The Coming Financial Reality

An Interview with Economist Michael Hudson for Counterpunch


The war in Iraq is allegedly over, interest rates are going lower and there are rumors of recovery although the economy is still in the doldrums. A Bush is president, but an election is around the corner. It sounds a bit like the recession of 1990-1991. In fact, the recovery from that period, anemic as it was marked by very little growth in employment–was actually stronger than this one. The US economy grew at an annual rate of 3.1% compared to the 2.6% annual rate currently. Except for the 1992 recovery, the last seven economic recoveries were much stronger than this one, and each of them, corresponded with the usual amounts of job creation. So far, the current unemployment rate has actually edged higher to 6.4%, and among African-Americans is twice as high. Meanwhile the mainstream financial press has been arguing that the virtue of “jobless recoveries” is even higher rates of profitability for corporations.

Generally echoing the jingoism of the general media, financial publications such as The Wall Street Journal, The Economist and Business Week have chosen to highlight the job growth in one sector-services. The refinancing boom, as they argue, contributes to the service sector by promoting the retail industries: lower mortgage payments mean more money for consumer goods. But, in this case, it also means all-time high rates of consumer debt. The Federal Reserve continues to exacerbate this problem, most recently by dropping rates once again, ostensibly to stave off deflation. The financial press celebrated the move by hyping the stock market. Little attention was paid to the fact the Fed itself admitted that the main reason for the rate cut was that the economy “has yet to exhibit sustainable growth.”

Meanwhile, the 2003 federal budget–thanks in part to Bush’s war and his reckless tax cuts-is expected to approach a $500 billion shortfall this year. In comparison, Clinton’s tax increases were almost progressive. His deficit reduction and spending restraint kept interest rates low and spurred the investment boom. Capital gains taxes from investment played a major role in creating the $236 billion budget surplus in 2000. Today, however, those taxes have been cut, along with dividend taxes and the massive federal deficit has begun to wreak havoc on the states’ budgets. California’s $38 billion shortfall is a nationwide all-time record. Thirty-eight other states are in situations nearly as dire. This, of course, means there will be huge layoffs in the public sector. And unemployment means no pricing power for labor, no wages to pay off debts accrued during the bubble, a potential wage of foreclosures and a resulting set off layoffs in the service sector.

On July 1st, as the state legislatures began their new fiscal year, I spoke with heterodox economist and historian Michael Hudson, one of the few with both real experience inside the financial services sector. He believes that it is not enough to know that corporations will do everything imaginable to extract profit at the expense of the workforce. It is not enough to know that politicians represent their donors, not the electorate. He believes you also need to have some background in the financial system as a whole to understand where the economy is headed and why “free market” propaganda dominates the terms of debate, despite all the evidence of its failings.

Professor Hudson is presently writing a book on the bubble, focusing on the increasing dominance of the financial industry over industrial production. I asked him to relate his ideas to the coming state of social security, employment, Bush’s war against the poor and the middle-class, and the international ramifications of US economic policy.

The downside of low interest rates

Standard Schaefer: Let’s start with the economy in general. Today’s interest rates are the lowest since the1958 recession, but the economy is essentially stagnant. What is your take on the Federal Reserve’s interest rate policy?

Michael Hudson: The first effect of these low rates is to benefit the banks. That’s the aim of central bankers today. Whether it benefits the economy at large is another matter.

The banking system’s cost of obtaining funds is now almost as low as it was after World War II. But long-term rates for mortgages and credit cards have not fallen. So the lending margins of banks have widened, increasing their earnings. This is why we don’t face a Japanese-style bank collapse. U.S. banks have managed to avoid bearing the brunt of the stock-market losses by passing their bad stock investments and bad debts on to their customers, the pension funds and mutual funds. Labor and its savings have borne the brunt of the post-2000 market downturn. It’s the people who put their trust in banks and other financial managers that are on the short end of the stick.

The rates that have responded most significantly to lower borrowing costs are short-term loans for financial speculation, above all for derivatives and related buying or selling of stocks and bonds on margin–enormous gambles on which way the dollar, the stock market and interest rates may go. This kind of lending does not help the economy invest more in fixed capital formation. It merely helps create a thriving and profitable new bank business.

Like Japan, the U.S. economy has painted itself into a debt corner that is locking in low interest rates. These rates can’t go up without causing widespread distress. This “lock-in” is a second effect of the Fed’s policy. As interest rates have fallen, home owners and businesses have found their income able to support a larger debt pyramid. A thousand dollars per month can carry twice as high an interest-only loan at 5% as it can at 10%.

Instead of using the decline in interest rates as an opportunity to pay down their debt, they have borrowed more. Mr. Greenspan has encouraged them to do this so that they can go out and spend more money, creating more profits for producers of the goods they buy. This is the first time in history an economic planner has advised people that they can live better and the economy can grow faster by running deeper into debt. This philosophy blatantly serves the commercial banks and other lenders and savers rather than keeping their self-interest in check as government financial policy would be doing in a better-run economy.

