A Black Agenda Report, The Fictitious Economy, Part 1

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A Black Agenda Report

Transcript of a Guns And Butter Radio Interview by Bonnie Faulkner originally broadcast on KPFA radio.

There is a rising sense of alarm in the United States, as tangible effects of the economic crisis of empire are unmistakably apparent at every hand. Ordinary people are burdened by debt as never before, and the soaring prices of fuel and food severely affect many tens of millions, bringing into question even the short term sustainability of American living standards. Our media and political elite only offer modified versions of business and usual. Barack Obama’s chief economic advisor, for example, is an open and long-time booster of NAFTA and Wal-Mart as good for poor people. So much for the politics of change.

Dr. Michael Hudson on the other hand, is a financial economist and former chief economic advisor to presidential candidate Dennis Kucinich. In part one of this wide ranging interview, originally broadcast on the Pacifica program Guns and Butter, Hudson explains how the parasitic dominance of the financial sector has led to the creation of a completely fictitious U.S. economy which creates nothing, but is exclusively devoted to extracting wealth from the rest of us.

The following is a transcript of the first half of an hour-long interview with financial economist Dr. Michael Hudson, that was broadcast on the Pacifica Radio program Guns and Butter. The interviewer was the show’s host, Bonnie Faulkner. A link to the MP3 audio of the full hour is provided below.

BF: Dr. Hudson is a financial economist and historian. He is president of the Institute for the Study of Long Term Economic Trends, a Wall Street financial analyst, and distinguished Research Professor of Economics at the University of Missouri, Kansas City. His 1972 book, Super imperialism, the Economic Strategy of American Empire is a critique of how the United States exploited foreign economies through the IMF and World Bank. He is also author of The Myth of Aid, and Global Fracture, the New International Economic Order. On today’s program we discuss his newest book, in progress, the Fictitious Economy; How Finance is Destroying Industrial Capitalism, and Paving the New Road to Serfdom. We examine what is meant by the term fictitious, as the term is applied to aspects of today’s economy including real estate and housing corporate junk bonds, pension plans, capital, statistics, theory and ideology. We take a look at the role of war and the demise of the dollar, the bubble economy, and what could unfold in the future.

Dr. Michael Hudson, welcome.

MH: Thank you Bonnie.

BF: Your new book the Fictitious Economy; How Finance is Destroying Industrial Capitalism, and Paving the New Road to Serfdom, details many fictitious aspects of the economy today, fictitious incomes, costs, capital, savings, statistics, theories and ideologies. What do you mean by fictitious?

MH: Something that’s unreal, something that’s pretend, for instance pretend earnings of companies that really aren’t earned, or pretended values for mortgages that were given by Wall Street banks, and their affiliates when there’s no underlying value there, or fictitious costs. Most economic theory today justifies fictitious costs, for example the Federal Reserve came up with a method of assessing land values that almost seems to come up negative in some years, because it treats buildings as steadily rising in value as their reproduction costs grow, leaving land as a residual, this understating the value of land and overstating the value of buildings.

“…if you’re wealthy in today’s economy, you don’t make any money at all, because it’s all a (tax deductible) cost…”

The tax code is fictitious, because real estate owners have been permitted for the last half century to pretend that buildings are losing value very rapidly, so they can take so much off for building depreciation that they pay no income taxes at all, as it works out. The fact is, buildings don’t lose value if they are well-maintained with normal maintenance and repair. If landlords don’t do this either they’re brought to court for violating the residential building laws, or they break the commercial lease. Right down to the seemingly empirical statistics and theory, the whole economy is based on a kind of parallel universe, a what-if world of assumptions designed to show that the wealthiest people don’t have any income at all.

In fact if you’re wealthy in today’s economy, you don’t make any money at all, because it’s all a (tax deductible) cost. Corporations don’t seem to make any money because they seem to have everything as an expense. For instance interest payments are the largest item that the IRS permits corporations to take off as an expense of doing business. But it’s not an expense of doing business at all, it’s a function of what outside raiders and corporate junk bond holders have paid to buy up the company, and instead of doing business, they’re carving them (companies) up, closing them down, stopping their long term research and other projects, and doing just the opposite of what’s needed for an industrial economy. That’s why the book deals primarily with what the financial sector, which is not part of the economy at all, nor is the property sector part of the economy. They are a completely separate consumption process, more in the character of a parasite, than of (producing) actual goods and services….

I should say that I am in the process of writing this book, it won’t be out for another year. I only sent you an indication of what I’m writing now. What we’re talking about is not a book that people can go out and buy, it’s a work in progress. I’m presenting part of it at a meeting of the university in Kansas City next weekend, at their annual post Keynesian heterodox economics meeting

BF: To follow up on what you’ve just said, Dr. Hudson, in your book that you’re working on, you say the economy is really two economies. There’s a productive industrial one that produces the needs of society, and a financial superstructure, sometimes called the FIRE sector, Finance, Insurance and Real Estate that is siphoning income away from workers and industrial capital and loading them down with ever-increasing debt. Could you explain this a little further?

