The Fallacy of High Falutin' Finance as Policy

By now, it should be clear that the advanced nations of the West have financed their way into a tar pit. Government policies to spur economic growth have devolved into ever more elaborate ways for citizens and governments to borrow, not to invest but to spend. The result has been recession, stagnation, volatility, heightened unemployment, smaller 401(k)s, underwater homeowners, and lowered expectations.

America's prosperity in the early 2000s came from real estate and credit bubbles fueled by Federal Reserve easy money policies and a large array of federal subsidies. The federal government's conscious decision in the 1990s not to regulate derivatives gave Wall Street's financial alchemists free rein to contort the financial system into a labyrinth of interconnections and pure side bets that remains impenetrable, harboring untold Minotaurs. When things blew up, the government's "solution" was to engage in more financial manipulation, bailing out the big banks that caused the problem with subsidies financed by deficit spending and a deluge of printed money courtesy of the Fed. Vast amounts of bad private sector debt was, in effect, transferred to the federal balance sheet, where it will burden future generations and hinder economic growth.

Things in Europe are even loopier. Most of Europe formed a currency union without effective control over the "union's" finances. The original idea was that by adopting a bloc-wide currency, trade barriers and transactions costs associated with currency conversions and fluctuations would be lowered and economic efficiencies would be achieved, facilitating growth. But the concept would work only if everyone stayed on the same prudent fiscal page. The absence of effective controls created incentives to cheat. An easy way for a member nation to slip a few extra shrimp on the barbie for itself was to borrow more than the rules allowed, perhaps with a sleight of hand or two arranged by Wall Street to maintain the appearance, if not fact, of propriety. The prudent, productive nations--especially Germany--profited from selling their products to debt-fueled southerly neighbors. But they want no part of the costs of their prosperity.

The Euro is really the Deutsche Mark, by another name. Germany was for a long time the strongest proponent of the Euro bloc, hoping that it would bring continent-wide prosperity and ready markets for German goods. Success, however, would have required that everyone on the continent become German, de facto if not de jure. Some other Euro bloc members apparently viewed the Euro bloc as a way to opt into a strong, stable currency, which would attract capital and lower their borrowing costs. But what happens when you lower borrowing costs? The same thing that happens when you lower the price of anything--people consume more of it. So people and governments borrowed more. The less thrifty Euro bloc members engaged in a financial manipulation, too, just differently and with the results we see today.

So the advanced Western nations have delved into financial machinations, shuffled some documents around, and appeared magically to foster economic growth. Forgotten, apparently, was the axiom that there is no such thing as a free lunch. Easing up on home loan standards, pushing up real estate prices, dumping borrowed money into consumers' hands through mortgage refis and home equity loans, ultimately don't create the conditions for economic renewal. An economy can't be built around borrowing and consumption. It has to be based on production. The wealth of nations comes from taking the resources of the Earth and converting them into forms usable by humans. That was so when hunter gatherers prospected for flint to swap for furs, and it's true today.

Even in Asia, where folks haven't forgotten that productive capability is what counts, the largest economy, China's, rests at the edge of the precipice. By linking the yuan to the dollar to get a trade advantage, China effectively vested its monetary policy in the U.S. Federal Reserve. That agency has famously kept short term rates extraordinarily low and will do so "for an extended period of time." The asset bubbles and price inflation that remain muted, for now, in America are emerging in China. China's central bank has raised bank reserve requirements, three times now this year, in an effort to keep the lid on the pot. To combat its own financial manipulation, China is slowing its economy down, and in so doing slow the world economy's recovery from recession.

When and how will this end? Only time will tell. There's too much debt, much of it cleverly stashed away in shifty derivatives transactions, for anyone to really know what's going on. The Euro bloc situation may give us some clues. Just two days after EU leaders trumpeted a much larger than originally expected bailout for Greece, European markets are sliding in the belief that yet bigger bailouts--for Portugal, Spain and who knows who else--will be necessary. It's doubtful that Europe (read, Germany), looking at a bill of hundreds of billions of Euros, has the wherewithal and stomach to organize a comprehensive Euro bloc bailout. And no one else can save Europe. The American financial crisis was just barely contained by the federal government. There's nothing America, beset by Tea Parties, can do for Europe. The 2007-09 recession in the West was stabilized by transferring bad private debts to governments. Where, then, can bad government debts be transferred? Abstractly speaking, to the strong governments with good credit ratings. But there's a political factor--the latter have to be willing to accept the transfer, and economic rationality rarely enters into political discourse. So the outcome is very much in doubt.

From some perspectives, much and perhaps most of the industrialized West is insolvent. The parts that aren't will probably bolt for high ground. There are many good reasons to institute serious, substantive regulation of the derivatives markets. An overpowering one is these contracts have created the illusion that we can use financial machinations to create prosperity. That's an illusion that must be destroyed.