Most of America’s new debt creation represents floating-rate mortgages. Their interest charges may rise if general interest rates increase. This will enable banks to pay their depositors rising rates, thereby holding onto these deposits rather than seeing the scale of withdrawals that killed the savings and loan associations (S&Ls) in the 1980s.

However, if and when interest rates rise, carrying charges on most peoples’ debts will jump sharply, especially for real estate. Some people and companies that have borrowed to the hilt will default, and be forced to sell their assets. Prices for real estate and stocks will fall, and many debtors may find themselves with negative equity in the property they have bought. By negative equity, I mean that the price of their home may fall to less than they owe on the mortgage.

The very thought of this scenario happening will deter U.S. planners from increasing interest rates in the foreseeable future because of the problems this would cause. But just as high interest rates caused problems in the past, low rates may cause a new kind of problem for the future.

A good example is the effect that low interest rates are having on corporate pension funds and other personal savings. Companies with “defined benefit plans” are obliged contractually to set aside earnings in a special fund that will generate enough interest, dividends or capital gains to be paid out to a growing number of retirees. Rather than paying these pensions out of current income as it is earned or plowing their earnings back into investment in their own business, companies take their income and “financialize” it by buying stocks and bonds for their pension funds.

As interest rates fall toward zero, however, an infinite amount of savings is required to produce interest income. This is the basic folly of not simply paying pensions on a pay-as-you-go policy in the way that Germany has done. As interest rates fall, companies need to set aside more and more of their net cash flow for their pension plans. And at today’s interest rates, almost all their earnings are absorbed by pension-fund commitments. This problem is as serious in Britain and other countries as it is in the United States.

This phenomenon has a number of effects. First of all, reported company earnings will fall after netting out pension-plan contributions. This is not good for the stock market, and makes it even harder for companies to pay pensions out of capital gains they hope to make.

To avoid this problem, companies are abandoning their “defined benefit plans” for “defined contribution” plans. The change in wording (from “benefit” to “contribution”) means that instead of getting a promised stream of benefits upon their retirement, employees will have a specific amount withheld from each paycheck. In effect they are told that their employers don’t have any real idea as to how much these workers are going to get upon retirement. Only the top executives have worked out golden parachute packages with stipulated payouts.

Companies also are firing workers just before they become fully vested in their pensions. This cheats them out of what they had expected and indeed, deserved. But a simpler way to wipe out corporate pension commitments is to merge with another firm or allow oneself to be raided, under terms that the new company changes the pension rules. The raiders empty out the pension funds and uses them for their own purposes, partly to pay off their financial backers and partly to pay bonuses to their leading officers out of the savings they have expropriated from the employees.

This is what Dick Cheney did at Halliburton with one of the companies it absorbed, attesting to the support this anti-labor stratagem has at the highest levels of our government.

Inflating a financial bubble as a precondition for privatizing Social Security

SS: How does all this effect public pensions and, most of all, Social Security?

MH: Lower interest rates mean slower accruals of interest in the government’s own Social Security and medical care funds. Low interest rates show how futile it is to try and pay for the future by buying bonds or stocks, or otherwise saving money without somebody, somewhere, actually investing to produce the goods and services that people they are going to buy when they retire. Saving, stock and bond speculation and real estate speculation do not by themselves lead to new investment. In fact, the higher speculative and financial returns are, the less incentive there is to actually tie down money in building new factories and expanding business.

I should point out that non-profit foundations also are being squeezed. The government has proposed that grant-giving foundations must give away no less than 5% of their endowment value in grants each year. Most foundations won’t be able to earn 5%. Rather than just sitting by as sinecures for cronies watching their endowments grow, they will have to begin doing something with the money they have accumulated, although their funds may shrink.

These exorbitant shares for management in the face of falling returns should warn people of what folly it would be to privatize Social Security. The only hope for it to be adopted lies in the privatizers’ ability to convince people that there’s going to be a new bubble that can make back the money they lost (or simply failed to make) in the last bubble.

SS: You have said that governments always are complicit in bubbles. How so?

MH: Every stock market bubble in history, starting with the South Sea and Mississippi bubbles in the 1710s in Britain and France, has been sponsored by government. The driving force has been the government’s attempt to cope with debt obligations beyond its foreseeable ability to pay. Creating a bubble has been a way to solve their public debt problem–and to pay off political insiders at the same time, thereby killing two birds with one stone.

Modern governments are not politically able to simply default on their debts–at least, not debts owed to their own bondholders in their own currency. The problem has to be solved through “the marketplace.”

The simplest solution is to get people voluntarily to swap their government bonds–or in today’s case, their Social Security entitlements–for stocks that then can be permitted to fall in price, once the investment no longer is the government’s responsibility.

For this to occur, it is necessary to prime people to expect that stock prices will rise sharply. They have to see fortunes being created in a new speculative run-up, and their imaginations as to a glorious new future need to be piqued.

In England in France the “new economy” industry of the day was the slave trade between Africa and the New World, and it promised to provide unprecedented gains. England bought the asiento slave-trading monopoly from Spain, and France began to establish plantations in its Louisiana territory.

