(The headline is a borrowing from the 1841 book by Charles Mackay, Extraordinary Popular Delusions and the Madness of Crowds. Dr Hudson suggested that the title here should include "and their financial sponsors" – by which he means governments, who always sponsor bubbles at the behest of the financial elites who control them. A bit too long for the head of a column here.)

I distilled this message from ongoing work of Michael Hudson, a specialist in finance, economic history and the evolution of economic doctrines.¹ In re-reading it a day or two later, I was struck by its similarity to the tone of newsletters issued by several financial analysts.2 The most interesting aspect of the similarity is the quite different applications that the authors had in mind. The newsletters dispense investment advice to people who are sufficiently middle-class that they have some discretionary wealth to manage and to protect against the shifting winds of fortune. Personal policy is their focus. The professor’s domain, in contrast, is public policy. Unless the current policy orientation and its supporting beliefs are altered, in his analysis, the middle-class is headed toward debt peonage.

This hapless posture of public policy is a consequence, in Hudson’s analysis, of almost universally shared but misguided beliefs about economics. He says that a big gap has opened up between reality and ideology, that there is a major disconnect between the economics of production and distribution and the economics of finance. Some commentators encapsulate this by saying that the economy has been financialized. This means that the real economy has been converted into instruments (claims, vested interests) that yield streams of liquid income. Instead of finance being an essential adjunct to the work of the world and the progress of technology, it has become a dominating, parasitical power over the real economy and is on course to destroy its host by consuming it. (Furthermore, every society in history that has built up an unrepayable structure of debts has defaulted on it.) Consider the following contradictory phenomena:

You may have heard that the way to gain wealth is to save up wages earned from doing useful work and to then start up and operate a profitable enterprise. If you tried that, you may have noticed that your net worth has grown much more by increases in the market price of your house or the premises of your business than it has by business profits. And if you are adventuresome in the pursuit of wealth, you must have noticed that many in the smart set are borrowing huge sums to buy various kinds of property on the expectation that the prices will rise. Their savings, out of business or personal income, amount to repayment of debt in the hope of a big gain when the property is sold. (Rental income is for paying interest!) Rising prices for assets have become more important to wealth accumulation than production and earnings. "The annual change in property values, stocks and bonds – and debts – far exceeds that of annual output and income, and most money is spent on these assets."

Run that by again. Rising prices are a source of wealth, even without improvements to the properties in question. The same quantity and quality of goods brings a higher money price. That sounds like the definition of inflation – but also like a good thing, if I could get some. This seems to contradict the insistence of monetary authorities (central bankers) that inflation is the enemy of a healthy economy and that their primary (even their sole) objective is to control it. Furthermore, it seems to contradict the attitude of monetarists toward government fiscal management: If big debts are the way for individuals and corporations to accumulate wealth, why is government debt condemned as inflationary and the enemy of a healthy economy? There are at least two elements in response. For one, if government invests importantly in social infrastructure (public goods), it reduces the influence and power of private financial interests. And if the government debts are incurred mainly for the adventures of princes and presidents in foreign wars, the relentless condemnation of debt encourages a sense of guilt among middle-class taxpayers that helps inure them to their fate of paying interest to the owners of government bonds.

Consequently, the focus of monetary authorities is on prices that diminish the value of assets. That means consumer goods and wages primarily. To the extent that they are successful, therefore, the money value of real estate, financial assets and monopolizing powers rises while the income of the average earner is progressively less adequate to grab a share of the increasing (inflating) wealth. To get title to a piece of the action (such as a house) requires the average earner to take on an expanding debt load as house prices increase. Once contracted, payments on the debt become the principal form of household savings. That may be OK if the market valuation (price) of your asset keeps rising or even holds its value until you are ready to cash it in, but if it falls significantly, some or all of your savings will be lost. From the side of wealth holders, the loss of a revenue stream is compensated by greater concentration of ownership.

Inflating asset prices are only a part of the financialization picture. Dr. Hudson has summarized his argument by setting out commonplace beliefs about economic systems and then contrasting these myths or fictions to their corresponding reality. The notion that the economy is about production and consumption is contradicted by noting that the money-measured volume of market transactions is heavily dominated by trade in financial assets.

