services.
The asset-price inflation ran up against a limit, namely, how high a price/earnings ratio can rise. The answer is, to the point where you pay more for a property than you get simply by capitalizing its net income at the going rate of interest. From the 17th century through the early 20th century, from William Petty onward, economists defined land value as the flow of rent capitalized at the rate of interest. But in recent decades, buyers built an expectation of capital gain into the price they were willing to pay. I live in a condominium in New York (in Queens), for instance. To buy an apartment there on a mortgage costs about $2,000 a month, while paying the carrying charge costs another $1,200 and taxes are $300 a month, but it can be rented out for only $1,800 a month. So a buyer would lose $1,700 a month, just to hope that somehow this property will continue to rise in price. A good friend of mine has bought three apartments in this building on these terms. I don’t think that’s a good deal. It is not an “equilibrium price.”
Now, factor in an expectation that real estate prices are going to decline, especially as about a quarter of U.S. real estate is estimated to be in a state of negative equity so that the mortgage exceeds the market price, and you see why the economy has a problem. People are losing their jobs as employers downsize, and many will have to put their homes on the market. So even though interest rates are falling, prices will fall.
EJ: We called the top of the Commercial Market in June 2008 when the Cap rate in New York City hit 9%. Historically it’s around 2%. Prices declined fairly precipitously since we made that call. Friends of mine in the commercial real estate industry say that they see this only as the beginning, and it probably will go on for years.
MH: It has to, because prices are too far beyond normal economic rates. The only saving grace for New York City – at least for Manhattan – is that a declining dollar will make apartments cheaper in foreign currency. Foreigners may buy just to have a place to stay here, and to conceal their earnings as capital flight as has been occurring in central London real estate.
EJ: Back in 2003 I found a wonderful paper written by a Bank of Japan economist about how their FIRE-sector deflation spilled over into their production/goods economy, the mechanisms of that spillover, and how the nation wound up with deflationary problems. Now Bernanke of course says in his speech that he’ll make his own mistakes, he’s not going to make other guys’ mistakes, so he doesn’t need to be reminded of what the Japanese did or didn’t do or U.S. policy makers in the 1930s.
For practical purposes the effective federal funds rate is already at zero. His monetary policy seems to be spent. The latest gambit is to print money and buy mortgage-backed securities. Do you think that will work?
MH: No. For starters, it doesn’t apply to negative equity. Nobody is going to make new loans or renegotiate debts for the quarter of U.S. real estate whose debt already is larger than the current market price. There is still an enormous debt overhead that has to be written down. Credit inflation – that is, “solving” the debt problem by extending yet more debt – is not going to address that problem.
EJ: Isn’t it becoming painfully obvious to everyone that eventually we’ll have to solve the problem the way we did in the late 70s, which is to inflate everyone’s nominal cash flow?
MH: For better or worse, that would threaten to end the era of American affluence. A better solution is simply to write down the debts. That’s what I’m lecturing on this afternoon at my Sumerian archeology seminar here at the Peabody Museum. Bronze Age clean slates were the predecessors of Judaism’s Jubilee Year of Leviticus 25, the Year of the Lord that Jesus spoke about in his first sermon (Luke 4) and said he had come to proclaim.
EJ: Explain how that could work in today’s world.
MH: It was beginning to work before Paulson intervened to stop market forces from writing down loan values. Junk mortgages and CDOs (Collateralized Debt Obligations) were selling for 22 cents on the dollar at the time Lehman Brothers went bankrupt. The government could have stood aside and let the market settle at this level. If it had let the market price of these mortgages and CDOs fall, their new buyers would have been in a position where they wouldn’t lose if the mortgage debts owed by homeowners were written down proportionally. This would have brought debts in line with the realistic ability to pay. So the free market actually was solving the problem until Bush and Paulson – with the support of both presidential candidates – came in and said, “No, we’ve got to bail out the creditors so they don’t take a loss.” Instead of letting their big campaign contributors take a realistic loss and then writing down the debts, the Democrats overruled Republican opposition and bailed out the creditors, taking some $7.7 trillion of government guarantees and new “cash for trash” transactions onto the Treasury’s and Federal Reserve’s books, as the recent Bloomberg report has documented.