Stocks in the South Sea and Mississippi Companies were issued in tranches, permitting people to buy on margin with only a small proportion as down payment, so that they could quickly double their small initial payment as the stocks were engineered upward in price. It seemed that money could be made off money itself. This is a basic illusion that is necessary for bubbles to take off.

But where was the money to come from? In the 1710s the major vehicles for saving were government bonds. Stock markets had not yet really come into being. In fact, it was the bubbles that created them in Britain and France, and also helped develop international investment as the Dutch in particular became major stock buyers.

Investors paid by exchanging government bonds for stocks in the South Sea and Mississippi companies. The stocks had fallen in price to a fraction of their par value, but were accepted at par, so bondholders felt that they were being given a chance to break even. And as stock prices rose, more and more bonds had to be exchanged for a given number of shares in the two companies.

This is the background that may help explain today’s privatization scheme for Social Security. There actually is a dual problem.

On the one hand, as in the early 18th century, the U.S. Government has future obligations that it claims it will have difficulty in paying. This actually is not the case, but there is another factor at work. That factor is the desire by financial institutions to make money off a new stock run-up, and to find a vast new source of money management fees for their executives.

The problem facing money managers is that the domestic U.S. savings rate has fallen to zero (actually, it is negative, as indebtedness is building up more rapidly than new saving is being accumulated). Despite this unprecedented development, employees are obliged to accumulate forced savings, in the form of the income withheld from their paychecks by F.I.C.A. withholding for Social Security and Medicare, and put into government bonds in the accounts of these two government agencies.

The financial sector is looking at these funds like a shark that sees nice juicy prey swimming in the water. They would love to get their hands on Social Security and Medicare funds to manage, at a 2% fee. Even just 1% this would amount to tens of billions of dollars annually, not including the speculative gains that could be made on the turbulent market run-up.

Chile in the mid-1970s was a dress rehearsal for the immense management fees that the large financial conglomerates could rake off from privatizing Social Security. The financial conglomerates given control of these funds were well connected to the Pinochet dictatorship, and they were told to buy domestic Chilean stocks–the stocks of other companies in the Chilean zaibatsu whose banking arms were managing these investments. Stock prices then were allowed to collapse once the insiders had taken their money out, South Sea style.

The financial insiders made off well, but the workers lost their savings. The plan then was revamped with management turned over to U.S. and other international companies, with the stipulation that the pension savings had to be invested in the stocks of large Chilean companies.

This was the scheme thought up by the Chicago Boys brought in by the military junta. Their experiment with the “free market” thus was introduced at gunpoint. This also became the case elsewhere in Latin America, where labor unions organized riots to protest their forced saving being turned over to international stock-brokerage firms. But the privatization is being done as an inside job by the Chicago Boys with strong arm-twisting by the IMF and World Bank acting as the financial sector’s international lobby.

SS: How are the Fed’s bubble-promoting policies contributing to this move to privatize Social Security?

MH: First of all, it was Alan Greenspan that lowered interest rates early in the 1990s when the stock market boom began to flag. Despite the fact that he talked about “irrational exuberance,” he made speculation rational by channeling the flow of funds to inflate the bubble.

He could have raised margin requirements on stocks. That is the time-honored way of discouraging borrowing that is used to bid up the price of stock. Or, Mr. Greenspan could have increased bank reserve requirements against deposits lent out to stock speculators. Or he could simply have told the banks to slow down on stock market lending if they did not want to see such requirements being imposed. But he did none of these things. He felt that inflating the bubble was what was making his reputation as a financial genius, John law-style. And his policies certainly helped get him reappointed for yet a new term as Chairman of the Federal Reserve System.

This explains why he is repeating his policy of lowering interest rates today and flooding the financial sector with cheap credit. Yet this money is not being invested in creating new means of production or employing more labor.

This brings us to the scenario for privatizing Social Security. If the system’s gigantic holdings of government bonds are sold off (with the Federal Reserve Bank supplying the funds to monetize the requisite credit) and put into the stock market, this rush of funds is going to push up stock prices. It will inflate the new bubble that is being promised, which will be called a “recovery.” Stocks will be pushed up for a few years as more paycheck withholding is channeled into Social Security than out-payments are made to retiring Baby Boomers, the Big Generation born right after World War II.

The big stock-market institutions will speculate on a boom and make much more than simple capital gains through their leveraged derivatives trading. Smaller investors will use some of the gains to buy real estate, bidding up prices for housing, commercial buildings and other property.

SS: This sounds like a winning political program. If it makes Americans richer–or even if it just makes them feel richer–shouldn’t they support a financial boom along these lines?

MH: The turning point will come just before the point is reached where more people retire than are entering the employment market. Stocks will begin to be sold off as institutional money managers dump their holdings, mainly onto their clients and small investors who do not realize that the wind is changing.

The stock market will collapse, as it did in 1710 in England and France. But the policy will have succeeded in getting people to give up their claims on the government for payment. When the dust settles, the government balance sheet will be freed of its Social Security and Medicare obligations. That’s the basic objective.

Public officials and newspaper commentators will wring their hands and exclaim, “Well, you see the madness of crowds. People are greedy.” But who really will be to blame? The crowds will have been doing what the professionals advised them to do. This bubble is a symptom of the madness of crowds mainly to the extent that it is a psychologically orchestrated disinformation program.

