Michael Hudson

Trade Theory Financialized

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To resolve matters, banks are backtracking and urging the European Central Bank to make loans to government – for the purpose of bailing out banks and bondholders, not to spend on employment in the “real” economy. Voters understandably resent further bank bailouts, under conditions where many debtors are themselves facing foreclosure and have lost much of their net worth. Why should governments bail out the financial sector at the top of the economic pyramid but not reflate production and consumption in the “real” economy. The problem today, after all, is under-employment and debt deflation, not inflation.

Economic theorizing has not caught up with this reality. National income statistics do not distinguish the economy’s rentier layer from the “real” economy below it, much less how the wealthiest 1% (and especially the richest 0.1%) are making money at the expense of the bottom 90% or even 99%. Credit is depicted only as financing economic expansion, not leading to shrinkage and austerity. But in America the easiest way to make money is not by “creating jobs” but by loading the economy down with debt, inflating asset prices on credit, privatizing natural monopolies and extracting economic rent in the form of higher access charges. None of this increases real output. But it does increase the cost of living and doing business.

Public over-indebtedness leads to privatization sell-offs

New investment and hiring taper off as rising debt charges divert income from being spent on current output. Economic growth slows in an S-curve, yet debts continue to accrue interest, which is lent out to obtain yet more interest, diverting yet more income from production and consumption. Slower income growth net of this debt service leads to lower tax payments (especially as interest is deemed tax-deductible), and hence to deepening budget deficits.

The financial sector’s political strategy is to use these deficits as an opportunity to insist that governments balance their budgets by selling off public enterprises and other assets. The result is a modern version of Britain’s Enclosure Movements of the 16th to 18th centuries, except that today’s version is international and driven by the financial sector. Starting with the IMF and World Bank, and most recently the European Central Bank (ECB), inter-governmental financial institutions have gained authority over national governments. The ECB has taken the lead in telling Greece to sell off some €50 billion euros worth of prime tourist land, some of its islands, offshore oil-drilling rights or even the Parthenon, as well as the water and sewer systems of Athens and other cities, the Piraeus port and other parts of the Commons.2

When the new buyers charge monopoly prices for the infrastructure being sold off, this increases the cost of living and doing business, turning the economy into a set of tollbooth opportunities. The resulting economic rent is financialized as buyers borrow from banks whose loan officers calculate the prospects for rent extraction available to pay interest. What the public sector relinquishes in user fees and taxes is made available to pay (tax-deductible) interest to the FIRE sector – without the public-interest dimension of public investment. So instead of being “neutral” in its price and income effects, credit transforms the economy’s structure itself.

A century ago U.S. economists described public infrastructure investment as a “fourth factor of production” – roads and canals, urban water and sewer systems, education, the post office, communications and other publically-owned utilities that represent the largest category of tangible capital investment (next to buildings) in many economies. Providing their services at cost or on a subsidized basis (transportation) or freely (as in the case of roads), their returns are to be calculated not like private-sector investment in user fees relative to capital investment costs, but in the degree to which this infrastructure lowers the economy’s costs and prices.3

Privatization adds to these costs by involving expenses that public enterprise rarely charges. These add-ons are headed by interest and dividend payments to private owners, other underwriting and financial fees, and much higher salaries and bonuses to the privatized managers, including stock options. And as part of the structural transformation of society urged by creditors, governments are to deregulate (or simply not put regulatory authorities in place) the sectors being privatized on credit. Finally, labor is outsourced, especially to non-union workers. On the broadest level, the world’s major financial centers replace national governments as economic planners allocating resources, particularly in nations that fall into foreign debt.

Financial lobbyists advise governments to sell off public infrastructure, to buyers on credit. Equilibrium conditions are resolved when the new owners pledge the current cash flow of rent-extraction opportunities to the banks as interest. They then try to raise access charges to roads, water, power, transportation and other public services.

Governments are forced into a budget squeeze by depriving them of a central bank of the sort that Britain and the United States have. The proper historical role of central banks or Treasuries is to finance government spending by creating money. This is in practice how the economy is supplied with money and credit, which, being fungible, is used as the means of circulation for overall activity – the purchase and sale of goods and services, and the transfer of property, stocks and bonds or other assets.

If central banks are deprived of this opportunity to create credit, governments must rely on commercial banks to finance their budget deficits – at interest. This provides a free lunch to banks as a result of their privilege of credit creation. To avoid crises and bank runs, bank deposits are insured by government agencies. This provides an opportunity for the banking system’s losses to be transferred onto the public balance sheet. Unless the bank insurance premiums accurately reflect this risk, such insurance represents a public subsidy to the banks.