MH: The National Income and Product Accounts treat everyone who earns an income as producing a service. So if you’re taking money out of an ATM machine, and I’m holding a gun, saying “your money or your life” then I’m giving you the service of your life for the money you’re taking out. This is the opposite of what classical economics is all about.

A century ago when the classical economists, Adam Smith, John Stuart Mill, in the reform era, tried to say look, there are some incomes that are not earned. Rent is not earned, it’s an excess price. Interest is not earned, it’s a monopoly price. Monopoly profits aren’t earned, they’re extortionate. All this was viewed (by classical economists) as something that government regulators should get rid of, either by not permitting it in price, or by holding the monopolies in the public domain, or by the land itself being either nationalized or taxed. The classical economists divided almost the entire economy into productive and unproductive labor, into wealth, and overhead, into real income and costs. This threatened the vested interests with taxing away their free lunch, so you have an anti-classical reaction that is epitomized by the Chicago school of anti-government, anti-tax people whose leader, Milton Friedman, said there’s no such thing as a free lunch.

“…a free market means that predators are free to extort any price from the public, they are free to deregulate, free to lie to consumers, free to exploit, free to load any company they want down with debt…”

Well, classical economics was all about the free lunch. Look at Ricardian rent theory. That’s all about the free lunch. The role of modern economic theory — I should call it post-modern economic theory and statistics is to pretend that the banks, the landlords and the monopolies actually earn their income instead of extracting it from the (productive) economy.

BF: Your book is really an antidote to the dominant Chicago school of free marketeers. What is the meaning of “free market” these days, as understood on Wall Street?

MH: It’s exactly the opposite of what Adam Smith, and Ricardo and the classical economists defined as a free market. Classical economics defined a free market as one that is free of overhead charges, free of unnecessary charges of production, free of watered stock. Today a free market means that predators are free to extort any price from the public, they are free to deregulate, free to lie to consumers, free to exploit, free to load any company they want down with debt, and basically lead (us) to a world of debt peonage… So the whole concept of freedom has been turned upside down by the Chicago school and by the Bush administration.

BF: Why is today’s understanding so different?

MH: Because hundreds of millions of dollars have been spent to mislead people and to endow business schools and universities to stop teaching the history of economic thought, to stop teaching the classical economist9999ffs, and essentially to brainwash students, so that those with a sense of realism simply drop out of the field of economics and go into some other field.

BF: You identify a huge bubble economy that has developed as a result of massive debt in several areas. Could you go into how the bubble is being inflated in several areas of the economy?

MH: All bubbles are inflated by credit, and the Federal Reserve under Allan Greenspan created a huge amount of credit that was lent out to almost anybody for any purpose. A bubble economy is when banks and other lenders will lend to borrowers with no visible means of repaying the loan. A bubble economy occurs when banks will make loans to companies that don’t make enough to pay the interest, that don’t make enough to amortize the debt, that can only repay the banks by borrowing the money and adding on the new loan to the existing balance, and essentially letting the loan grow exponentially through compound interest. That’s impossible to maintain over time because no economy can grow exponentially over time, so the bubble bursts.

BF: Could you talk about corporate junk bonds as part of this bubble, and also could you talk a little bit about the elimination of defined benefit pension plans?

“…The result of the junk bond process was to load American industry down with so much debt that there’s no money to pay pensions…”

MH: They are two separate topics but they are related. Junk bonds came in after 1980. Around 1980 the Carter-Volkher inflation had pushed interest rates up to 20%. There were a lot of books at the time… talking about how this spelled doom for the economy, because they couldn’t see how the economy could run up any more debt… But lo and behold, here came Drexel-Burnham and its legal firms. They were essentially a group of gangsters. They said we have a way of taking over companies. We’re going to borrow the money, buy up the stockholders, and instead of the companies paying dividends on their stock as they have in the past, which they have to pay after taxes, they can pay twice as much in interest. In 1980, they paid 50%, so if you had a company earning 2 million dollars a year, say, it could pay a million dollars in taxes, and a million in dividends, but once the junk bond people took it over, the company could just pay two million in interest, it could pay twice as much to the debt holders.

The banks had lobbied the government for interest to be made a tax deductible expense, so essentially the taxpayers were subsidizing the takeover of industry at very high interest charges, so high that companies had to cut back their employment, cut back their investment and downsize in order to pay the people who had taken over. There were a lot of lawsuits about this, but the courts declared that all of this was basically legal.