The same thing is happening in almost every country. The Fed’s policy of lowering interest rates is a precondition for reviving popular hopes for a Bubble and suckering voters to approve Social Security privatization. Starting a new bubble will set the public up for the rip-off the financial sector is hoping will make the 2000s as nice for it as the 1990s were.

How the financial sector is concentrating economic planning in its own hands

SS: It sounds contradictory: the private sector-most notably the financial service companies is sponsoring a massive planned economy-even though they denounce planned economies as inefficient and ineffective. And the government-who would normally do such planning-seems to accept that they can’t do the job properly. And yet they quietly support letting the private sector do it themselves. How can this be?

MH: The large financial conglomerates are using their economic gains to break down public regulatory power so as to transfer economic control and resource allocation into their own hands. Yet their objective is simply to pursue the short-term trading gains, not to see savings invested in fixed capital formation.

To promote deregulation, financial lobbies and their academic public relations spokesmen have rewritten economic history. In so doing, they have turned it upside down. The result is a caricature of government regulation, whitewashing the universally bad experience of privatization’s failures. A rosy Walt-Disney picture of the future is painted to convince the population to relinquish its existing government protections and sign them over to the new planners.

If you want to see America’s future under these new conditions, you might want to look at Russia’s experience since 1991, where the Washington Consensus had a free hand. Look at what it brought about. In abolishing what it called the Road to Serfdom resulting from government planning and regulating markets, Russia, Britain and Chile have become object lessons for a New Road to Serfdom–financial rentier serfdom, in which a class of people live off the fixed income from government bonds or land rents paid by others who do the work to generate this revenue.

If ever there was a Faustian proposal by the proverbial devil, this is it. And it is good to remember Baudelaire’s quip about the devil: He achieves his victory over humanity at the point where people become convinced that he doesn’t exist.

Today, the debt problem has all but ceased to exist intellectually, along with property and rentier economic relations in general. A body of theory has been popularized that excludes the study of debt, history and the history of economic thought. Peoples’ attention has been distracted into speculation about of how they might get rich in a parallel universe that might exist in theory–if one accepts the narrow-minded assumptions that are being taught–but whose most important real-world consequence is to impose a debt spiral on America and other nations.

SS: What should the government do to protect labor and most savers from the losses resulting from the bubble bursting? Is re-regulation and planning the solution, or is it part of the problem?

MH: Free enterprise under today’s financial conditions threatens to bring about an unprecedented centralization of planning, not in the hands of government but by the financial conglomerates and money managers. Whatever government planning power is destroyed becomes available for them to appropriate, with plenty of vigorish left for the politicians whose campaigns they back and who will “descend from heaven” into high-paying private-sector jobs, Japanese style, after having performed their service for the new regime.

SS: The financial regime is nothing but parasites?

MH: The problem with parasites is not merely that they siphon off the food and nourishment of their host, crippling its reproductive power, but that they take over the host’s brain as well. The parasite tricks the host into thinking that it is feeding itself.

Something like this is happening today as the financial sector is devouring the industrial sector. Finance capital pretends that its growth is that of industrial capital formation. That is why the financial bubble is called “wealth creation,” as if it were what progressive economic reformers envisioned a century ago. They condemned rent and monopoly profit, but never dreamed that the financiers would end up devouring landlord and industrialist alike. Emperors of Finance have trumped Barons of Property and Captains of Industry.

SS: Why have so many academic and think-tank economists endorsed the Bubble Economy and the privatization of Social Security?

MH: First of all, they have re-defined as “wealth creation” what most investigative journalists and other people with old-style values would call a rip-off and many people a free lunch. Their next step has been to follow Milton Friedman and deny that a Free Lunch exists. Yet the economy has become all about getting a free lunch. That is the essence of the classical theory of rent: one collects interest off bonds or land rent, well beyond cost outlays. The aim is property income, not the creation of new means of production.

SS: Why haven’t people been able to see through this switch of values more clearly?

MH: The financial beneficiaries of the stock-market bubble call it “wealth creation.” Two-thirds of Americans are homeowners, and they feel that they are benefiting. Rising prices for houses are called “wealth creation,” and borrowing more money against this property is called “value extraction.” In fact, riding the wave of asset-price inflation–the real estate and stock market bubble–has been the way in which most people have been able to get to be what they consider to be pretty rich.

Stock traders say “The trend is your friend.” Rising prices for assets seem to make most people better off, unless they are renters, or ethnic minorities, or immigrants, or come from large families and don’t inherit a home of their own, or get sick and need to pay for medical care, or get fired, or get their pension fund ripped off or otherwise fall outside what most people think of as the bell-shaped curve of good fortune. But polls show that most Americans expect to grow rich, and the bubble seems to be the way to do it.

How financial engineering has replaced industrial engineering

SS: What is the role of technology in all this? The “Progressive Century” was inaugurated by breakthroughs in energy, electricity and then nuclear power, radio, air travel, medical cures and so forth. How much has actual technology been responsible for “real” wealth creation as opposed to bubble financing?