These bad loans have been added onto the government’s balance sheet, but the underlying debts themselves have not been written down. They still can’t be paid. This leaves the government in the position of having to either go out, foreclose and empty out the houses, or absorb the bad-loan loss, making “fictitious debt claims” real as far as the irresponsible lenders and investors are concerned. Either way, it is a giveaway to save creditors from taking losses on what in many cases were outright fraudulent junk loans packaged into junk CDOs by fraudulent Wall Street firms and guaranteed by A.I.G. and investment banks using junk-mathematics models.
EJ: This is more or less what the Japanese did, isn’t it? They took private bank loans and moved them onto the public account, and undertook job-creation programs: print money to pay salaries. Salaries pay off the debt, private debt goes down, public debt goes up. They started off at 39% of the GDP and right now they have 193%, just below Zimbabwe. Yet the yen remains strong …
MH: Wait a minute. You have to realize why it’s strong today. It’s not because of what Japan is producing and selling. It’s strong because the Japanese government enabled the banks to “rebuild their balance sheet” and “earn their way out of debt” by providing them with nearly 0% interest credit, which they could then lend out at 0.25%. This free credit started the international carry trade. Japanese banks made a teeny profit creating credit to lend to foreigners, who then converted the yen into dollars or, for instance, into Icelandic currency to lend to Iceland at a huge arbitrage margin. Today, nobody wants to lend to Iceland any more. So these loans are being would down. This means that Japan’s former borrowers are repaying by converting foreign currency back into yen to repay the banks. So the yen is strengthening not because the economy is strengthening, but because of the unwinding of this carry trade that helped fuel the global debt bubble.
The United States dollar is in much in the same position as its banks are being repaid. When Greenspan lowered interest rates here, banks made cheap dollar loans. Global arbitrageurs borrowed in dollars, converted them into foreign currency to fuel real estate markets throughout the world – a property and stock market bubble. Now that these bubbles are bursting, arbitrageurs are unwinding this debt leveraging. This de-leveraging is creating a temporary flow into the dollar, just as it’s doing into the yen. But once the de-leveraging process is completed, the Japanese and U.S. economies will have to actually earn and pay their way in the world, just like other economies, through economic growth. De-leveraging is not economic growth. It’s a balance sheet relationship involving assets and debts, not the production of goods and services.
EJ: Lets think this through. What will the dynamics be of the end of the de-leveraging, and how will this impact the dollar? Is the dollar more likely to stabilize at the value where it ends up after de-leveraging is over, or will it resume its decline?
MH: There’s no model that you can come up with that is stable at this point. In any event, I don’t believe in economic models that have an equilibrium point. I think it’s nutty to look for equilibrium or stability in asset pricing in today’s economy. Rather, we see a careening between top and bottom limits. To think that there’s an equilibrium point in between is to enter the world of highly sophisticated junk mathematics. The resolution of today’s dynamics will occur in the political sphere, and it will involve a change in the institutional environment within which financial and economic market forces operate.
Here’s the problem. The U.S. government owes $4 trillion to foreign central banks. There is no model you can come up with that shows how America can repay this amount in the face of its now-chronic trade deficit, its overseas military spending and the proclivity of money managers to treat the dollar like a hot potato and move into other currencies. So you’re back with Adam Smith’s observation that no government has ever repaid its foreign debt. And today this can be said of the U.S. private sector as well.
EJ: $9 trillion.
MH: Yes, for the banking system’s questionable real estate loans, not even counting the lack of coverage on the losing side of derivatives gambles and hedge guarantees. Let’s look at the real estate sector you brought up before – all those junk mortgages written without any idea of the mortgagee’s ability to pay or a realistic market valuation of property pledged as collateral. There’s no way that the debtors can pay out of their own resources.
