Could the financial bailout work?

In a word, no.

I've been listening to news analysts and their 'experts' all day and getting quite irritated. The experts are the ones who got us into this mess. Why on earth would we turn to them to explain it, or get us out of it? The problem defies ordinary economic/financial explanations. There is something far more fundamental going on and the economists and politicians simply don't get it.

OK the administration used the wrong terminology in the first place. It isn't a bailout, it is a rescue. The government proposes to buy up the so-called toxic assets held on the balance sheets of many banks. One of the more 'creative' justifications for this approach is that then the US taxpayers will 'own' these assets and that eventually, when things get back to normal, those assets will once again be worth something. The government can then sell them off, at least breaking even if not making a profit. All well and good except for one thing.

Things won't be getting back to normal.

As I have explained, real capital is the hard assets in our economy that either make it possible to obtain more energy, making it available to do useful work, or increase the efficiency of using energy, thus conserving it for other useful work. Over the past several decades we have used our energy flow to build toys and diversions and wasteful machines. We've used it to build bigger houses than we really needed. We've been on an entertainment spree, channeling a dwindling resource — fossil fuels — into things that make us feel happy, or at least make us feel like they will make us happy. Meanwhile infrastructure has crumbled, manufacturing has gone overseas where cheap labor can substitute for capital improvements in manufacturing processes, and in response we started making credit available to anyone breathing.

We had to do the latter. People inherently think that things are going to get better. They believe a day will come when the good jobs will come again. They go back to school thinking they will get a high-paying job with more education. They need to believe in the future. So they rationalize borrowing money to buy consumer goods. The money lenders were all too happy to enable this behavior. They, it turned out, were borrowing from other money lenders. And everyone was borrowing against the belief that housing prices would continue to rise. Beliefs are not our friends sometimes.

Meanwhile the government is telling everyone that consumer spending is what is keeping our economy strong and growing. I've already written a good deal about the idiocy of believing a growing economy is a good thing. Sure it 'creates' jobs, even if those jobs are flipping hamburgers. But growth for its own sake is just plain crazy. I honestly have difficulty understanding how any educated person could believe that growth can just keep going on forever and ever. Of course, the way the government justifies this is based on a huge fallacy. The Gross Domestic Product (GDP) is a monetary measure of, well actually it is a lie! I won't go into the details here, but GDP is a bogus measure of anything, including economic health. Put simply, the GDP had been growing somewhat but anybody who had to pay the bills would realize that life was not getting better.

The economy has not been strong. The President lied or was incredibly naive when he told the American people that it was. It has been in decline since the 1970's, believe it or not. Even in the so-called Clinton miracle years (remember, just before the dot-com bust) when high tech soared, it was an illusion. Even then globalization and increasing pumping of oil made it seem like everything was rosy. But it wasn't.

Hidden beneath the surface of dollar economy measures was the fact that the energy cost of getting more energy was in decline. Remember it is net energy available to do useful work that determines how much real work can be done. Real work, meaning building capital assets, would have included repairing the infrastructure and developing an new energy base (if that is even possible). It never happened. And as net energy continued to decline (even as volumes were increasing) the real basis for wealth building frittered away.

And real assets frittered away with the decline. What to do? The economy was already heading toward a consumption-driven mode. Ever since WWII ended and the national policy that everyone should be able to own a home (and then cars) the idea that we should be able to borrow against the future to enjoy life now has taken center stage. With the advent of consumer lines of credit and credit cards we moved more to the notion that we could buy all sorts of things and pay back later when we were, ourselves, making more money (remember we were supposed to be in a growing economy - a high tide lifts all boats, and all that). As long as it looked like there was more money available this party-on mood seemed justified.

The banks and other Wall Street geniuses had a nifty way to make it all work. They would create a new kind of asset (or at least something that was like an asset for accounting purposes). They had, for a long time, been in the habit of lending from their deposit reserves. They would lend small percentages to people who had a compelling story about how, if they just had a grub stake they could bring in more dough (like gold mining). A prudent banker would loan to those that seemed reasonable risks, but they charged interest to cover their other risks and for profit. All well and good. And most local banks still try to be prudent in lending. But the big Wall Street boys had a better idea. Theories, like portfolio management, suggested that there are ways to combine varying qualities of risk into paper instruments that were, in theory, backed by real assets. If one risky venture didn't pan out, the risk was spread out over enough other ventures that the pain was minimized and if all the others came in, well profits were to be made.

Also, the notion that the level of risk taken should correlate with the expected returns prompted some to take higher risks on because it meant higher profits. Greed is good according to modern capitalism, right? Some kinds of banks have apparently been using deposit reserves to buy hedge funds and mortgage-backed paper. Perhaps that seemed prudent at the time. But mortgage lenders were busy getting house appraisals boosted, because their cut would then be more profitable (greed again) and finding customers who were, well, not really qualified. So, lo and behold, all those banks were buying paper that was valued poorly. And they were rushing into it.