MH: Higher prices for houses and stock in large corporations look like a way to build up wealth without having any tangible cost associated with it. This absence of what the classical economists defined as value–ultimately the cost of supplying labor effort–has changed the popular meaning of “wealth” to mean financial market value, not industrial capital measured in terms of its productive power. In this sense today’s anti-government economics runs against what economists, politicians and most people considered to be industrial progress a century ago.

SS: Given all the we know about the corporate crime and deregulation behind bubble of the ’90s, why is no one talking about the old-fashioned solutions like those types of regulation that have been shown to actually increase competition and increase the efficiency of the markets.

MH: The bubble of the 1990s has been called a bubble, an internet bubble and other forms of technological bubble, but technology was only a vehicle for what basically was a financial bubble. It was not powered by industrial engineering as much as by “financial engineering,” manipulating corporate balance sheets in a Japanese zaitech-style.

Investment bankers treated telecoms and kindred companies as vehicles to float their stock, take huge cuts for themselves, and then make yet more money on first-day stock run-ups. These are the practices that Eliot Spitzer’s office took the lead in investigating when Pres. Bush’s deregulatory appointees blocked the SEC and other government agencies from protecting the public interest.

The bubble was fed largely by the “forced saving” that was withheld from the paychecks of employees. These “savers” were not permitted to spend their savings in a discretionary way–for instance, using it to buy their homes or pay down their mortgages or even to pay off their higher-interest credit-card debt. The money that was withheld out of wages and salaries was set aside in pension or retirement plans managed either by their employer or by large financial institutions.

These money managers, along with investors using their own liquid savings, saw prices for high-tech companies taking off. Even though most investors knew there was a bubble, they thought that they could ride the wave and get out quickly before other people did.

Of course, the turnaround time is so short that only the large financial institutions are able to play this game. To be good at it, you have to devote your entire life to following the market hour by hour. Only professionals can afford the time and effort to do this.

Most people held onto their stocks when prices turned down in 2000 because they imagined that they would go up–someday. They thought the crash was simply one more zig-zag, not a phase change, largely because they saw that Alan Greenspan was committed to using monetary policy to prevent a stock-market downturn. When Long-Term Credit Management (LTCM) got into trouble in 1997-98, he bailed out the banks that had put up the money that was gambled on derivatives. The government seemed committed to protecting savers from risk, or at least protecting the large banks and other financial institutions deemed “too big to fail.”

Saving the economy from a market downturn was what made Mr. Greenspan’s reputation as a financial “maestro,” after all. People wanted to believe that he could succeed, because his success would enable them to make money on their own savings.

The media jumped on the bandwagon, and this is where psychological engineering came into play, without even having to be planned. Days on which the stock-market averages turned down were euphemized as “profit-taking,” implying that the basic trend was upward and that most people simply took out profits, presumably to spend on SUVs and other signs of consumer affluence.

The reality is that when stocks decline, the only “profits” being made are by short sellers–gamblers that stocks will fall in price–who cover their bets at a low price. When markets rise, these short sellers are “squeezed,” as they have to buy stocks at a high price that they bet would fall rather than rise. So the media get matters backward in oversimplifying their reports to always give a positive spin on every development, up or down.

Financial analysis in most news broadcasts and in the press was becoming part of the entertainment industry, turning news reports into virtual advertisements for the bubble and Mr. Greenspan. His origins as an Ayn Rand acolyte seemed to be reaching their logical conclusion, and he credited the boom to the “magic” of deregulation, getting the government out of the oversight business so as to let money managers make everyone rich.

What we are dealing with here is Junk Science in the service of political ideology. The closest parallel I can think of is Lysenko’s biological and genetic theories promoted under Stalin on ideological grounds. The idea that environmentally acquired characteristics could create lasting genetic change in species was supposed to support the idea that a new Soviet Man could be created. Mr. Greenspan and his financial supporters believed that he had changed the economic and political environment of modern capitalism. It seemed that the laws of economic nature themselves were being transformed by developing a way for the Federal Reserve to modify industrial economies and their value-creation through labor and physical capital investment by financial engineering that required neither growing employment nor new fixed capital formation.

So the economy’s DNA molecule had been changed in a way that made business cycles–including downturns–a thing of the past. Mr. Greenspan helped prevent a downturn by flooding the economy with money, while the U.S. Treasury and State Department arm-twisted Europe and Asia to keep on accepting a growing U.S. trade and payments deficit by using their surplus dollars to spend on Treasury bills to finance America’s growing domestic federal budget deficit.

A new kind of circular flow seemed to have been created–not Say’s Law of Markets, which depicted producers as paying their labor and suppliers and these parties turning around and buying the products they produced. Labor had to borrow to keep up its living standards, and companies were running into debt to stay afloat. Repaying these debts withdrew revenue from this circular flow between capital and labor, employers and consumers.

The new circular flow was to have Europe and Asia recycle the U.S. payments deficit to finance the budget deficit, so that Americans didn’t have to save money any more. They could spend what they had, and let foreign central do the saving.

