The Malignant Nodes of our Hyped Economy

William Krehm

Elsewhere we have set up diagrams of our mixed economy that show the interactions of its various subsystems in pursuit of their goals that allow the system as a whole to function. The market economy alone has as prime purpose earning a profit. The other subsystems – the government, the household economy, the environment, education, health, social security and so forth, get most of their money from the various levels of government. These in turn levy the taxation to cover their costs. It falls to the government to look after the creation of the infrastructures, physical and human, without which the economy could not operate. To achieve this governments must have lengthier time-horizons than the private sector.

Power has always been a key factor in any society. Privileged groups, whether a military elite, landowning classes, merchants, or bankers in various societies set the official ideology. Even the language helps predetermine how the national income is distributed. For the past three decades or so, that economic power has been largely in the hands of speculative finance. There is no lack of evidence on the point, starting with much in our law books that is disregarded.

Thus, in the very preamble of the Bank of Canada Act, the purpose of the Bank of Canada is given "to mitigate fluctuations in the general level of production, trade, prices and employment, so far as may be possible within the scope of monetary actions." That notwithstanding, in fact for at least forty years, the central bank has directed its efforts not to mitigate fluctuations but to keep unemployment high enough to provide enough unemployment to hold the price level flat. Even the word "deflation" disappeared from the vocabulary of the central bank. When its then Governor let a warning about the prospect of it slip out of his mouth before the Commons Finance Committee, he was back in eight days flat for having uttered it. He even declared that he would probably regret having done so all his life. However, his warning about the danger of deflation was realized in Eastern Asia within two years and spread its devastation to Latin America and Russia, and now even to Canada and the United States. and Europe.

Moreover, our central bank like many throughout the world had abandoned the only effective means of dealing with deflation – a systemic lack of demand to take care of the over-supply of goods, services and willing workers. After WWII the widely expected depression was avoided by the central banks of the Western world taking on enough government debt to finance the huge backlog of neglect in infrastructures that had accumulated during a decade of depression and six years of war. The mechanism for this was simple, and was adequately described in the economic textbooks of the period. Because in countries like Canada and the United Kingdom, the sole shareholder of the central bank is the government, interest paid to the central bank on the debt of the government reverts to it substantially as dividends. But even where the central bank is owned by private banks as is the Federal Reserve in the US, roughly the same thing occurs by virtue of the monopoly of the ancestral monarch in coining precious metals. (This was known as seigniorage and has been largely assigned to the private banks.)

In 1991 an amendment to the Canadian Bank Act was slipped through Parliament without debate or press lease phasing out the statutory reserves. These were a modest proportion of the deposits deposited with them by the public that the banks had to leave – interest-free – with the central bank. They served a double purpose:

A Tool for Controlling both Inflation and Deflation

The provided a means of dealing with either inflation or deflation as the need arose, without being entirely dependent on interest rates. Instead, the amount of credit that the banks could create on a given deposit base could either decreased (to restrain inflation) or increased (to combat deflation). Moreover, it allowed the government to target its goal, with a minimum of the collateral damage resulting from high interest rates. Our banks had at the time lost much or all of their capital in speculative loans in gas and oil and real estate plays, and the ending of the statutory reserves in 1991-3 had released the reserves to recapitalize them.

But those reserves had had another vital purpose. They allowed the central bank to make near-interest free loans to the Government within existing credit constraints. The mechanism was simple enough: the interest paid on the government debt held by the Bank of Canada found its way back to the government as dividends with the exception of administrative charges. Now that virtually free financing has been replaced by debt held by the commercial banks.

The Bank for International Settlements – a sort of central bankers’s club whose sessions are not open to anybody connected with the government – issued its Guidelines on Risk-Based Capital Requirements. Essentially these replaced cash reserves that had been abolished in a few countries like Canada and New Zealand and reduced to near irrelevance in most others including the US and the UK. Very little of the banks’ capital is kept in cash because cash breeds no interest. It gets invested in stocks and bonds and derivatives, much of which, if at all, appear on the banks’ books at their original purchase price.

Were the statutory reserves in place all that would be necessary in dealing with the deflation that is engulfing the world today would be to lower the reserve quota and have the government make essential infrastructural investments to fill the gap arising from the blue funk of the private sector. As in the 1930s idle physical and human resources for the purpose are gathering all around us.

There is talk of the Japanese Central Bank starting to buy government debt. That is good, but not enough. The private sector both in Japan and now in the US has been demoralized not only by the stock market crash but by the evidence still pouring out of the American courts of the massive fraud in some of the highest corporative circles.

A note of disbelief is replacing the awe that financial columnists used to show when the mighty Alan Greenspan, Governor of the US Federal Reserves, read the tea-leaves. Thus Brian Milner (The Globe and Mail, 23/6, "Those who watch Fed watchers fun to watch"): "[Greenspan] said that because ‘the cost of taking out insurance against deflation is so low we can aggressively attack some of the underlying forces, which are essentially weak demand.’ The only question then becomes how much to cut, and the answer hinges on how worried Mr. Greenspan and company are about the threat of deflation and how much ammunition they have left to fight it. Fed officials insist they have plenty of other arrows in their quiver, but outside observers are not so sure."

A Self-inflicted Dilemma

Those arrows were all shot at the moon in the great bailing out of the banks over a decade ago.

Were the statutory reserves still here and their use not proscribed by Wall St., all that Washington and Ottawa would need do is to lower the reserve requirement, and use the central bank to finance projects to renew and extend our defective infrastructures, health, education, social security. The contracts for such work, of course, in most cases would be let to the private sector, and the lower reserve requirements would make available inexpensive financing for the private sector to step in to fill government contracts. That would set in motion the forces of economic recovery that are so clearly absent at present.

