Michael Hudson

ON FINANCE, REAL ESTATE AND THE POWERS OF NEOLIBERALISM

Saving, Asset-Price Inflation, and Debt-Induced Deflation

By Michael Sunday, June 27, 2004 Articles, Debt No tags Permalink

Post-Keynesian Conference
Kansas City

Summary

The exponential growth of savings and debt takes the form mainly of loans to finance the purchase of real estate, stocks and bonds. These loans extract interest and amortization charges that divert revenue away from being spent on goods and services. The payment of debt service by the economy’s non-financial sectors interrupts the circular flow that Say’s Law postulates to exist between producers and consumers.
Financial institutions re-lend their interest and other financial inflows as new loans to finance asset purchases. The result is that net savings do not increase for the economy as a whole. Meanwhile, lending out savings helps bid up asset prices, but does not necessarily promote new tangible investment and employment or increase real wages and commodity prices. In fact, new tangible investment and employment decline as investors find it easier to obtain price gains in stocks, bonds and real estate than to make profits by investing in factories and other tangible means of production. The effect is to divert savings and credit away from financing new direct investment, and hence from employing labor to produce more output.

* “Saving, Asset-Price Inflation, and Debt-Induced Deflation,” in L. Randall Wray and Matthew Forstater, eds., Money, Financial Instability and Stabilization Policy (Edward Elgar, 2006):104-24. Dr. Hudson is Distinguished Research Professor, Department of Economics, University of Missouri at Kansas City (UMKC). E -mail address: michael.hudson@earthlink.net, or mh@michael-hudson.com.

Saving, Asset-Price Inflation and Debt-Induced Deflation

The National Income and Product Accounts (NIPA) measure the circular flow between production, consumption and new investment. Employers earn profits which they invest in capital goods, and they pay their employees who spend their income to buy the goods they produce (Fig. 1).

Production and consumption represent only part of the economy. Governments levy taxes and user fees, which they spend and sometimes run budget surpluses (the government’s way of saving) that drain income from the economy’s flow of spending. But more often, governments inject spending power by running deficits (financed by running into debt). The NIPA measure these fiscal removals or injections of revenue by taxing and spending (Fig. 2).

A half century ago economists anticipated that rising incomes and living standards would lead to higher savings. The most influential view of the economic future was that of John Maynard Keynes. Addressing the problems of the Great Depression in 1936, his General Theory of Employment, Interest, and Money warned that people would save relatively more as their incomes rose. Spending on consumer goods would tail off, slowing the growth of markets, new investment and employment.

This view of the saving function – the propensity to save out of wages and profits – saw saving break the chain of payments simply by not being spent. The modern dynamics of saving – and the debts in which savings are invested – are more complex. Most savings are lent out. Nearly all new investment in capital goods and buildings comes from retained business earnings, not from savings that pass through financial intermediaries. Under these conditions, higher personal saving rates are reflected in higher indebtedness.

Since World War II, in fact, each new business upswing has started with a higher set of debt ratios. A rising proportion of savings find their counterpart more in other peoples’ debts rather than being used to finance new direct investment. The net savings rate has fallen, even though debt ratios and gross savings have increased.

To understand these dynamics it is necessary to view economies as composed of two distinct systems. The largest system is that of land, monopoly rights and financial claims that yield rentier returns in the form of interest, other financial fees, rents and monopoly gains (which can be viewed either as economic rents or super-profits). These returns far overshadow the profits earned on investing in capital goods and employing labor to produce goods and provide actual services. This reflects the fact that the value of rentier property and financial securities far exceeds that of physical capital in the form of factories and machinery, buildings, or research and development.

Keynes was not careful to analyze how the savings functions associated with financial securities and rentier claims – and the property rights backing them as collateral – differed from personal savings functions. Some help, however, is provided by the NIPA, which break out the distinct flow of property and financial income that accrues to the FIRE sector, an acronym for Finance, Insurance and Real Estate.

To fill out the picture from the investor’s vantage point, especially that of FIRE, it is necessary to recognize the increasingly important role played by capital gains rather than current earnings. The economy’s wealthiest layers take their “total returns” primarily in the form of capital gains, not profit, interest or rental income.

No regular measures of capital gains are published, but they can be estimated on the basis of the Federal Reserve Board’s balance-sheet data published in Table Z of its annual Flow-of-Funds statistics on financial assets (stocks, bonds and bank deposits and loans) and tangible assets (land, buildings and capital goods). These statistics show that capital gains and the returns to property and finance – rent, interest and capital gains – far overshadow profits.

This distinction between the property and financial sectors and the rest of the economy is not immediately apparent, however. NIPA statistics follow modern “value-free” economics in conflating all forms of current income (excluding capital gains) into the single category of “earnings.” Interest, rent, insurance and financial fees are treated as payments for current services, not claims by property, credit or monopoly power that find no counterpart in direct outlays.