Now the companies were in such financial stress, having to pay the bondholders so much money that they were facing bankruptcy. So they went to their workers, as General Motors did a year ago, and as one company after another has gone to their labor force and said, “Look, we’re gonna go bankrupt, and if we go bankrupt that’s gonna wipe out your entire pension fund, because the law says you’re at the end of the line, as far as collecting from us. The basic rule in America is that the rich get paid first and normal people get paid last… the richer you are, you’re at the head of the line, the poorer you are you’re at the back of the line. We owe so much money to our bondholders and bankers who lent us the money that there’s not enough money to pay them and to to pay you workers.”

The labor unions said wait a minute, we agreed to lower our current wages (in years past) so you could pay these pensions later. The bosses replied “Well, we don’t care about that, the law is on our side, we’ve bought the congress, we’ve bought the courts, our lobbyists give congressmen and the lawmakers a lot more money than yours do, so you lose”

The result of the junk bond process was to load American industry down with so much debt that there’s no money to pay pensions. So instead of paying a defined pension benefit as people expected, they’ve gone to a defined payment program (to a 401K or stock market or mutual fund). Now the word “defined” remains the same to convince people nothing has changed, but pension plans are now like roach motels. You see stuff going in, but you don’t have any idea what comes out.

These plans have been based, essentially, on Pinochet’s plan imposed at gunpoint in Chile in 1974. When the Chicago boys went down to Chile they said we cannot have free economics without closing down every (academic) department in the country that disagrees with us. So every economics department was closed down, every social science department was closed down, about 10,000 labor leaders, government workers and others were murdered or driven into exile. That was the prerequisite needed to pave the way for the Reagan-Bush policy of having … an employee stock ownership plan (ESOP). The (workers pension) money is put into company stock, as in Enron or Bear Stearns. The company then lends the money to itself, pays the executives exorbitant salaries and bonuses, and then says “we’re wiped out.”

About half of US ESOP plans have gone bankrupt, as in Enron. President Bush says that this is the free market, it’s a wonderful breakthrough, it’s wealth creation, you’re now free to keep all the money that workers have set aside for themselves, and you can pay them (a little) out of dividends.

BF: Right, and in the old defined benefit pension funds, you knew what you were going to be able to collect when you retired. But that’s not the case any more.

MH: No, that’s paid out in dividends, and interest and executive renumeration.

BF: Acolytes of the Chicago school claim that there’s no such thing as a free lunch, but they don’t mean what people usually think they mean. What do they really mean?

MH: They say that everybody “earns” what they get, so that if you’re an executive, let’s say you’re the CountryWide executive who paid himself $125 million last year, while the company went bankrupt, he provided the service of adding wealth. All of the rich people, Donald Trump is worth what he gets, anybody who owns property and inherits it is worth what he gets, anybody with a trust fund earns what he gets, so that nothing’s free, and nothing should be taxed, because if everybody earns what they get then the government is just taking things away. Therefore nothing should be taxed because everything is perfectly in balance.

“… today, instead of the government taxing wealth under the progressive tax code it used to have from 1913 until the 1970s, it now borrows from the rich and pays them interest on it…”

BF: A very important component of all this is tax policy. Could you talk about tax policy?

MH: The idea of classical economics was to tax away the free lunch. In other words, they said there were two kinds of taxes. Most people these days think of taxes as adding to costs, as in if you earn wages and pay taxes out of those wages you have less to spend on consumer goods and investment… if a profitable company is taxed, it has to raise its prices to cover taxes plus the cost of production. The classicists said there were exceptions to this, that those exceptions were monopoly profits and land rents. For instance if you tax the land at rental value, it’s not going to remove the land from production because nature provides it. You’re not going to reduce the supply of land because you tax it, you’re just collecting the rent for it because you’re the government. Since ancient Babylonian times, Greece, Rome, medieval Europe, England after the Norman invasion, almost every governmental system based its taxation on land rent.

The advantage of this is that the government used this rent to finance its infrastructure, its operations and everything else, so it didn’t have to go into debt. Well gradually, the vested interests were able to gain enough power to argue that land shouldn’t be taxed, and monopoly shouldn’t be taxed. The money then, that used to be taxed was kept by the private sector, and usually put into the financial market, forcing government to do one of two things. Either it had to tax incomes or sales, excise taxes, or it had to borrow. In effect government began to borrow from the landlords and the financial sector, from precisely the wealthy groups it used to tax.

So today, instead of the government taxing wealth under the progressive tax code it used to have from 1913 until the 1970s, it now borrows from the rich and pays them interest on it.