This was not really getting the government out of economic affairs, of course. It put European and Asian governments right in the middle of the new kind of circular flow. In the process, of course, the U.S. Government was running up an unprecedented and unsustainable debt to foreign governments, or at least to their central banks.

When the dust settled after the stock-market downturn proceeded after 2000, the gains that people had thought were exposed as largely illusory. They turned out to have been produced by fraud. What is remarkable is that despite the fact that Arthur Andersen was put out of business and its practices turned out to have been followed (although not quite so blatantly) by the other big accounting companies, Mr. Greenspan’s reputation remained intact. Despite the SEC’s regulatory failure to have prevented the accounting and financial fraud, no public reaction against deregulation as such has occurred.

The reason largely is because the monetarists have created an intellectual vacuum in academia and the popular press when it comes to thinking about any alternative to regulation. Margaret Thatcher put it in a nutshell with her famous TINA–There Is No Alternative.

Of course there are alternatives. But the free-market boys have been able to foreclose serious discussion by acting as censors of any such discussion. It seems therefore that today’s individualistic free-market philosophy is not compatible with a free market in ideas. This is a byproduct of the financial sector’s rise to dominance. It is what I referred to above when I spoke about the parasite taking over the host’s brain as well as diverting nourishment to feed itself and its progeny.

SS: How precarious has all this left today’s situation? Has deflation become a serious threat?

MH: Deflation in the form of falling commodity prices does not look like much of a threat, at least not as it was following the Civil War and World War I, when debtors found their interest and principal payments fixed while their money-wages declined.

The kind of deflation that is occurring today is not the traditional phenomenon of falling prices (price deflation) but a bleeding of incomes–debt deflation. As debts grow, more income must be paid out as interest and amortization rather than being available for spending on goods and services. This breaks the circular flow that economists call Say’s Law of Markets, whereby supply is supposed to create its own demand.

The principle doesn’t work when people use their income to pay mortgages on increasingly expensive homes and pay credit card debts and other loans they have had to take out just to break even as the economic screws have been tightened. Families that have not gone further into debt usually have had to take extra jobs to stay afloat.

How Bush’s tax cuts favor finance at the expense of industry and labor

SS: It almost sounds like the government is getting out of business, cutting taxes as well as regulatory activity. What is the effect of Bush’s tax policy, particularly reducing the capital-gains tax to just 15% and ultimately eliminating it altogether?

MH: Nobody seems to be talking about this, but about 80 percent of capital gains are real estate gains. The real estate sector tries to camouflage itself as new technology entrepreneurs, representing its tax cuts as benefiting mom-and-pop family businesses developing new products. But capital gains other than real estate only account for 20 percent of the tax.

This makes the term “capital gains” a euphemism for land-price gains. It is not the building that grows in value, after all, but the geographic site on which it happens to be situated. Buildings wear out, but are maintained by “maintenance and repairs,” normally about 10% of the rent roll and of course tax deductible as a normal operating cost.

Landlords also can depreciate their buildings–and new buyers can depreciate them all over again, and they can be re-depreciated ad infinitum, as if they were losing value. Real estate investors (but not homeowners) are allowed to depreciate and re-depreciate buildings at such a generous rate that all the nominal rental income left after paying interest is offset by such fictitious “non-cash costs.” When the building finally is sold, the fictitious write-offs are registered as a capital gain. There is no obligation that landlords repay what they would have had to pay at the higher income-tax rate had such fictitious depreciation not been permitted.

The upshot has been to make it much more profitable for investors to buy land and property already in existence than to invest in creating new plant and equipment that actually employs labor. Why invest in a risky enterprise when all you need do is put down as little money as you can, borrow the rest, and ride the real estate and stock market bubble?

This favoritism to real estate is part of the anti-industrial character of modern tax codes. These tax laws are the product of intensive political lobbying by the FIRE sector. The financial lobby is happy to back the real estate lobby, secure in the knowledge that whatever rental income the government relinquishes from taxation is left free for prospective borrowers to pledge to their mortgage lenders. These buyers bid against each other, until one party or another has committed the entire rent roll to pay interest, hoping that ultimately he or she will be able to sell the property at a capital gain, keeping the difference.

In this deal bankers get the operating income, the absentee owner–or the homeowner, for that matter–get the capital gain. This policy works in financial bubbles. But when the downturn comes, it results in negative equity.

Speculation has become a faster and even less risky way to make one’s fortune than the tangible investment which the Bush administration pretends is the objective of its tax cuts. Why build new structures when you can buy one already in place? Why create more fixed capital formation, when after-tax capital gains yield a higher “total return,” that is, current income plus asset-price gain?

How Bush’s federal tax cuts are forcing up state and local taxes and prices

SS: Let’s turn to the state budgets. The mainstream press is attacking the state legislatures for overestimating their surpluses from the boom and overspending on social programs.

MH: It’s appropriate that we’re discussing this today, July 1, because this is the beginning of the new fiscal year for many state and city budgets. This year will inaugurate a new kind of austerity plan that will resemble if not surpass those imposed by the IMF on Latin American countries in past decades. And like most austerity plans, the result threatens to be higher prices, depopulation and emigration.