These forms of revenue are not inherently necessary expenses of production, but are best viewed as being institutional in character. Returns to finance and property may be viewed as transfer payments rather than as actual costs entailed by producing goods and services. This contrast makes the savings and debt functions of these rentier sectors differ from those associated with the wages and profits paid to labor and tangible capital investment (Fig. 3).

Monetary considerations

Industry and agriculture, transport and power, and similar production and consumption expenditures account for less than 0.1 percent of the economy’s flow of payments. The vast majority of transactions passing through the New York Clearing House and Fedwire are for stocks, bonds, packaged bank loans, options, derivatives and foreign-currency transactions. The entire stock-market value of many high-flying companies now changes hands in a single day, and the average holding time for currency trades has shrunk to just a few minutes.

The value of these financial transactions each day exceeds that of the entire annual U.S. national income. It therefore seems absurd to relate the money supply only to consumer and wholesale prices, excluding asset prices.

Today’s anomalies that need to be explained

Today’s world requires more variables to be analyzed. The (net) savings rate has moved in the opposite direction from what Keynes had anticipated. The NIPA report a zero-savings rate for the economy at large. If the recycled dollar holdings of foreign central banks are excluded, the domestic U.S. savings rate is a negative 2 percent. A time series of the U.S. propensity to save since 1945 shows a steady decline in (net) S/Y.

Despite a falling savings rate, however, the economy never has been flusher with savings and credit. The growth of savings, wealth and net worth is less and less the result of new direct investment in tangible capital formation, but rather the product of rising asset prices for real estate, stocks and bonds. In balance-sheet terms, gross savings are soaring while net savings are zero or negative.

This growth in net worth occurs despite the fact that most new saving is offset on the liabilities side of the balance sheet by growth in debt. The rise of net worth is the result of savings being lent to borrowers who bid up asset prices by using new loans and credit to buy property and securities, that is, wealth and financial claims on wealth.

These features of today’s economy appear to be an anomaly as compared to the formulae that Keynes traced out in 1936. Today’s economy is best seen as a financial bubble, just the opposite of the deflationary Great Depression described by Keynes. Credit – and hence, debt – is being created to inflate the bubble rather than to finance direct capital formation. In this respect the banking and financial systems have become dysfunctional.

Monetary expansion and prices in the commodity and asset markets move asymmetrically. Today’s asset-price inflation goes hand in hand with commodity-price stagnation and a deflation of labor’s spending power. Upon closer examination this inverse relationship is not an anomaly. But the phenomenon shows that the savings problem has become more serious than Keynes feared, for reasons that he had little reason to discuss seventy years ago.

For one thing, the volume of savings compounds by being recycled into the creation of new interest-bearing debt as savers or financial institutions use their accrual of income, dividends and capital gains to buy more securities, make more loans or buy property rather than to spend this revenue on current output. The growing debt overhead – and the savings that form the balance-sheet counterpart to this debt – bears interest charges that divert income to debt service rather than being available for spending on consumption and direct investment.

The FIRE sector in relation to the rest of the economy

The institutions that distinguish one national economy from another are the property and financial institutions that steer saving and investment, and the public tax policies that shape markets. These policies determine the character of the FIRE sector. The largest and defining features of any economy are those of the property and financial sector, whose rent, interest, monopoly revenue and “capital” gains (most of which are real-estate gains) rise relative to overall national income.

Instead of examining these contrasting financial and fiscal policies, most economics texts concentrate on abstract technological production and consumption dimension of economic life. It is as if the property and financial dimension – tangible wealth and financial claims on property and income – lie somewhere on the far side of the moon, invisible to earth or at least wrapped in a cloak of invisibility.

When Keynes viewed individuals as saving a portion of the income they earned, he defined (S) as a function of income (Y) multiplied by the marginal propensity to save (mps, or simply s), so that S = sY. Keynes thus derived the savings function s = S/Y for economies as a whole.

This formula does not acknowledge that financial institutions tend to save all their income. Furthermore, over time a rising proportion of this inflow of interest, dividends and rent is plowed back into new loans rather than invested in tangible capital formation.

Keynes recognized that wealthy individuals save a higher portion of their income as they earn more. He feared that as economies grew richer over time, the propensity to save would rise. But he did not describe corporate financial institutions as having a distinct propensity of their own to save all their interest and dividend receipts.

Today we can see that the problem with saving is not simply that it is “non-spending.” A rising proportion of savings are lent out or invested in loans and securities, dividend-yielding stocks and rent-yielding properties, to become interest-bearing debts owed by the economy at large. These savings expand of their own accord as their interest receipts are recycled into new loans and other income-yielding assets, growing in an exponentially rising curve. This exponentially rising curve is that of compound interest, so that St = St-1(1+i), where i represents the rate of interest. Meanwhile, the growth of debt grows pari passu, as Keynes would have put it.