Now if your real estate taxes go down, people have the idea that that’s going to make their living cheaper, but it doesn’t make it cheaper at all, because it taxes on a property go down, there are going to be bidders who will say there is now more rent available, that they can borrow the money from a bank and pay the mortgage out of the rental income. The less tax there is, the more rental income is going to be freed to pay the bankers, and that’s pretty much what’s happened since the 1930s. The lower the taxes on property the more money is free to pay the bankers.

The result is that the homeowner or the renter has to pay exactly the same price in any case because home prices and commercial building prices are set by the local marketplace. But instead of the rental value going to the government in taxes, it goes to pay the banks. Meanwhile the government, lacking this revenue, has shifted away from taxing property and has levied heavier and heavier taxes on income, so that people are paying twice for what they used to only pay once. The money they used to pay in taxes goes to the banks, and they still have to pay the taxes. So the tax and debt burden has approximately doubled for ordinary people, making the banks and financial sector people very rich. The banks and financial sector have used this money to become the largest political contributors in Washington, and essentially to buy senators like Mr. McCain who rewrite the laws in their favor, un-tax them more and more and shifting the tax burden onto workers and even more and more onto industry.

BF: I believe in one of our earlier shows we did talk about real estate taxes, and how when real estate taxes go down, instead of the money going to the government, which would invest in infrastructure, etc., the money goes to the banks. Now how would the banks invest the money? They spend it differently than the government would, don’t they?

MH: Banks lend 70% of their money for mortgage credit. There’s a myth in the textbooks that banks lend money to finance industry. No bank lends money to finance industry. They lend against collateral that’s already in place. They land against real estate, that’s mortgage loans, the 70%. They’ll make loans to corporate raiders. They’ll make loans to brokerage houses to buy stocks that have already been issued. And they’ll lend money to other governments, and they’ll lend for speculation, for derivatives trade. These are all things that governments do not spend money on. Governments spend money doing what governments do, bombing people, military spending is the best, paying off their political constituencies, also a little bit of welfare, social security and health care, and some infrastructure spending.

BF: Now the banks tend to invest their money in assets that already exist, not really investing in new research and development, or new industry.

MH: No, capital formation, research and development are financed almost entirely out of the retained earnings of corporations. To the extent that the banks lend money to outside raiders to take over these companies, the money that used to be spent on capital formation and long term research and development have to be spent to repay the banks. So the effect of bank lending is actually to crowd out research and development spending, and new capital formation.

BF: What is the relationship of the stock market to industrial…

MH: The stock market has been turned into a vehicle that allows investors to take over companies on credit, and strip their assets and close them down. There’s been a huge flow of money OUT of the stock market, as corporate raiders use the money to buy up stocks on credit and load the companies down with debt. The stock market has become exactly the opposite of what it used to be, in theory, not a way of raising money for investment, but of stripping assets.

BF: Did the stock market of the past used to function differently?

MH: In theory it did, but always in this country and in England, it’s been rife with fraud. In the 1890s, the biggest part of the market were the railway stocks. Insiders would simply issue bonds, essentially “watered stocks”, to themselves, the politicians in their pay and their cronies and say look at all the bond interest we have to pay, we have to raise the railway rates because we have all these expenses. This is what led to the regulation of railroads, to the Interstate Commerce Commission being created, and to the anti trust laws being enacted. The stock market has always been something that raises money pretty much only after a company is already in place. Basically it’s been venture capitalists who start companies with their own money, and cash out afterward, putting the company up for sale on the stock market, mainly to sell to pension funds who are the main buyers. If you’re the manager of a company and you think I’m only getting paid $25 million a year, that’s not fair, I should be paid $100 million a year. So you give yourself stock options, you essentially give yourself free stock, and you have to find somebody to buy it. With pension funds and foreigners in the market you can sell to the poor hapless pension funds, or to the Saudis or whoever… once you’ve got your money out you really don’t care what happens, you can let the stock collapse, which is pretty much what Bear Stearns did in its stock operations.

BF: What about people’s pensions, are they going to be there, in your view?

MH: Some will, some won’t. The ones that are actually in the most trouble are state and municipal pensions. These are vastly underfunded, there’s simply no money in there to pay these. The one source that was supposed to pay municipal pensions was the real estate tax, but now property prices falling. The banks are saying, wait a minute, if we have to pay taxes the banks will go under, we already have negative equity, you can’t tax us. So one after another, it looks like, they’re going to default on their pensions. Last year President Bush said that social security is purely fictitious, that there is no social security fund, and for once he was telling the truth to people. He said that essentially, the FICA withholding being taken away from workers paychecks is really just a concealed tax, that it was to cut taxes on the rich, and so there really isn’t any money to pay social security and he would like to stop it right now. McCain has come out and said that too. So we’ve got the two of them saying that social security is broke, we haven’t got the money to pay for it. Voters apparently agree with this, and have re-elected the Congress which produced this state of affairs.