The Wall Street Journal (25/6, "The Fed Sharpens Rate-Cut Shears Again" by E.S. Browning pins down the prevailing business mood: "Some investors are…starting to look past the Fed news for signs of actual improvement in the economy and business performance. In some ways, they say, it matters relatively little how much the Fed cuts rates.

What really matters is whether the Fed’s previous 12 rate cuts are starting to have impact. The Fed has suggested that this rate would be more of an insurance policy than anything else. (The 13th Fed rate-cut came in the next day at 1/4% bringing the Fed rate down to 1% the lowest since 1957.)

But clearly liquidity is not the problem. It is a sign how deeply all that was learned in the thirties has been buried, for it to take our political leaders so long to figure this out.

And the comparison of the present cut with an "insurance policy" could hardly have been more tactless. For the press is full of the scandal-tinged plight of the insurance industry.

The Globe and Mail (14/06, "Soaring Insurance, Outraged motorists" by Paul Waldie and Peter Chney) writes: "Canada’s auto-insurance industry is in crisis and governments across the country are scrambling to respond to pressure from outraged drivers who face soaring premiums.

"Rising injury costs, falling stock markets and a global slump in the insurance business since the Sept 11/01 terrorist attacks on the US have driven auto insurance beyond the reach of many Canadians. Industry officials said it is not uncommon for some drivers to be quoted premiums of up to $8,000 a year.

"Insurance companies say they are not making money. They cannot rely on stock market profits to keep premiums low, it costs them more to buy their own insurance known as reinsurance – to spread risks and they face skyrocketing claims. Undoubtedly the over-congested highways due to Globalization and Deregulation have contributed to this.

"A typical fender bender in Ontario can cost as much as $75,000 because of fees to lawyers, medical professionals and other. Only a small fraction of that money, they said, goes to the victim.

"Bob Smalley, a retired life-insurance executive in Florenceville, NB, saw his car insurance premium go up to $3,700 from $1,500 this year after he made two minor claims that cost his insurance company less than $1,200 after he had paid his deductible."

That introduces a fistful of factors from elsewhere in the economy. It makes it necessary for us to introduce a map of flows from one section of the economy to another, based not on what those connections should be, but what they have become under the stressful misdirections of exponential growth, globalization and deregulation, and the domination of financial capital.

There are definite nodal points in the economy where communications converge and where the economy is particularly exposed to serious ravaging by private interests. The term "node" is borrowed from mathematics, or more fully from biology (as in "lymphatic nodes") where malignant cells metastasize more rapidly throughout the body. They are points of vulnerability that should be under constant attention from policy-makers. In general it is at such crossroads that much of society’s capital pools are to be found, and can be most easily preyed on. One of these is the areas of money creation – the central banks and their control over commercial banking. Another is the insurance industry, where capital reserves are particularly important at a time like the present when an overstressed, world, at murderous odds with itself, raises risk to a fever pitch.

The notion of any insurance firm keeping its reserves on a hyped up stock market fingers an essential part of the trouble. For that compounds risks of our society rather than controls them. However, if you remove the firewalls that had been put in between insurance and banking, and the stock market, you are off to the races with a guaranteed ticket on the wrong horse. The trouble is that in its desperate to keep its bubble in ascent, any pool of capital, no matter what its purpose, has been seized upon to keep the cauldron boiling. The fact that bank holding companies were acquiring insurance companies and tapping their reserves to keep their favourite stocks looking well, was a cross-bred risk that no insurance company needed. Government debt is the proper investment for insurance reserves. The stock market itself in all its aspects is the node of nodes, where auditors are corrupted and lawyers become accustomed to a level of earnings that can only be explained by the black magic expected of them.

You can hardly open your newspaper any day of any week without being confronted with something novel that qualifies disturbingly for this new concept of an economic node.

Investment Trusts — The Next Bubble

Today’s Globe and Mail (June 27, "Banking on yield not a wise move – A Matter of Trust – The Booming Business of Investment Trusts" by Andres Willis and Rob Carrick) takes a hard look at the new fad of investment trusts intended to revive the drooping stock market:

"Investing in trusts means embracing a contradiction. Trusts are bought for their yield, for the monthly income promised to trustholders. So doesn’t it just make sense that the best trust boasts the highest yields?

"Not at all. Focusing exclusively on units that promise the highest income bang, is a strategy that’s bound to backfire. The reality of today’s market is trusts with the highest yields are the most likely to disappoint.

"More often than not, soaring yields signal a business is stumbling, and a trust’s all-important distributions are about to be cut. The income trust hall of shame is rapidly filling with companies that boasted sweet double-digit yields before the took the axe to investors’s income."

Unless of course, you believe in Santa Claus, and even if you did you would be at the wrong address unless you had control of stuffing the stockings. What you have there is the latest node to highjack income intended for other destinations. And the real trouble is that our economy re-engineered for dependence on a stock market that cannot function without such contrivances.

What we are encountering on all sides is a charter of interaction between the different areas of the economy not as they logically should be, but as they have become. We are driven to think in term of nodal points where flows are intercepted and diverted to uses that have no call on them. The deregulated banks are one such, and we have alluded how the statutory reserves that provided both a control over the leverage of the banks’ money creation and virtually free funds to the government, were preempted to serve as an annual entitlement for the deregulated banks’ gambles. The deregulated banks themselves now in control of our stock markets and a growing interest in every capital pool taps money creation for speculation. That and adds an unprecedented leverage to mega-gambles. Derivatives are another such nodal point combining insane leverage with a minimum of disclosure and endless possibilities for keeping things off the corporative books. Command of such nodes by speculative finance explains Governor Greenspan’s plight with a single useless tool in his much-advertised kit. He has become a plumber called upon to fix a burst water pipe with a single toothpick in his tool kit.

William Krehm

— from Economic Reform, August 2003