It thus is helpful to distinguish between the propensity to save (1) by labor and industrial firms out of income earned by producing goods and services, and (2) by the FIRE sector out of debt service and rental charges. Drawing this distinction requires that the economy itself be viewed as a combination of two separate parts, by separating the FIRE sector from the rest of the economy. I refer to these two sectors as (1) the production and consumption economy comprising fixed capital and labor, and (2) the economically larger property and financial sector receiving rentier income (defined to include financial “service” fees).

Although net saving does not increase in such cases, the volume of loanable funds expands. These funds are built up as interest, dividends and rents accrue to owners of securities and property. To the extent that these revenues accrue to large financial institutions – insurance companies, pension and mutual funds – the propensity to save such returns is nearly 100 percent. To be sure, bankers pay interest to their depositors while insurance and pension funds pay their policy holders. However, most of these interest and dividend accruals are left in accounts to accumulate. The result is an exponentially rising curve of savings at compound interest.

The idea of a propensity to consume is appropriate only for consumer income, not that of the financial, insurance and real estate (FIRE) sectors. Consumers, especially retirees, do indeed consume some part of their rentier income, but this is not true of institutional investors. Keynes recognized that the wealthiest income brackets have a high propensity to save, while less affluent brackets have a lower propensity. Today, the wealthiest 10 percent of the population holds most of the savings in every economy. The bottom 90 percent tend to be net debtors rather than net savers in today’s highly financialized economies of North America and Europe.

Additional saving is created when banks create credit. Most finds its counterpart in the new debts that borrowers owe, so that the net saving rate is not affected. Keynes concerned himself almost entirely with net saving, not gross savings and their counterpart debt.

When Keynes defined saving as equal to investment, he did not emphasize the distinction between direct investment in tangible capital goods and loans that became the debts of the economy’s non-financial sectors. Failure to draw this distinction led to an ambiguity between gross or net saving. National income accounts define saving net of the growth in debt, so that no increase in net saving occurs when savings are lent out.

This condition has become more and more the case for the U.S. economy in recent decades. Today’s propensity to save is less than zero as the economy is running into debt faster than it is building up new savings. Keynes did not address this possibility, and indeed it was not a pressing concern back in 1936 when he wrote his General Theory.

Modern national income accounts also combine the wages and profits that labor and industry earn with the interest and rent that finance and property receive. The basic idea is that providing land, the radio spectrum, subsoil minerals and even monopoly goods supplies a “service” alongside the goods and services produced by labor and capital goods. But it is equally possible to view finance and property not as “factors of production” producing services that earn interest, financial fees and rent, but as receiving transfer payments or what Henry George called “value from obligation.” This distinction enables the classical distinction between “earned” and “unearned” income to be preserved in a way that I believe Keynes would have appreciated in view of his call for “euthanasia of the rentier.”

Nearly all new fixed capital formation is financed out of retained business earnings, not out of bank borrowing. Banks finance sales, foreign trade, consumer debt and the purchase of property already in place, but hardly ever have they taken the risk of financing new direct investment. Their time horizon is short-term, not long-term.

This chapter proposes a model to integrate the analysis of asset-price inflation with debt deflation and Say’s Law. Viewing savings and debt in their institutional context, it relates the behavior of banks and institutional investors to the dynamics of asset-price inflation and debt deflation. A central theme is that most lending and credit creation are directed into the capital markets via borrowers who buy property or financial securities. As the economy’s assets are loaded down with debt and its interest charges, this credit growth extracts interest payments that divert revenue away from current demand for goods and services. That is why asset-price inflation usually involves debt deflation. The deflationary effect may be mitigated by lowering interest rates, as occurred in the United States during 1994-2004. The debt/savings overhead can rise without extracting a higher flow of interest payments as interest rates approach their nadir (about 1 percent today).

Keynes viewed saving as causing insufficient market demand to provide full employment. The long-term threat seemed to be that as economies grew richer, people would save more, disrupting the circular flow of spending between producers and their employees as consumers. What was not emphasized was that as savings were recycled into loans, economies would polarize between creditors and debtors.

Today the net savings rate has fallen to zero, and the major factor impairing effective demand is the diversion of revenue to service the economy’s debt overhead. Paying interest and principal reduces the disposable income that debtors have available to spend on goods and services, while the financial institutions that receive this revenue do not spend it on goods and services. They lend out their receipts to enable the buyers to purchase assets that already exist.[1]

The National Income and Product Accounts (NIPA) define the amortization of debt principal as saving. Most of these repayments are lent out to new borrowers, including corporate business whose balance sheets have reached what Hyman Minsky called the Ponzi stage of fragility – the point at which the debt overhead is carried by debtors borrowing the interest charges that are growing exponentially. In this respect “debts cause saving.”

Today’s problem of inadequate consumer demand and capital investment lies on the liabilities (debt) side of the balance sheet, not on the asset (saving) side. Keynes anticipated that as economies grew and incomes rose, a rising proportion of S/Y would reduce consumption, leading to overproduction if employers did not cut back their own direct investment. This line of thought reflected the psychological theorizing of British marginal utility analysis rather than a financial view of the dynamics that determined the buildup of savings.