Fractional reserve banking had turned into a money grab. Everyone in the financial sector was going to get stinking rich off these creative forms of 'capital'. Meanwhile, oil started approaching the peak of production. Jobs had been shipped overseas. People were borrowing to support consumption. And the whole house of cards came tumbling down when oil prices started moving up. Sure investors taking their money out of financial instruments may have caused a spike in oil prices, but the overall trend had already been established. The relationship between money and energy was starting to reveal itself. Inflation, which always comes shortly on the heels of energy price rises, started to become a factor.

Now I tell you real money is really energy. And the energy flow is starting to tail off. And all hell is breaking loose because no one wanted to believe this simple fact. Fractional reserve banking, borrowing for consumption, and subsequent money-creation schemes like derivatives, is a violation of the first law of thermodynamics. Energy (money) can neither be created nor destroyed under ordinary circumstances (non-E = mc²). You can't just create seeming money out of nothing that has any real meaning. If you are going to borrow from the granary there had better be some grain from last year's harvest in it. You can't borrow food that hasn't been grown yet. And now, thanks to the second law of thermodynamics, which tells us that every time you use energy some of it is lost doing the work, we are faced with having used up our easy, energy-cheap energy on toys and cannot produce the energy we require to pay back the supposed loans. The bank of oil and coal that we have been borrowing from is running low. It takes more energy to get energy out of it and so we have less energy to do truly useful work.

In other words we are screwed. The banking crisis will unfold as the greatest loss of money ever. But it isn't real. There never was any true wealth represented in that second- and higher order illusions of money. It was always a scam. No matter what kind of bail out, or rescue plan is tried, nothing will save the 'financial' industry in the end. It was all a great pile of foam, no substance. Meanwhile we have little real capital to fall back on.

I suppose you want to know what to do about it. That is the sad part. Everyone is looking for a way to save the banking system and believing things will get back to normal. But that won't happen. Normal wasn't reality. Reality is that you need energy to do work. Reality is that without a sufficient flow of energy you cannot do as much work as you might like even if you eek every last bit of efficiency out of what you are doing. The solution is to abandon our notions about economics and growth that have deluded our vision. The solution is to call upon all citizens to recognize that reality and prepare for substantial sacrifices as we try to work our way out of this conundrum. We need to channel every possible bit of fossil fuel energy into the production of an alternative energy infrastructure. We need to recognize that we will never replicate the energy flow that we have enjoyed over the last hundred years with alternative energy sources. We will have to manage population so that we eventually shrink it to a sustainable level commensurate with the actual energy we are able to produce. Unless our leaders begin to show some gumption and start telling the truth, and start us down this path, there will be nothing left to salvage.

Comments

[e sciaroni]

This is so true. But these ideas will be derided by the vocal "experts" and our economy will continue it's long decline. Conditions will need to become much worse before real solutions are tried as a last resort.

[Sukhbir Dadwal]

Dr Mobus,

In general when you talk about the economy in this post and in prior posts, are you talking about the entire world or just the US? I do understand that the US' economy affects the world economy, But can you be a bit more specific as to who is to blame for the majority of this problem (ie US, World, Western Nations etc..).

[murray g]

well said. I write like this in New Zealand - when the papers take it! Absolutely on the......money!

[George Mobus]

Sukhbir,

In general I take the whole world into account since the financial system is global in scope. People in Europe and many parts of Asia, India, etc. have been just as imprudent as in the US and Canada.

And so far as blame is concerned it is hard to point a single finger. Certainly the Wall Street geniuses who came up with these various instruments should have known better. But so should their managers.

So should the mortgage lenders who loaned out money to people who clearly could not qualify under the historical rules. The sub-prime/foreclosure debacle was just a trigger event, not the basic cause.

We are all to blame for believing that our profligate lifestyles in the West could go on forever. We are all to blame for using credit to buy stuff we didn't really need. This isn't just a phenomenon in the US, although it is probably more pronounced here, it has become the modus operandi in most of the world. Borrowing against presumed future earnings as opposed to borrowing from past savings has spread to every nation, it seems.

And since the production of wealth has always been a function of energy flow, and now that flow is subsiding, we are not going to be able to produce the right kind of wealth in the future that will allow us to pay back the loans. The paper that supposedly represented wealth will simply vanish from existence since it was unreal to begin with.

So I can't be specific in blame because what is to blame is our attitudes toward work and wealth. What ultimately causes the pain we are going to suffer is the reduction in oil production and energy in general.

It's all a complex system!

George

[George Mobus]

Thanks murray g.

[alex]

great post, lots of important ideas.

in the conclusion you say, "Unless our leaders begin to show some gumption and start telling the truth, and start us down this path, there will be nothing left to salvage."

with the passage of this absurd bailout, isn't it about time we gave up on the political/corporate leaders and become our own leaders? if anything positive is going to happen in the future, it will be because WE made it so.

my blog is endofcapitalism.com

thanks!
alex

[George Mobus]

Hi Alex.

I suspect that as things get worse, people will cling more to their own chosen leaders. A lot will be revealed if Obama wins and things still decline. I expect there will be continuing failures in the financial markets in spite of the government's efforts. And the majority of people will just cling tighter.

On the other hand there are already a few wiser people setting up intentional communities working toward achieving energy independence from the centralized economy.

The wise shall inherit the Earth.