But first, with regard for your comment about “overspending,” many states set up “rainy day” funds prior to the 2000 elections. They put their extraordinary capital gains tax revenues in these funds, rightly anticipating that these gains could not possibly be permanent over any protracted period of time. But Mr. Bush’s tax policies, in conjunction with the bursting of the stock market bubble, have now led to the depletion of such funds.

I’m not sure what “overspending” means. Government commitments are financed mainly out of tax revenues, not borrowing. Local governments relied mainly on property taxes, but have been shifting these onto labor. What has occurred has not been more spending so much as an un-taxing of real estate and the financial sector to which it pays most of its net rental income. Because local borrowing is limited by law, lower tax returns will cut spending.

SS: The traditional federal grants-in-aid to the states have dried up. Is this problem related to Bush’s tax cuts?

MH: Cutting the capital-gains tax has hurt because this was the major extraordinary fiscal source in the 1990s. States and cities used it as an excuse for holding off raising real estate taxes in keeping with the boom in property prices. In Pennsylvania the real estate tax is only 1 percent of assessed property value, which has been growing around 10 percent a year. Land prices are soaring in California, but property taxes are limited to just 2% annual increase, from a base that is now utterly obsolete.

The basic principle is that what the tax collector refrains from taking is left available to be pledged to bankers for mortgages to buy property to ride the real-estate price boom.

As for the stock market boom, since it burst since 2000, states have found themselves without this extraordinary source of credit, which now appears to have been a one-time surge.

What has not been adequately emphasized is that Bush’s tax cuts imply sharp, devastating tax increases at the state and local levels. New York City’s decline in tax receipts has forced it to raise its real estate taxes by 18% and public transit fairs by 33%. It also has to cut back services, providing less public service for the existing tax levy. The effect has been to increase the unit price of civic services. The money is going to creditors instead.

Also increased has been the cost of obtaining a public education. CUNY–the City University of New York, which operates a number of campuses–is raising tuition reportedly beyond the ability of many of its traditional students to afford. The irony here is that just last week the U.S. Supreme Court approved the legality of the University of Michigan’s affirmative action program for black and Hispanic students. Just as this corrective policy was legalized, states were forced to increase public college tuition so sharply as to put higher education out of reach of its intended constituency.

The cutbacks in hiring are expected to hit minority workers the hardest, for the large cities traditionally have had a large proportion of minority labor in their public administration. For many years state and municipal hiring absorbed a large part of the growing labor force. This employment now has been closed off as departments are being downsized.

Another effect is that culture is being Thatcherized. There is no longer a non-commercial classical music station in New York City. When I moved here in 1960, it was common to hear WNYC, WNCN or other classical music stations on the radio in offices or homes. Now there either is silence or the opposite–loud, blaring repetitive commercials interrupting semi-classical “easy listening” music, pop music and political talk shows.

With regard to live music, symphony orchestras are facing bankruptcy throughout the United States. The same phenomenon happened in Britain after 1980 under Margaret Thatcher, but the situation in New York is even more extreme. At least when I visit London, I hear my friends listening to BBC music, and there is still a lively musical scene. In New York the opera and symphony have been turned into backdrops for local real estate promotion.

In 1930 real estate accounted for 80% of state and local revenues nationwide. Today this ratio is down to about 17%. The fiscal burden has been shifted off property owners onto labor. To put this into perspective, the value of New York City real estate alone exceeds that of all the machinery in the United States.

What used to be welcomed as a postindustrial society thus is lapsing back into the pre-industrial rentier economy. The focus of economic activity is property gains, not actual production. New York’s industrial neighborhoods have been gentrified and their traditional small manufacturing companies, employees and family businesses have been driven out.

There’s an interesting political twist to the fiscal crisis of the states. The three biggest problem states are California, Massachusetts and New York, which all went Democratic in the 2000 presidential election. It is as if the Bush administration is saying, “Drop Dead, Democratic States” when it comes to federal revenue sharing.

Even when it comes to anti-terrorist spending, for instance, New York has been short-changed. Next month, in August 2003, Project Liberty is going to lay off some two thousand social workers hired after 9/11 to work with the families of victims and others affected by the attack on the World Trade Center. FEMA (the Federal Emergency Management Agency) provided $150 million for psychotherapy. This was more money than the government had given for mental health in its entire history, for all disasters put together. It would seem to be enough to send every New Yorker to a shrink and still have some money left over.

But now it seems that $50 million is missing. The Bush bureaucrats decided that rather than find out where the missing money went (and into whose election campaign?), they would just shut down the program as a result of their own mismanagement.

International implications of low interest rates, tax cuts and a new financial bubble

SS: We spoke before about the your insightful view of the balance of payments between nations. (See the super imperialism interview.) How do low rates and the dollar’s falling affect prices and the balance of payments?

MH: One effect of low interest rates is to keep the dollar’s exchange rate down. Although interest rates are an element of cost, lower interest rates in this particular case may work to raise prices, to the extent that a declining dollar leads to higher prices for imports priced in non-dollar currencies and those not tied to the dollar. If the OPEC countries, for instance, were to price oil in euros, this would make forward hedging more expensive if the dollar declines further.