Keynes’s discussion of savings led him to re-examine Say’s Law, which described circular flow of spending between producers and consumers. Under normal conditions producers would hire workers, who would spend their wages on buying what they produced. This was the basic meaning of the phrase “supply creates its own demand.” But savings threatened to interrupt this circular flow by diverting the purchasing power of consumers away from the demand for goods and services, and that of employers away from the purchase of capital goods.

Keynes found saving to be the main culprit for the economic slow-down of the Great Depression on the ground that it led to reduced market demand, deterring new direct investment and hence slowing the growth of employment. But in today’s U.S.-centered bubble economy the problem has become more complicated. To the extent that savings are lent out (rather than invested out of retained earnings to purchase capital goods, erect buildings and create other tangible means of production), they divert future income away from consumption and investment to pay debt service. In this respect the growth of savings in financial form (that is, in ways other than new direct capital formation) adds to the debt overhead and hence contributes to debt deflation. This is what occurs with nearly all the savings intermediated and lent out or reinvested by the banks, insurance companies and other financial institutions.

Keynes did not devote much attention to the accrual of interest on past savings. His General Theory was ambiguous with regard to the specific forms that savings might take. They were identified simply as investment, so that on the macroeconomic plane, S = I. The implication by many Keynesians today is that savings actually cause investment. The reality is that savings not invested directly in new means of production were invested indirectly in stocks, bonds and real estate. Investment in securities and property already in existence had no positive employment effects. But there was not much growth in either borrowing or this kind of indirect investment back when the General Theory was published. The tendency was for savings to sit idle, as did much of the labor force.

The self-expanding growth of savings through their accrual of interest

The financial system exists in a symbiosis with the “real” economy. Each system has its own set of growth dynamics. Financial systems tend to grow exponentially at compound interest. The cumulative value of savings grows through a dynamic that Keynes had little reason to analyze in the 1930s – what Richard Price described as the “geometric” growth of a penny invested at 5 percent at the time of Jesus’s birth, growing to a solid sphere of gold extending from the Sun out beyond the orbit of Jupiter by his day (1776). He contrasted this “geometric” growth of savings invested at compound interest to the merely “arithmetic” growth of a similar sum invested at simple interest. This was the metaphor that Malthus adopted to describe the growth of human populations in contrast to the means of subsistence.[2]

Many people saved money back in the time of Jesus. But nobody has obtained savings amounting to anywhere near a solid sphere of gold. The reason is that savings that are invested in debt tend to stifle economies, causing downturns that wipe out the debts and savings together in a convulsion of bankruptcy. This was what happened to the Roman Empire, and on a smaller scale it has characterized business cycles for the past two centuries. Yet this dynamic rarely has been related to the bankruptcy phenomenon although it is a key factor countering the growth of savings.

Economies do grow faster than “arithmetically,” but not “geometrically.” Their typical growth pattern is that of an S-curve, tapering off over the course of the business cycle. The exponential growth of savings and debts thus tends chronically to exceed that of the “real” economy. Unless interest rates decline, the debt burden will divert income away from spending on goods and services, turning the economy downward (Fig. 5 & Fig. 6).

Fig. 5. How the Rise in Debt Overhead Slows Down the Business Cycle.

The General Theory recognized saving as arising out of current income, not as growing through the compounding of interest, doubling and redoubling at compound interest by their own inertia. They accrue interest independently of the course of incomes when invested in bonds or left in savings accounts, as well as accruing dividends if invested in stocks, or rental income if invested in property. This is especially true of “forced savings” in the form of paycheck withholding for Social Security, pension and retirement accounts, along with insurance policies segregated in a way that makes them unavailable for current spending.

Not being limited by the course of income or the ability to pay, the exponential growth of savings tends to exceed growth of the real economy. This is what occurs when economies are loaded down with debts, which could equally well be thought of as the savings overhead that is lent out. Rising savings on the asset side of the balance sheet connote a rising debt overhead on the liabilities side. In this case saving does not necessarily reflect an increase of productive powers and the means of production, nor does it tend to employ labor. Rather, the debt service that results from lending out savings tends to shrink markets and employment.

It should be noted that while the financial sector represents itself as providing credit to consumers and producers, it also absorbs income by charging interest, in amounts that are as large as the entire loan principal every doubling period – seven years at 10 percent interest, 13 years at 5 percent. Ultimately the financial sector extracts revenue from the economy. That is why it is in business, after all: to “make money from money.”

Money cannot be made from money, of course. It is itself sterile, as Aristotle noted long ago. But it can charge interest from the rest of the economy that does perform the work. Levying interest, rent and other property and financial charges is not to be confused with making money through labor or capital investment. The perception of classical economics that the property and financial system is different has been lost in today’s economic thought.