EJ: The front cover of Time Magazine represents President-elect Obama as FDR, driving a 1930s car, wearing a hat and so on. Everyone seems to forget that FDR was elected after the economy crashed, not at the start. His role was savior. Obama is coming in at the beginning of the process, more like Hoover.
MH: Well, FDR did help crash the world economy in one of his first acts, by scuttling the World Monetary Conference.
EJ: What had been done from 1930 until 1933 when he came on board was essentially to let all the debt default. So there was basically a mass default.
MH: That was “cleaning out the system.”
EJ: Upon taking office, the first thing FDR did was to devalue the dollar by 70% against gold, used at that time to back international trade payments. It was a unilateral export of deflation to the rest of the planet.
MH: Keynes wrote an article the next day saying that Roosevelt was “magnificently right.”
EJ: Probably the rest of the world didn’t feel that way.
MH: France didn’t. But if you want to see mismanagement, look at how France responded to it. You could say that the problem lay in the rest of the world’s response to the American action. That may be a lesson for today.
EJ: How did they respond to it?
MH: They subjected themselves to deflationary bankruptcy for the balance of the decade.
EJ: The other thing that happened was that the market wasn’t clearing in terms of the banking system. So one positive thing FDR did was to shut all the banks for a week, have a bunch of accountants determine who was and wasn’t solvent, and then open all the solvent ones. The Japanese didn’t do that and that’s why they’re still having problems. We obviously are not going to let our debt and credit markets clear. We’re going to keep shoveling money at the banks, as if the current solvency issue is just a liquidity issue. If we don’t let the banking system clear, can this just keep going on?
MH: No, for the following reason: What are you going to do about all these bad loans that people are stuck with – the fact that they have more mortgage debt than they can afford to pay? What are you going to do about the 10 million families that are going to be foreclosed on next year? The Treasury is trying to pump enough credit into the economy so that existing mortgage debtors can refinance their properties at a lower, more affordable interest rate – or, failing that, to inflate property prices by enough so that new buyers may come in and take over from defaulting debtors. But all this is an attempt to keep the existing debt overhead in place. It won’t work much for properties in serious negative equity.
It also doesn’t address the problem of bank losses on derivatives and the losing side of hedge trades – “casino finance capitalism” over and above the real estate bubble. The Treasury and Fed are trying to clean up junk mathematics gambles with by printing up new government bonds and making “cash for trash” swaps. The government is trying to keep a financial fiction alive – the fiction underlying the ideology that the “real” economy won’t work if the financial sector is not made solvent on its losses. But the two sectors are decoupled, as I’ve been arguing. I think it’s crazy to plunge economic reality into debt deflation to bail out creditors as if their fictitious computerized balance sheets reflected some underlying economic reality, if only we can wait long enough and let the economy grow by enough to carry the debt overhead with which it’s been loaded down. The debt overhead is what is shrinking the economy. That was the problem that the 1930s dealt with, and which most crashes solved by wiping out “bad savings” along with bad debts to create a kind of clean slate. That’s not happening today.
EJ: What if the U.S. takes the Japanese approach. There are always islands of cash flow somewhere in the economy that the government can go after to finance the debt.
MH: There’s plenty of money, of course. It used to be said that the amount of debt doesn’t matter, because we owe it to ourselves. But the problem is, who is “we”? The Western states owe it to the East — which is what the early 1930 political wrangling was about. Debtors owe their creditors, and the bottom 90% of the population owe the top 10%. How are you going to get money from the rich people to the debtors? That’s the problem.
You could say it is the same problem Rome had. Rome didn’t solve it and we basically entered into the Dark Ages. The United States is trying to solve it by the Treasury monetizing bonds to give to creditors in exchange for their loans-gone-bad, and then will go after the “taxpayers” – the bottom 90% – to siphon off enough income to pay the interest charges on the vast new public debt being printed up.
