Friday, September 14, 2012

Incorporating the Rentier Sectors into a Financial Model

From Michael Hudson: via the World Economic Review:
Current macroeconomics ignores the roles that rent, debt and the financial sector play in shaping our economy. We discuss the Classical view on rents and policy responses to the rentier sector in the 19th century. The finance, insurance & real estate sector is today’s incarnation of the rentier sector. This paper shows how financial flows can be conceptually and statistically studied separately from (but interacting with) the real sector. We discuss finance’s interaction with government and with the international economy.

1. Introduction
Now that the Bubble Economy has given way to debt deflation, the world is discovering the shortcoming of models that fail to explain how most credit creation today (1) inflates asset prices without raising commodity prices or wage levels, and (2) creates a reciprocal flow of debt service. This debt service tends to rise as a proportion of personal and business income, outgrowing the ability of debtors to pay – leading to (3) debt deflation. The only way to prevent this phenomenon from plunging economies into depression and keeping them there is (4) to write down the debts so as to free revenue for spending once again on goods and services.

By promoting a misleading view of how the economy works, the above omissions lead to a policy that fails to prevent debt bubbles or deal effectively with the ensuing depression. To avoid a replay of the recent financial crisis – and indeed, to extricate economies from their present debt strait-jacket that subordinates recovery to the overhang of creditor claims (that is, saving the banks from taking a loss on their bad loans and gambles) – it is necessary to explain how credit creation inflates housing and other asset prices, while interest and other financial charges deflate the “real” economy, holding down commodity prices, shrinking markets and employment, and holding down wages in a downward economic spiral. We are dealing with two price trends that go in opposite directions: asset prices and commodity prices. It therefore is necessary to explain how credit expansion pushes asset prices up while simultaneously causing debt deflation.

Yet the typical MV=PT monetary and price model focused on commodity prices and wages, not on the asset prices inflated by debt leveraging. Similarly, today’s ‘Dynamic Stochastic General Equilibrium’ (or DSGE) models are characterized by the “absence of an appropriate way of modeling financial markets” (Tovar 2008:p.29). While Schumpeter (1934:95) already noted that “processes in terms of means of payment are not merely reflexes of processes in terms of goods. In every possible strain, with rare unanimity, even with impatience and moral and intellectual indignation, a very long line of theorists have assured us of the opposite”, this finds no place in DSGE models or, for that matter macroeconomics in the last decades. Cecchetti et al (2011:p.2) describe current practice in writing that “for a macroeconomist working to construct a theoretical structure for understanding the economy as a whole, debt is … trivial … because (in a closed economy) it is net zero – the liabilities of all borrowers always exactly match the assets of all lenders. … With no active role for money, integrating credit in the mainstream framework has proven to be difficult.“ And yet credit and its counterpart, debt, have shaped our economic systems since prehistory (Hudson 2004). Understanding how credit is used is therefore a sine qua non for understanding our economy. That requires, in turn, to think about a fundamentally different model which can replace DGSE type models as the standard for analysis. Only then can the ’naked emperor be dethroned’ (Keen 2011).

2. Finance is not The economy
In the real world most credit today is spent to buy assets already in place, not to create new productive capacity. Some 80 percent of bank loans in the English-speaking world are real estate mortgages, and much of the balance is lent against stocks and bonds already issued. Banks lend to buyers of real estate, corporate raiders, ambitious financial empire-builders, and to management for debt-leveraged buyouts. A first approximation of this trend is to chart the share of bank lending that goes to the ‘Fire, Insurance and Real Estate’ sector, aka the nonbank financial sector. Graph 1 shows that its ratio to GDP has quadrupled since the 1950s. The contrast is with lending to the real sector, which has remained about constant relative to GDP. This is how our debt burden has grown.

Graph 1: Private debt growth is due to lending to the FIRE sector: the US, 1952-2007

Source: Bezemer (2012) based on US flow of fund data, BEA ‘Z’ tables.

What is true for America is true for many other countries: mortgage lending and other household debt have been ‘the final stage in an artificially extended Ponzi Bubble’ as Keen (2009) shows for Australia. Extending credit to purchase assets already in place bids up their price. Prospective homebuyers need to take on larger mortgages to obtain a home. The effect is to turn property rents into a flow of mortgage interest. These payments divert the revenue of consumers and businesses from being spent on consumption or new capital investment. The effect is deflationary for the economy’s product markets, and hence consumer prices and employment, and therefore wages. This is why we had a long period of low cpi inflation but skyrocketing asset price inflation. The two trends are linked....MUCH MORE