The growth of net worth through capital gains

The cumulative volume of savings also grows through a dynamic that Keynes had little reason to analyze in the 1930s: capital gains. Property and financial securities tend to appreciate in price over time. The main cause of this price appreciation is that the physical volume of assets grows slowly, while the financial volume of loanable funds grows exponentially.

Let us return for a moment to Richard Price’s example of a penny saved at the time of Jesus being worth a sphere of gold extending from the sun out to Jupiter. Few investors buy gold, as it does not yield an income. The largest investment – and the most heavily debt-financed asset these days – is land. More credit does not expand the volume of land, which is fixed, but it does raise its market price. A rising volume of savings is channeled to buy a fixed supply of land. The financial system thus creates capital gains as the finite volume of property and supply of buildings and financial securities expands more slowly than the potentially infinite volume of loanable funds.

Keynes did not anticipate that savings would be channeled in a way that bid up asset prices for securities and property without funding tangible capital formation. In the 1930s net worth was built up mainly by saving, not by asset-price inflation such as is occurring today. In traditional Keynesian terms, revenue or credit spent on buying property in place represented hoarding, not investment.

Homeowners and investors imagine themselves growing richer as prices rise for their assets. Their net worth rises without their having to save. However, this rise tends to require more income set aside to pay debt service on the loans taken out to buy their property. Credit lent out in this way does not increase consumption and direct investment. It creates debts whose carrying charges shrink markets. Savings and debts rise together, so that there is no increase in net saving.

New saving does occur as financial institutions recycle the receipts of debt service into new loans, whose carrying charges absorb yet more future income. The result is that gross savings (and hence, indebtedness) rise relative to national income. Stated another way, saving for many homeowners takes the form of paying off their mortgages. This is not the same thing as hoarding (in Keynes’s sense), but it plays much the same function, as it is not available for spending on current output.

As savings rise and are lent out, debt service absorbs more income. But the net economic surplus available to service these savings – by paying interest and dividends on the debts and securities in which they are invested – tends not to keep pace with their stipulated debt service. This debt problem therefore plays the deflationary economic role that Keynes attributed to savings.

How asset-price inflation aggravates economic polarization

Keynes favored inflation as eroding the burden of debt. Calling for “euthanasia of the rentier,” he saw inflation as the line of least political resistance to wiping out the economy’s debt burden. His idea was that inflation would leave more income available for consumption and for new direct investment. But asset-price inflation works in a different way. Instead of eroding the purchasing power of wealth relative to commodities and labor, it increases property prices without increasing consumer prices or wages. At least this has been the pattern since 1980. Wealth disparities have increased even more than have disparities among income brackets. The net worth for the wealthiest 10 or 20 percent of the population has soared, while the rest of the economy has fallen more deeply into debt and many of its gains have turned out to be short-term.

Keynes recognized that rich and poor income and wealth brackets had differing marginal propensities to save. But today’s financial polarization has gone beyond anything he anticipated, or what anyone else anticipated back in the 1930s, or for that matter even in the 1950s.

Long before the General Theory, economists recognized that wealthy people did not expand their consumption in keeping with their income growth. The image of widows and orphans living off their interest was relevant only for a small part of the economy. Rentiers always have tended to save their income and reinvest it in the financial and property markets. This occurs also with savings deposits, which banks lend out or invest directly in financial securities. Most of the interest and dividends credited to savers thus is left to grow by being lent out or plowed back into indirect securities and property investment, increasing asset prices.

The ability to get an easy ride from the resulting asset-price inflation – coupled with an easy access to credit and favorable tax treatment – prompts investors to take their returns in the form of capital gains rather than current income. In real estate, the economy’s largest sector, property owners use their rental income to pay interest on the credit borrowed to buy properties, leaving no taxable earnings at all. The same phenomenon characterizes the corporate sector, where equity has been retired for bonds and bank loans since 1980. Ambitious CEOs, managers of privatized public enterprises and corporate raiders have bought entire companies with debt-financed leveraged buyouts. Interest charges have absorbed corporate earnings, leaving little remaining for new capital investment. The name of the game has become capital gains, which have been spurred more by downsizing and outsourcing than by new corporate hiring.

Prices for property, stock, and bonds have soared relative to wages, forcing home buyers to spend a rising multiple of their annual incomes to buy housing. Also rising has been the cost of acquiring companies relative to corporate profits as price/earnings ratios increase.

Capital gains make the inequality of wealth and property more extreme than income inequality. The wealthiest layer of the population derives its power from capital gains, while using its income to pay interest – as long as interest rates are less than the rate of asset-price inflation. The ratio of wealth and property has risen relative to the value of goods and services, wages and profits, while the debt overhead has grown proportionally.

Does asset-price inflation “crowd out” new direct investment?