The problem is that extracting this debt service will shrink markets for goods and services. This will deter new investment and employment, preventing the economy from “earning its way out of debt.” So what we have is an erroneous economic theory. And when you find an economic theory that doesn’t work, the “error” almost always turns out to benefit some special interest. So “error” and junk economics are rarely innocent.
EJ: Last time we were in this kind of a negative equity situation in the 1930s, FDR called in gold and re-priced it. The top 10% or so had money in gold in safe deposit boxes in an attempt to keep it away from the government. FDR took it away and said: “The bad news is that we’re going to give you an instantaneous 30% haircut when we take away the gold and replace it with devalued currency. The good news is that things are not going to go as badly here for you as in other places where people have money.” That was the deal.
MH: That’s right.
EJ: So what’s the deal going to be this time?
MH: The only deal that would have worked was to write down the debts. The government had a chance to do it, and missed it. The Treasury cared only about its constituency – the bankers and other creditors, not the debtors. So it’s going to be like pulling the skin off the “real” economy slowly. It’s going to be torture until they write down the debts to reflect the ability to pay and still have enough spending power to grow.
EJ: Let’s talk about where the torture is. The torture I assume expresses itself in unemployment. It will rise and rise and stay there, and then all the secondary factors that arise out of unemployment; all the political problems that arise, divisiveness among income and other groups as you mentioned. Then there’s the crash in local and state government tax receipts from falling income and property tax collections …
MH: Now that property values are down and there are abandonments, you’re going to have the heaviest squeeze on state and local finances that you’ve had in 60 years. So how are states and localities going to pay? Normally they…
EJ: I have a theory, and would appreciate your thoughts.
EJ: You know what the Japanese did? They allowed the prefectures to run deficits. Here in the U.S. states can’t do that … yet. They can’t run deficits. What if we change the law to let them effectively print their own money just like the federal government does? Then they can effectively execute deficit spending just the way the federal government does.
MH: There’s an ideological block to that. I don’t see U.S. cities getting people to accept the chits. For one thing, the banks and bond underwriters would mount a huge public relations campaign insisting that cities should borrow from them. But I do indeed accept the State Theory of Money: What gives value to money is its acceptance as payment for taxes. Financial and fiscal policies are thus symbiotic. Taxation is how governments give value to the money they create. If they issue it in excess of taxes, the market price of money plunges; that is, prices rise.
EJ: Don’t tell the gold bugs that, by the way. They think gold is natural money.
MH: But that’s historically wrong. I’ve been trying to convince some of China’s western states for the last ten years to issue the equivalent of Germany’s Rentenmarks (currency issued against taxes levied on land and industrial production, starting in 1924 to end the German hyperinflation). You can indeed finance deficits that way, at least to a reasonable extent.
EJ: Governments didn’t want to get paid in cows and wheat and stuff. I tell our readers that gold was adopted by governments because they wanted to be paid taxes in a medium that people didn’t have the means to produce themselves. That doesn’t go over very well.
MH: As I said, the government creates a demand for money by levying taxes. But today there’s pressure on states and municipalities to do exactly the opposite. They’re cutting property taxes as real estate owners cry that they’re going to forfeit their property to the banks if they’re not given tax relief. Most cities have a few years’ lag in assessments, so these are just now catching up with the recent bubble economy – just as property prices are turning down. So owners can’t just go to their bank and borrow the tax money and interest to keep current, and don’t even want to keep subsidizing renters in the hope that they can sell out at a capital gain to make the operating loss all worth while. Hopes for capital gains are now dashed.
Instead, there is growing pressure to un-tax the land. I guess the point that you’re making is what a city can do to raise revenue. To issue its own money and credit, a local economy would need to raise the real estate tax. This would get the tax structure back to where it was in the 1920s, by the way. It would provide a demand for local money, or backing for bond issues for that matter.