A second effect is to make clear to the world that the United States is conducting economic policy with only its own objectives in mind, with a “benign neglect” for how its balance-of-payments affects other countries. A falling dollar means a rising euro, and this will squeeze European industrial exporters. Germany will feel the squeeze most of all.

U.S. diplomats are anticipating that the problems that Germany faces with its overvalued currency may force it to roll back its social legislation, especially its pro-labor rules and pension system. The aim is to transfer the economic surplus from labor to finance, as is occurring in the United States. This would break up the world’s social democracies politically and economically, forcing them to follow the U.S. financial restructuring.

The economist David Hale recently estimated that Europe and Asia will end up financing about 60 percent of America’s domestic federal budget deficit this year, by recycling the surplus dollars being pushed onto the world via the U.S. international payments deficit. So instead of the deficit “crowding out” domestic U.S. saving, America is getting the kind of free ride that we discussed in our last interview. Europe and Asia are lending us the money at virtually no interest to buy as much as we want from them, for our paper IOUs of increasingly dubious quality.

SS: How are their central banks responding to this phenomenon?

MH: They are lowering their own interest rates in what is becoming much like the beggar-my-neighbor devaluations and tariff wars that occurred in the 1930s. Lowering interest rates in today’s case certainly is preferable to raising tariffs and manipulating currencies as occurred 70 years ago. But by lowering interest rates, British and continental European pension plans also are experiencing the same insolvency that I described above with regard to U.S. pension funding, except for countries such as Germany that are in much better condition because they have not “financialized” Social Security but pursued a pay-as-you-go policy of paying pensions out of current output. This enables them to use their current revenue to invest in expanding the means of production–including construction–rather than putting it into financial paper.

SS: You have described central banks as following the Washington Consensus. But there are those like Jack Kemp who argue that we need to return to the gold standard. Likewise, in “Gold and Economic Freedom,” Alan Greenspan argued for central bank independence on the ground that the alternative is fiat currencies, which lead to hyperinflation and eventually to the collapse of financial systems. Does this logic hold water as solution to the financial regime you’ve described today?

MH: There is no historical basis for his ideology. It is basically an attempt to demonize public control of the monetary system. This prejudice has been sponsored by the financial sector hoping to elbow governments out of the picture. Rather than being based on economic history, it reflects Mr. Greenspan’s mentor, Ayn Rand, and her passionate antipathy to government. The empirical evidence is just the opposite, which helps explain why the free-enterprise monetarists have excluded economic history from the academic curriculum.

A colleague of mine, Stephen Zarlenga, has just published a historical study, The Lost Science of Money (2002), showing that public-sector fiat money has a much better record than privately created fiat money. The best example is America’s own greenbacks issued to finance the Civil War in the 1860s. Several of the colonial currencies also worked well, even the Continental Currency (the “continentals”), of which 200 million were authorized and printed. Their value collapsed when the British counterfeited billions of them in order to stifle the colonies becoming financially independent. But this wasn’t a problem of the currency itself.

Zarlenga also demonstrates that Germany’s hyperinflation of the 1920s was aggravated by the Reichsbank lending credit to private speculators betting against the German mark. He thus turns the tables on the privatizers by showing that their anti-government views rest on a false mythology.

What is most important to recognize about successful government financial policy is that control of the money supply historically has been accompanied by control over the economy’s debt overhead, including the ability to write off debts that could not be paid. This is an area of study that is excluded by the Chicago Boys’ economic curriculum. They talk about money as if it were something disembodied rather than part and parcel of the debt overhead–an overhead that is compounding exponentially.

SS: What long-term lessons can we draw from the history of national treasuries taking control of monetary policy rather than central bankers and commercial bankers?

MH: The main distinction that needs to be drawn concerns whether the monetary system is privately or publicly controlled. Public systems are stable mainly because they aim at supporting long-term investment. The private-sector’s credit creation has different aims. The usual priority is to finance short-term asset-price gains–that is, to inflate bubbles. If you want to see a public fiat currency that works, look at the U.S. greenbacks. This has become a forgotten epoch in financial history, yet it led to the first clear mathematical formulation of the quantity theory of money, expressed by Simon Newcomb already in the 19th century.

Every hyperinflation in history, especially in the Germany of the 1920s, stemmed from the government’s being painted into a debt corner and trying to inflate its way out of debt. This is what Adam Smith himself noted when he observed that no government in history ever had repaid its debts, although some had pretended to do so, i.e., by inflating prices.

The same observation could be made of private-sector debt as well. The question that needs to be asked today concerns just how America is going to avoid paying its debts, and how other countries are not going to pay their own public and private debts?

It looks like the debts to labor will be wiped out in order to preserve the “sanctity” of debts owed to the wealthiest layer of the population. Obligations to pension funds and social Security and medical insurance and life insurance will be wiped off the books, in order to pay a small number of rentiers–the class that Mr. Bush has made exempt from inheritance taxes, lowered capital gains taxes for, and reduced income taxes on. His policy is essentially one of “Big fish eat little fish.”