The FIRE sector has been expanding at the expense of the “real” economy. It drains revenue in the form of interest, rental income and monopoly profits, which are paid out increasingly as interest and financial fees. This triggers a fresh cycle of saving and re-lending by the FIRE sector itself, not so much by the rest of the economy. The more interest accrues in the hands of creditors, the faster their supply of loanable funds increases, thanks to the “magic of compound interest.” This revenue is lent out and accrues new interest (“interest on interest”), which is recycled into yet new loans.

This growth of savings and loanable funds in the hands of financial institutions is lent out mainly to buy property in place and financial securities, not to fund tangible capital formation. This financial dynamic spurs asset-price inflation, which in turn reduces the incentive to invest directly in capital goods, because it is easier to make capital gains than to earn profits.

These developments have prompted investors to seek “total returns” – capital gains plus profits or earnings – rather than earnings alone. Under Federal Reserve Board Chairman Alan Greenspan as “Bubble Maestro” in the 1990s, stock prices for dot.com and internet companies soared without a foundation in earnings or dividend-paying ability. Balance-sheet maneuvering was decoupled from tangible investment in the “real” economy. Companies such as Enron prided themselves in not having any tangible assets at all, just a balance sheet of speculative contracts. People began to ask whether wealth could go on increasing in this way ad infinitum.

Keynes’s analysis implied that the income “multiplier” (Y/S, or 1/mps) would increase as prosperity increased and people consumed a smaller portion of their income. What was being multiplied, however, was not national income – wages, profits and other earned income – but the volume of credit and hence the pace of capital gains in the asset markets.

Tax policy and financial bubbles

Unlike the industrial sector, real estate does not report a profit – and hence, pays no income taxes. Property owners do pay state and local real estate taxes, to be sure, but they have been joined by the financial and insurance lobbies to shift local government budgets away from the land and onto the shoulders of labor, through income taxes, sales taxes and various user fees for municipal services hitherto provided as part of the basic economic needs and infrastructure.

Although land does not depreciate – that is, wear out and become obsolete – by far the bulk of depreciation tax credits are taken by the real estate sector. This is because the economic theory underlying tax obligations has become essentially fictitious. Each time a property is sold, the building is assumed to increase in value, rather than the land’s site value generating the gain.

Nothing like this could happen in industry. Machinery wears out and becomes obsolete. (Think of computers and word processors bought a decade ago, or even three years ago.) Technological progress reduces the value of physical capital in place. But the prosperity that progress brings increases the market price of land.

In calling for “euthanasia of the rentier” Keynes pointed to the desirability of preventing the diversion of income into the purchase of securities and property already in place. He hoped to restructure the stock market and financial system so as to direct savings and credit into tangible capital formation rather than speculation. He deplored the waste of human intelligence devoted merely to transferring property ownership rather than creating new means of production.

Today’s financial markets have evolved in just the opposite direction from that advocated by Keynes. New savings and credit are channeled into loans to satisfy the rush to buy real estate, stocks and bonds for speculative purposes rather than into the funding of new direct investment and employment. Matters are aggravated by the fact that financial gains are taxed at a lower rate, thanks to the growing power of the financial sector’s political lobbies. This prompts companies to use their revenue and go into debt to buy other companies (mergers and acquisitions) or real estate rather than to expand their means of production.

Going into debt to buy assets with borrowed funds experienced a quantum leap in the 1980s with the practice of financing leveraged buyouts with high-interest “junk” bonds. The process got underway when interest rates were still hovering near their all-time high of 20 percent in late 1980 and early 1981. Corporate raiding was led by the investment banking house of Drexel Burnham and its law firm, Skadden Arps. Their predatory activities required a loosening of America’s racketeering (RICO) laws to make it legal to borrow funds to take over companies and repay creditors by emptying out their corporate treasuries and “overfunded” pension plans. New York’s laws of fraudulent conveyance also had to be modified.

Tax laws promoted this debt leveraging. Interest was allowed to be counted as a tax-deductible expense, encouraging leveraged buyouts rather than equity financing or funding out of retained earnings. Depreciation of buildings and other assets was permitted to occur repeatedly, whenever a property was sold. This favored the real estate sector by making absentee-owned buildings and other commercial properties virtually exempt from the income tax. To top matters off, capital gains tax rates were reduced below taxes on the profits earned by direct investment. This diverted savings to fuel asset-price inflation. By the 1990s the process had become a self-feeding dynamic. The more prices rose for stocks and real estate, the more mortgage borrowing rose for homes and other property, while corporate borrowing soared for mergers and acquisition.

Meanwhile, the more gains being made off the bubble, the more powerful its beneficiaries grew. They turned their economic power into political power to lower taxes and deregulate speculative finance – along with fraud, corrupt accounting practices and the use of offshore tax-avoidance enclaves – even further. This caused federal, state and local budget deficits while shifting the tax burden onto labor and industrial income. Markets shrank as a result of the fiscal drain as well as the financial debt overhead.