EJ: I don’t know how the Japanese do it. I assume the prefectures, as municipalities or financial entities, were running some sort of surplus?
MH: I haven’t looked at it. I don’t know how they get a surplus. You would have to look at the flow of funds in their budget. New York City could get the money it needed to build the Second Avenue subway, for instance, by calculating how much added value this would give to property along the route, and then recapturing this rise in rental and market value by a windfall tax. It could explain that this isn’t really a property tax as such; it’s a windfall tax on the rising value that municipal infrastructure spending gives to the land. It’s the community that creates this value, after all, not the landlord.
EJ: Part of what I’m trying to promote in my book are politically palatable ways to do the right thing. To tax property at a higher rate is kind of a non-starter. But a windfall tax: that’s a good idea.
MH: Thank you.
EJ: I ran across an interesting piece of research done by the Cleveland or St. Louis Fed, I can’t remember just where. They were testing the idea that wages were the primary transmitter of inflation to an economy, a central tenet of the ideology we’ve been getting out of the Chicago School for the last thirty years.
MH: Alan Greenspan himself controverted that idea a few years ago when he said that right now workers are so deep in debt that they’re one paycheck away from missing their mortgage payment, one paycheck away from homelessness. They are afraid to go on strike for better wages and even to complain about their working conditions. Instead of wage inflation, just the opposite has occurred. Not only have real wages drifted down since 1979, but workers have to enter a lifetime of debt peonage to afford their houses. Mr. Greenspan’s junk-credit creation is what’s been pushing up the cost of living. And businesses now have higher break-even costs as a result of the debt they’ve taken on to buy back their own shares, to take over other companies and even to pay out as dividends. We’ve experienced asset-price inflation, not consumer price inflation.
EJ: What was interesting about this analysis was how rigorous and mathematical it was. They did everything they could to make it look non-ideological and even-handed. Their conclusion was that inflation leads to higher wages, not the other way around. Which sounds pretty commonsensical, but it took them a long time to get there.
MH: The minimum wage hasn’t been raised in many years, so it has lagged far behind inflation. In fact, real wages often lag behind goods and service prices, and it’s a way to squeeze labor. In my history of trade theories I cite John Barton’s 1817 Observations on the circumstances which influence the condition of the labouring classes of society: “That a fall in the value of money lowers the recompense of labour has been incidentally pointed out by several late writers. … Mr. Malthus observes, that ‘the discovery of the mines of America, during the time that it raised the price of corn between three and four times, did not nearly so much as double the price of labour.’” For many years an argument along these lines occurred in Brazil with its indexing. The Chicago School simply ignores facts and theory that don’t bolster its anti-labor, pro-creditor ideology.
EJ: I get stuck on this because I don’t see the debts being forgiven. Within our system, I don’t see how everybody is going to get off the hook and not have to pay the mortgages and credit card debt. One of the things I learned from my research – and one of the things that really precipitated the downward spiral in the 1930s – was that consumer loans were full recourse loans. That made a big difference, because people would get their first refrigerator and their first stove and they didn’t want to give it back. So the best debt you could possibly purchase in the 1920s was consumer debt, because people paid it back before anything. Not mortgages, however, because those were not recourse loans.
MH: Many are still paying their mortgages because “the poor are honest.” They believe that it is moral to pay debtors, even to impersonal banks. This is quite different from the way that professional real estate investors such as Donald Trump think and calculate.
EJ: Following that line of thought, mortgage debt in Japan was full-recourse, unlike here where mortgages are quasi-recourse.
MH: It depends, state by state.
EJ: If a bank can attach your income for the rest of your life to get you to pay your mortgage that was one of the things that drove property prices down and down for 20 years in Japan. Who wants to buy a house when prices are falling and you know you’re going to get stuck paying the mortgage no matter that you’re upside down on it. Both ideologically and also in terms of the way our system works its much more likely mortgage debtors are going to punt. A lot of people walking away from their debt.