Most important from the vantage point of national competitiveness is the fact that the privatization of credit creation raises the cost of living and doing business, by building in financial overhead charges. Privatization of public infrastructure has the same effect, by providing extractive rent-seeking opportunities for natural monopolies financed on credit rather than providing their basic services at subsidized rates or freely, financed out of progressive taxation.

“Internal devaluation” or tax and financial reform to make labor more competitive?

Economies are complex systems whose interconnections are broader than current trade theory takes into account. To analyze costs and trade competition requires integrating the “real” production and consumption economy with balance-sheet transactions in assets and the debt overhead, as well as with government fiscal policy.

The key to fiscal policy is much more than the level of taxation. The incidence of taxation affects domestic cost structures and determines whether the burden will fall on labor and its employers (increasing production costs) or on property and rent-yielding assets. Taxing land rent holds down the price of housing; taxing employment and sales raise the cost of living and doing business. Likewise in monetary policy, the terms on which credit is created affect the degree of debt pyramiding, while public capital investment in infrastructure tends to provide its basic services at a lower cost than privatization.

Failure to take account of these property, financial and the government balances leaves today’s mainstream trade theory – and above all, the adjustment policies being prescribed for countries in deficit – to focus crudely on labor’s overall wage rates rather than on the structure of family and business budgets. What neoliberal policy misses is that its demand for wage cuts overlooks the fact that the cost of labor may be reduced more efficiently by shifting the mode of taxation to focus on collecting economic rent and minimizing the debt overhead. This policy can reduce costs and increase competitiveness much less wastefully than austerity programs aimed at cutting wages and social spending. The effect of neoliberal austerity programs is to shrink markets and induce emigration of labor, worsening international deficits rather than overcoming them.

A policy antidote: The Progressive Era’s attempt to ward off financialization

Financialization has reversed the Progressive Era policies designed to minimize the debt overhead, and to minimize the economic rent-extracting opportunities that are today’s prime objective of bank marketing departments. The classical anti-rentier policy featured:

  1. a central bank to monetize government spending deficits, rather than borrowing at interest from commercial banks and other creditors (e.g., as dictated by the ECB and the Lisbon treaty);
  2. taxing away land rent, and enacting anti-monopoly laws and regulatory agencies to keep prices in line with necessary and justifiable costs of production;
  3. keeping basic infrastructure in the public domain, providing it at cost or at subsidized rates or freely (as in the case of roads), with construction costs financed out of progressive income taxation and taxes on economic rent;
  4. paying for pensions and Social Security and health insurance on a pay-as-you-go basis rather than by financialization (pre-saving by purchasing bonds and stocks);
  5. not permitting interest payments to be tax deductible; encouraging equity financing rather than subsidizing debt;
  6. providing a national income accounting format that (a) distinguishes economic rent paid to the FIRE sector and monopolies, and (b) recognizes the contribution of public infrastructure investment to lowering the cost of living and doing business.

Countries that recently have been neoliberalized may still rectify matters by taxing rent and windfall gains to recover what has been appropriated or is newly created by infrastructure investment. They also can remove the tax deductibility of interest and “watered” charges such as high salaries, and tax the fictitious transfer pricing and savings via offshore banking centers at the rate that normal earnings would be taxed. These are the classical economic policies proposed to free markets from the legacy of European feudalism and conquest of the land. They remain the great tasks confronting economies today as they enter the End Days of the post-World War II credit/debt expansion.

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Footnotes:

[1] I describe the reparations and arms-debt tangle in Super Imperialism (2nd ed. 1992), and the distinction between the domestic “budget problem” and the international “transfer problem” in my historical review of theories of Trade, Development and Foreign Debt (2nd ed., 2010).
[2] See for instance Andy Kessler, “The ‘Brady Bond’ Solution for Greek Debt,” Wall Street Journal, June 29, 2011: “Private buyers are increasingly skeptical of government guarantees and will demand real collateral. Credit default swap derivatives, which merely spread the risk, will no longer do. Some other sweetener will be needed. The solution? Bonds backed by real Greek assets. … utilities, railroads, tollways, airports, cellphone services, tourism, Ouzo factories and maybe even the islands of Santorini and Mykonos. If (some say when) the Greeks default, the Germans or new bondholders end up with the assets, much like in a home foreclosure.” This is why the Financial Times’ Lex column reported (“Greece: reckoning postponed,” June 29, 2011): “the vote in parliament was held to the sound of rioting and the smell of tear gas.”
[3] I describe the logic in “Simon Patten on Public Infrastructure and Economic Rent Capture,” American Journal of Economics and Sociology 70 (October 2011):873-903. Patten was the first Professor of Economics at America’s pre-eminent business school, the Wharton School at the University of Pennsylvania.

Published by kind permission of Michael Hudson.

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