Abuses of arrogance and outright fraud occurred in what became a golden age for Enron, WorldCom and other “high flyers” akin to the S&L scandals of the mid-1980s. But free-market monetarism draws no distinction between tangible direct investment and purely financial gain-seeking. Opposing government regulation to favor any given way of recycling savings as compared to any other way, the value-free ethic of our times holds that making money is inherently productive regardless of how it is made. “Free-market fundamentalism” came to shape neoliberal tax policy in a way that favored finance, not industry or labor.

Can economies inflate their way out of debt?

Only a limited repertory of opportunities for profitable new direct investment exists at any given point in time. The exponential growth in savings tends to outstrip these opportunities, and hence is lent out. This lending – and its mirror image, borrowing – may become self-justifying at least for a time to the extent that it bids up asset prices. Homebuyers and investors feel that it pays them to go into debt to buy property, and this is viewed as “prosperity,” although it is primarily financial rather than industrial in character.

About 70 percent of bank loans in the United States and Britain take the form of real estate mortgages. Most new savings and credit creation thus enables borrowers to bid up the price of homes and office buildings. The effect is to increase the price that consumers must pay to obtain housing, as new construction loans account for only a small proportion of mortgage lending. Over-extended families become “house-poor” as rising financial charges for housing diverts income away from being spent on new goods and services, “crowding out” consumer spending and business investment.

Governments may try to mitigate the inflation of housing prices by raising interest rates. But this will increase the carrying charges for borrowers with floating-rate mortgages, as well as debtors throughout the economy. (Also, as Britain discovered in spring 2004, the increase in interest rates also raises the currency exchange rate, making its exporters less competitive in world markets.) For fixed-rate mortgages, higher interest rates may squeeze the banks, leading to losses in their portfolio values and prompting calls for the government to bail out losers (at least depositors, if not to rescue S&Ls and commercial banks).

Perception of this problem leads central bankers not to raise interest rates and take the blame for destroying financial prosperity by pricking the bubble. Instead, they try to keep it from bursting. This can be done only by inflating it all the more. So the process escalates.

Balance sheets improve as the pace of capital gains outstrips the rate of interest. Debt service can be paid out of rising asset values, either by selling off assets or by borrowing against the higher asset prices as collateral. The problem occurs when current income no longer can carry the interest charges. The financial sector absorbs more income as debt service than it supplies in the form of new credit. Asset prices turn down – but the debts remain on the books. This has been Japan’s condition since its bubble peaked in 1990. It may result in “negative equity” for the most highly leveraged mortgage borrowers in the real estate sector, followed by debt-ridden companies.

When interest charges exceed rental income, commercial borrowers hesitate to use their own money or other income to keep current on their debts. The limited liability laws let them walk away from their losses if markets are deflated, leaving banks, insurance companies, pension funds and other financial institutions to absorb the loss. Sell-offs of these properties to raise cash would accelerate the plunge in asset prices, leaving balance sheets “hollowed out.”

Savings do not appear as the villain in such periods. The zero net savings rate has concealed the fact that gross savings have been relent to create a corresponding growth in debt. America’s national debt quadrupled during the 12-year Reagan-Bush administration (1981-93). This increase in debt was facilitated by reducing interest rates by enough so that the unprecedented increase in credit rose without extracting more interest from many properties.

The natural limit to this process was reached in 2004 when the Federal Reserve reduced its discount rate to only 1 percent. Once rates hit this nadir, further growth in debt threatened to be reflected directly in draining amortization and interest payments away from spending on goods and services, slowing the economy accordingly. Further debt growth would require a rising proportion of disposable personal income to be spent on debt service.

How long can bubbles keep expanding?

The potential credit supply is limited only by the market price of all existing property and securities. The process is open-ended, as each new credit creation inflates the market value of assets that can be pledged as collateral for new loans.

Until bubbles burst, they benefit investors who borrow money to buy assets that are rising in price. Running into debt becomes the preferred way to make money, rather than the traditional first step toward losing the homestead. The motto of modern real estate investors is that “rent is for paying interest,” and this also applies to corporate raiders who use the earnings of companies bought on credit to repay their bankers and bondholders. What real estate investors and corporate financial officers are after is capital gains.

There is no inherent link with making new direct investment. Indeed, the after-tax return from asset-price inflation exceeds that which can be made by investing to create profits. Retirees, widows and orphans do best by living off capital gains, selling part of their growing portfolios rather than seeking a flow of interest, dividends and rental income. The idea begins to spread that people can live off capital gains in an economy whose incomes are not growing.

Asset-price inflation would be a rational long-term policy if economies could inflate their way out of debt via capital gains. The solution to debt would be to create yet more debt to finance yet more asset-price inflation. This dynamic is more likely to create debt deflation than commodity-price inflation, however. It is true that a consumer “wealth effect” occurs when homeowners refinance their mortgages by taking new “home equity” loans to spend on living, or at least to pay down their credit-card debt so as to lower the monthly diversion of income for debt service. If this were to lead to a general inflation, interest rates would rise, prompting investors to shift out of stocks into bonds. Foreign investors and speculators bail out, accelerating the price decline. This threatens retirement funds, insurance companies and banks with capital losses that erode their ability to meet their commitments.