MH: That’s right, starting at the top of the financial pyramid. General Motors, other auto companies, steel companies and airlines are managing to avoid paying their pension debts. They are threatening bankruptcy to wipe out employee claims. Other companies simply replace defined-benefit plans with defined-contribution plans. So debts are being wiped out all the time – mainly debts owed by the wealthy, not those of the poor or (as they are called in the United States) the middle class.
The bankruptcy laws were rewritten in 2005 so aggressively that I’d be surprised if there enormous pressure doesn’t grow for the incoming Obama administration to draft a new and easier bankruptcy law.
EJ: To get it back to what it was.
MH: At least, or to continue the increasingly pro-debtor trend that’s been underway since the 13th century. If it doesn’t become easier to wipe out debts, then a left wing of the Democratic Party will emerge with the bankruptcy law at its core.
EJ: You can bet there will be a long line of people behind that. But what about the possibility of inflating some of it away over time. As you say, it sounds like it might damage U.S. standing but what if all the governments adopted the approach at the same time, deflating debt against commodities, for example, instead of wages and salaries? What if there was a global inflation, not of huge proportions but higher than what might would be considered orthodox?
MH: Some countries would lose more than others. That’s the problem. If everybody were doing it, if the economy were like a balloon with a pre-printed pattern on it that just gets bigger or smaller, you could see that happening. But it’s not like a balloon, and there would be distortions. For instance, what do you do about the big dollar holders like China and Japan? They would lose, compared to debtors. And what do you do about the self-destructive neoliberal ideology that the Europeans have? For your scenario to materialize, countries would have to act in their self-interest. Although that is the premise underlying all international diplomacy theory, it’s rarely applied in practice.
EJ: The other way to do it is for the United States unilaterally to allow the dollar to depreciate back to where it was earlier in 2008 before the de-leveraging.
MH: I think that’s going to happen simply by market forces. The market will push the dollar back down, and the yen too.
EJ: That takes us back to the contest to see who has the least ugly currency.
MH: America is really the only country that has a real currency. The Euro is not one.
EJ: It’s a spin-off of the dollar.
MH: Right, so the real question we’re moving towards is whether other countries will have a currency of their own or not? I don’t see any sign of that yet. Or even a discussion of that yet. That’s what amazes me. Nobody is talking about the real issue, just like during the recent U.S. election.
EJ: So nobody is talking about creating a new currency?
MH: Do you know of any, apart from the “nutters”?
EJ: By “nutters” I assume you are taking about the one-world currency conspiracy theorists. One branch has the world going to a single central bank based on the IMF, with the IMF playing a key role.
MH: The reason that’s impossible in principle is that any currency is based on the power to tax – and taxes have to be passed by a legislature. “No taxation without representation.” The Euro doesn’t have the power to tax because there is no European parliament with authority over its nations. America is large enough so that it does have the power to tax and hence to have a currency. But Europe does not; it’s fragmented.
So the idea of the IMF offering a world currency is really about making the dollar deficit the world currency. That means backing world monetary expansion with American military spending abroad, America consumer spending (the chronic trade deficit), and the free lunch of the American takeover of foreign industry. That is not a model of stability for a world monetary system.
EJ: China recently floated a trial balloon about the idea of making the yuan a hard currency. What do you hear?
MH: That would require political changes that have not yet occurred. I know they are thinking about it. It’s almost as if you’re getting physicists together to create a new means of production.
EJ: Yes. People vastly underestimate how difficult that is to do, to create a global currency. For one thing, the Chinese would need to create a bond market that can compete with Japan’s and the USA’s. Can you imagine the difficulty?
MH: Yes. You need enough scale to get a critical mass. The question is, in what financial form would other countries hold Chinese currency – or that of any other key-currency nation?
EJ: There’s no European bond market. People forget that. That’s one of the reasons why the euro is not a currency. There are German bonds in euros, and there are French bonds in euros, but no central systemic European bond market.