The goal of these transactions is to increase the wealth of the traders, but it is not an activity consistent with growth in the wealth of nations. The trade is in claims to a proprietary interest in streams of revenue that are of an increasingly ephemeral quality. The main point overall is that property and its associated financial operations dominate production activities and deter the potential benefits of advancing technology.

The following list is extracted with light editing from Hudson’s own texts:

Reality: Financial and property objectives determine production technology. Economic rent and interest grow as a proportion of direct production costs, even to overshadow them. Financial managers focus on balance sheets and their perspective comes to override that of production engineers. Wealth seeking becomes mainly financial in character. Among its manifestations are insider deals among a few owners and managers (e.g., disguising theft of shares as production costs) and political lobbying for special tax favors.

Myth: Political and cultural institutions are designed to encourage technological innovation. This line of causation enables scientific and material advance to transform society and politics in an upward and onward direction.

Reality: Debt and other financial dynamics promote the monopolization of property, and block the employment of optimum technology. As political power becomes centralized in the hands of creditors and monopolists it deters the economic interest of the majority from steering public policy. The control of political and fiscal processes by the perspective of narrowly-owned financial wealth progressively hollows out the real economy and polarizes economic classes. Labor cannot work with optimum technology because business (not to be confused with wealth-ownership) is progressively less able to afford it. (The fall of Rome remains the most notorious example.)

Fiction: All economic activity that earns a return is productive, in proportion to the money it makes, whether in the form of profits, wages, interest, rent or capital gains.

Reality: Some forms of earning income are more productive than others when measured by the increase of productive powers and economic expansion. The financial sector’s gain is a loss for the real economy.4

Fiction: The economic system is fair in the sense that peoples’ income and wealth are a reflection of their personal productivity. "There’s no such thing as a free lunch."

Reality: Free lunches are available, and they offer the biggest, easiest, even lowest-risk payoff. In the hands of the financial managers, business investment is about how to obtain the proverbial free lunch, at the expense of the real economy.

Fiction: Finance promotes capital formation.

Reality: Instead of involving actual new spending on plant and equipment, the "capital" in "capital gains" is created increasingly by inflationary means – by monetary policy increasing asset prices.

Fiction: Finance and property produce services, for which interest and rent are payments.

Reality: Finance and property are extractive claims, and hence are parasitic on the "real" economy.

Fiction: Most credit is productive. It enables business borrowers to buy capital equipment, pay labor and earn the income to pay off their loans. Wage earners are thereby enabled as consumers to pay for the pleasure of buying now rather than later.

Reality: No economy ever has managed to repay its public or private debts. When debts are paid off it is most often out of income earned elsewhere.

Fiction: The economy’s driving force is consumer demand. Consumer choice determines prices for goods and services, steering saving and credit into the most profitable marketing opportunities.

Reality: The exponential growth of debt and forced saving leaves less freedom of choice.

Fiction: Finance is in equilibrium with the economy, and helps establish its overall equilibrium, bridging present savings and resources with the future needs.

Reality: The exponential growth of interest-bearing debt is inherently destabilizing.

Fiction: Financially oriented wealth creation makes economies richer.

Reality: Asset-price inflation leads to deflation of wages and product prices as the finance-and-property sector drains income from the production-and-consumption economy.

Fiction: Regulation of finance is an inefficient intrusion into free markets.

Reality: Finance distorts the market in its own favor, headed by tax favoritism that inverts traditional social and political values.

Fiction: Economies are converging as globalization spreads modern technology and efficiency throughout the world.

Reality: The global economy is polarizing as creditor nations impose deadly austerity on debtors.

Fiction: Economic theory and statistics have become more scientific and realistic.

Reality: Economic theory has been warped into special-interest pleading. This is most pronounced in the denial of structural debt problems and the facilitation of free lunches for the FIRE sector. (Finance, Insurance, Real Estate)

1. Professor of Economics at Universities of Missouri, KC and Riga, and Senior Advisor to the Government of Latvia.

2. Examples are provided regularly in The Daily Reckoning by Bill Bonner and associates, and are reminiscent of the early 1990s book, The Great Reckoning, by Davidson and Rees-Mogg.

3. In Ottawa, the federally supported Policy Research Initiative made an extensive review of asset-based social policies in several countries and commented positively.

4. For an example of how gross these unnecessary costs can be, see Paul Krugman’s column in The New York Times of 16 February 2007 ("The Health Care Racket"), about medical insurance in the U.S.A.

–from Economic Reform, March 2007

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