The more likely constraint comes from asset-price inflation itself as price/earnings ratios rise. Interest rates and other returns slow, making it difficult for pension plans and insurance companies to earn the projected returns needed to pay retirees. In any event, asset sales exceed purchases as the proportion of retirees to employees grows, causing stock and bond prices to decline. Pension funds must sell more stocks and bonds – or employers must set aside more of their revenue for this purpose, in which case their ability to pay dividends is reduced.

Asset-price inflation reaches its limit when interest charges absorb the entire flow of earnings. Debt-financed bubbles remove more purchasing power from the “bottom 90 percent” of the population than they supply. Debt spurs rising housing prices but reduces consumer demand as a result of the need to service mortgages. Likewise, financing for leveraged buyouts, mergers and acquisitions may increase stock prices, but the interest charges absorb corporate earnings and “crowd out” new direct investment and employment.

The drive for capital gains thus complicates the traditional macroeconomic Keynesian categories. Although these gains are not included in the national income statistics, they have become the key to analyzing how asset-price inflation leads to debt deflation of the “real” economy. One thus may ask what sphere of the economy is more “real” and powerful: that of tangible production and consumption, or the financial sector which is wrapped around it.

Can the debt and savings overhead be supported indefinitely?

Richard Price’s illustration of the seemingly magical powers of compound interest is a reminder that many people saved pennies (and much more) at the time of Jesus, and long before that, but nobody yet has obtained an expanding globe of gold. The reason is that savings have been wiped out repeatedly in waves of bankruptcy.

The reason is clear enough. When savings, lending and “indirect” financial investment grow by compound interest in the absence of new tangible investment, something must give. The superstructure of debt must be brought back into a relationship with the ability to pay.

Financial crashes occur much more quickly than the long buildup. This is what produces a ratchet pattern for business cycles – a gradual upsweep and sudden collapse of financial and property prices, leaving economies debt-ridden. Many debts are wiped out, to be sure, along with the savings that have been invested in bad loans – unless the government bails out savers at taxpayer expense.

Financial crises are not resolved simply by price adjustments. Almost all crises involve government intervention, solving matters politically. As the financial and property sectors gain political power relative to the increasingly indebted production and consumption sectors, their lobbies succeed in lowering tax rates on rentier income relative to taxes on wages and profits. Tax rates on capital gains have been slashed below those on “earned” wages and profits, whereas the two rates were equal when America’s income-tax laws first were introduced.

Financial lobbies also have gotten law-makers to adopt the “moral hazard” policy of guaranteeing savings. Debtors still may go bankrupt, but savings are to be kept intact by making taxpayers liable to the economy’s savers. Ever since the collapse of the Federal Savings and Loan Insurance Corporation (FSLIC) in the late 1980s a political fight has loomed over just whose savings are to be rescued. Unfortunately, the principle at work is that of “Big fish eat little fish.” Small savers are sacrificed to the wealthiest savers and institutional investors.

The mathematics of compound interest dictates that such public guarantees to preserve savings cannot succeed in the long run. Financial savings and debts tend to grow at exponential rates while economies grow only by S curves, causing strains that cannot be supported as credit is used to buy assets rather than to invest in capital goods or buildings.

Financial strains become further politicized as large institutions and the “upper 10 percent” of the population account for nearly all the net saving, which is lent out to the “bottom 90 percent” and to industry. The balance-sheet position of the wealthiest layer increases as long as capital gains exceed the buildup of debt. The bottom 90 percent also benefit for a while during the early and middle stages of the financial bubble. Workers are invited to think of themselves as finance-capitalists-in-miniature rather than as employees being downsized and outsourced. But much of what they may gain in the rising market value of their homes (for the two-thirds of the U.S. and British populations that are homeowners) is offset by the debt deflation that bleeds the production-and-consumption economy.

Throughout history societies that have polarized between creditors and debtors have not survived well. Rome ended in a convulsion of debt foreclosure, monopolization of the land and tax shifts that reduced most of the population to clientage. Third-world countries today are being stripped of their public domain and public enterprises by the international debt buildup, while industry and real estate in the creditor nations themselves are becoming debt-ridden.

Today’s bubble economy is seeing interest charges expand to absorb profits and rental income, leading to slower domestic direct investment and employment. Much as classical economists believed that rent would expand to absorb the entire economic surplus, it now appears that interest-bearing debt will play this role.

[1] Keynes noted that Malthus pointed out that landlords helped contribute to aggregate demand by spending their rental income on hiring servants. But banks lend to service producers and other labor, increasing the volume of debt.

[2] I review how economists have treated this phenomenon in “The Mathematical Economics of Compound Interest: A Four-Thousand Year Overview,” Journal of Economic Studies 27 (2000):344-363.