MH: That’s right. And the neoliberals have blocked nations from running a budget deficit of more than 3% of GDP, so that prevents Europe from doing what America has done and create enough Treasury debt to absorb the balance-of-payments deficits the economy is running. It’s as if the Europeans haven’t even sat down to look at the basic balance-sheet relations of domestic money creation, tax policy and the balance of payments. In think that even in this country over the last forty years, the classes I taught at the New School in balance-of-payments accounting were the only graduate economic courses in this area that remains arcane to most economists and especially to politicians and journalists. They seem to be lost in a pre-scientific, non-quantitative frame of mind.
The Euro was mis-structured from the outset. Once you have something mis-structured, the costs of retrofitting – of undoing something and doing it right – is too expensive. That is why this bailout is going to be so expensive. How are we going to undo the $7.7 trillion that’s been wasted?
EJ: Playing devil’s advocate here, doesn’t that still put the dollar in a favored position, despite the problems here?
MH: Yes. It’s favorable politically and diplomatically, because other countries are still leaving it up to the dollar, to U.S. diplomats to define the coming world. U.S. diplomats always put American national interests first and other countries don’t put their national interest first. That’s an asymmetry we’ve had since World War II in the global financial system.
EJ: Getting back to the economy, how do you see events developing? Of this volatility we’ve seen in the stock market, my expectation for 2009 is that the market will be a proxy for the hopes and fears of government intervention, rising when stimulus programs are perceived to have promise, and crashing on evidence they are not.
MH: A slow crash is what I expect, resulting from debt deflation and debt peonage for consumers.
EJ: Will the decline be ongoing?
MH: Ongoing, as long as debts are kept on the books instead of being written down or written off. Each time there’s another decline the newscast will say “Unexpected this” and “Unexpected that,” “Nobody could have foreseen it,” and more cognitive dissonance of this sort.
The problem is that “demand” has been coming from credit, and that’s now ended. People – and companies – are having to pay back the debts they’ve run up during the past few bubble years. National income statistics report this amortization as “saving,” but it’s not a form of saving that’s available for spending. It’s just working off past credit creation. Like Keynesian-type saving, it’s non-spending on goods and services. But in this case the hoarding is not done by consumers, but by the creditors. They recycle their debt service into new loans or into buying assets already in place.
Companies won’t invest without having a market – and the market is now dead, not only in the United States but also in the post-Soviet economies and satellite economies to the U.S. (Europe, etc.). So banks won’t lend, because there’s no prospective new income to be earned to repay new loans. That’s why trade is stagnating, and why more defaults will occur.
EJ: On iTulip we keep a collection of the surprises that we expected, going all the way back to the tech-stock bubble in 1998. Everything is “unexpected” if you watch TV. So you say that the crash will continue until we get rid of the debt. Until we address the real problem, the debt, it goes on and on.
MH: That’s correct. You won’t solve the debt as a financial problem until you solve the fiscal problem of restructuring the tax system so you that you avoid subsidizing debt rather than equity and tax the free lunch of asset-price inflation rather than give it special tax breaks. The economy would work much more efficiently – and equitably – by taxing economic rent – land rent, the airwaves, monopoly rent and other income that is only an access charge that adds to the price instead of taxing labor and capital that adds value.
Right now, American labor has to pay so much for housing – largely mortgage debt – and for personal debt service that there’s no way U.S. labor can compete with workers in countries that have a lower debt. So we’re not dealing with comparative costs, as in Ricardian theory, we’re dealing with absolute costs and the highest absolute cost in every country for labor is no longer corn, like it was in Ricardo’s day. It is housing debt and personal debt. So we have debt levels and debt-fueled housing prices, pension and health care debt determining exchange rates and competitive costs.
EJ: Interesting. So the real value of the dollar the net present value of the cash flows that are generated by these heavily indebted U.S. households and corporations?
MH: The only way you can lower the debt is to wipe it out, given that interest rates cannot be driven lower than they are now. Everybody would like to lower the debt overhead. But to write off debts you have to write off somebody’s savings on the asset side of the national balance sheet. It’s simply not possible today to lower the debt by paying it off or earning your way out of debt. But it’s politically hard to write it off because of the choice as to just what savings you’re going to wipe out. These debts represent some party’s assets – fictitious as these assets or “finance capital” may be. So the economy finds itself politically and also ideologically obliged to keep its fiction on the books. That’s the financial tragedy we’re in today.
A lot of bad loans are going to be taken over by the government. How willing will it be to write down the $8 trillion in bailout loans and guarantees it’s taken on? You can imagine the political screaming and blame. “Hey, you’ve given away $8 trillion to the people who made the bad loans to begin with – banks that were being indicted for fraud, and their enablers who underwrote, guaranteed and bought these packaged junk mortgages and junk derivative plays!” So the fiscal problem will turn into a political problem. You can’t isolate an economic forecast from the fiscal and the political forecast.
EJ: It sounds to me like we’ve got a serious conundrum over the next few years. The things we really need to do to get the economy moving again are politically impossible. So how does an investor deal with that? It certainly doesn’t sound like a robust environment for stocks. I don’t see how U.S. treasury bonds can maintain their extraordinary performance over the next few years.
MH: Obviously, bonds can’t increase in price from a near-zero interest rate – especially as the dollar decline resumes after the carry trade is unwound. Investors will keep their money in short-term Treasuries as long as they can’t see anything better than safe places to park their money. Even 1% is better than a loss. Until the banks regain solvency, most people are in much the same position as billionaires: Their main concern isn’t to make money, it’s to preserve the capital they have. Preservation is more important than trying to make money in a risky environment. People simply try to avoid risk and by putting their money in Treasury or money market funds.
EJ: To my way of thinking, one way out of this is to use one of the still functioning portions of our capital financing system: venture capital. It has its problems, it ain’t perfect, but it does finance capital investment without creating debt. It gets very expensive in times like this. Last I checked, first financing rounds are typically 50% of your business, so it’s not cheap. But it does fund real invention that actually will improve the economy. It got out of hand during the tech boom and has never really recovered, but my sense is that this ultimately will be what helps drag us out of this, precisely because it is equity-based financing of industry that actually improves productivity and competitiveness.
MH: New tax rules could help this, above all by ruling debt a choice of how to finance investment, just as equity investment is a choice. This would equalize the playing field – and if anything, I would prefer to favor equity investment. That is what the St. Simonian reformers in France pressed for throughout the 19th century, and it fueled the German and Central European takeoff.
What’s blocking the recovery of investment today are mainly the debts that are left in place. If you leave labor, real estate, cities and the government – and infrastructure – with a high break-even charge, it becomes uneconomic globally for recovery to work. So you’d almost need a neo-protectionist policy in the United States.
EJ: I would propose very low tax rates on money invested in private equity.
MH: I would like to see no income tax at all, and taxes shifted on free-lunch rents (including financial rents). Most credit has gone into buying rent-yielding properties in recent years rather than into tangible capital formation or technology. You could make America or any nation the lowest cost economy in the world by a tax system that falls on excess prices rather than on labor and capital. This goal was the central aim of classical political economy from Adam Smith to John Stuart Mill, Henry George, Thorstein Veblen, Simon Patten and the business schools in the 19th century. But it changed after World War I, and now we’re in a Counter-Enlightenment. Today’s neoliberals are not liberals in the sense of the classical economists. They’re free lunchers and apologists for an emerging rentier oligarchy. If their policies win out, they will stifle the real economy.
EJ: Maybe when you and I have this conversation ten years from now, we’ll see more capital and value-friendly policies. We’ll see how it goes.
MH: Nobody can foresee what’s going to happen, so I’m sure it will be interesting – and even surprising, as the newscasters say. Cognitive dissonance will have a field day.
EJ: Thank you for your time.
MH: Thank you for the opportunity to talk these important matters through.