Can Borrowing create Wealth?

Most countries in the developed world are trying to cross a debt high wire. Today, their ability to balance on the wire is essential to the financial stability of the world. How did all these countries get into such precarious positions? Largely, the blame can be assigned to borrowing. Such an obvious assertion does not explain much.

We need to go further back and understand why each country began borrowing. Unfortunately, the answer is simply, because there were lenders willing to loan money. No country evaluated their capacity to repay the loans. Political leaders depended on the lenders to evaluate their country's capacity to repay the loans. This task was done about as competently as the risk evaluations of subprime bonds. In fact, there is a parallel between subprime borrowers and Finance Minister borrowing. Both assumed the willingness of a lender to give them money implied they must have the capacity to repay the loan. In both cases this was a flawed assumption. The lender was not evaluating their capabilities, but only the quality of the collateral in the case of subprime borrowers and the implicit gurantees of repayment in the case of sovereign borrowers. Each evaluation only scratched the surface of what needed to be evaluated.

Risk Managers of subprime lenders did not look at the stability of the entire market. Their focus was only on the specific property.  Risk Managers of Sovereign lenders did not look at the competing demands of tax revenues, but only whether a "guarantee" was implied. No one probed into whether the guarantee could be fulfilled. The Global Debt Crisis is largely a result of sloppy lazy work by all sides.

Even so, the negative consequences of this laziness might have been avoided if the borrowers and lenders had made loans that made sense. What is a loan that makes sense? It is a loan that generates sufficient revenue to repay the principle and interest. What kind of loan is that? The simplest example is a toll road that will generate enough income to repay principle and interest. Very few public expenditures meet this standard.

Let's review some of the more common public expenditures that get countries in trouble. All defense borrowing is of this type, but there are others. Surprisingly many of the most egregious examples are the funding of education. Most of the developing countries in the Middle East are using funds from their oil rich brethren to educate their populous. Admirable, but once educated these graduates cannot find jobs. Consequently, the poor countries hire many of them in "make work positions" funded with precious tax revenues insufficient to pay their salaries and meet the principle and interest payments for the colleges and universities funded with borrowed funds. This is a classic example of loading the camel before having a market destination to travel to. Development of the private sector must proceed the education of the employee.

In N Theory the requirement of being able to repay a loan is the Finance Rule. Failure to consider the Finance Rule when making a borrowing or lending decision ends in a Debt Crisis. Escaping from a Debt Crisis after the fact is extremely difficult as we are learning. Every country should make the Finance Rule part of their governing documents.

Dualistic Boundaries

Dualism, the condition of opposites, plays a large role in N Theory. Dualism is embraced as a necessity. Dualism defines the world through contrast with the opposite concept. Black is clearer when contrasted with White. Republican positions are better understood by American voters when contrasted with Democratic positions. Health is valued when placed beside sickness. Peace is fully appreciated after the ravages of war. Grace is adored when it replaces boorish self-interest. Harmony is delightful when it follows discord.

If Dualism is defined by opposites, then there must be a boundary between the two polar terms. The boundary between black and white is gray. The boundary between U. S. political parties, Republicans and Democrats, is occupied by Independents. N Theory argues it is at this boundary that change occurs, just as in a black tunnel when enough light enters to allow the walls to reappear and enable a lost spelunker to reorient. Likewise, two adversaries cannot understand the other sides' position unless they travel far enough to stand on the other side of the boundary. A child will never understand why a parent is asking them to behave unless the child is allowed to slip on the parent's shoes for a moment. 

There are numerous Dualistic Boundaries that must be crossed for conflict resolution to occur. For parents who want their children to be successful, the parent/child boundary  should be straddled whenever a teaching moment occurs. In economics the Business Sector/Government Sector boundary should be heavily traveled. In politics it is important members spend more time on the fence than on building fences. In international relations it is important leaders understand as much about their country as those countries that threaten them. Gates are more important than walls. Open your hearts and hands to paranoid fence builders. Beware of countries that build warships.

In economics the importance of dualism is to realize one side is material and the other immaterial. Although the two opposite positions clarify each side and make the contrast vivid, one is right and one is wrong; or both are wrong and the best solution is a compromise. To arrive at the best solution requires intelligence, a good ear and a willingness to cross the boundary and look at the problem from all possible perspectives. The ability to meet your adversary and listen to his argument makes a great leader.

Aggregate Demand

Even among Conservative Economists, the solution for job creation is to increase Aggregate Demand including government spending.  This blog is the only one that offers an alternative to the conclusions of Supply and Demand Theory.  In N Theory it is not Aggregate Demand, but Wealth that increases the willingness of the consumers to spend.  Even in Supply and Demand Theory it is the spending of money that increases Aggregate Demand (the total demand for goods and services over a specific time period).  For instance, it is the amount spent in a year on goods and services.  We can all agree with that definition, but it gets complicated when we compare this amount to Aggregate Supply (the volume of goods and services produced within the economy at a given overall price level) and then make predictions about the quantity sold (the main criteria for the number of jobs in the economy.  In other words, the price of goods sold equals the cost of goods produced including a profit. 

Now all the terms are in money.  We are talking apples to apples.  Therefore, the number of jobs in an economy is related to the amount spent on goods and services.  N Theory does not argue Supply and Demand Theory is wrong in this commonsense explanation, but disagrees about the role of government plays to increase spending (Aggregate Demand).  Supply and Demand Theory states if government increases spending (Aggregate Demand),  Aggregate Supply will increase as well.  This equation did not work during the Great Depression and did not work after the Great Recession.  Government spent lots of money, but the number of jobs created was minuscule.  N Theory explains that it is not the amount spent by government that matters, but the wealth and security of consumers (Buyers) that creates jobs.

In conclusion, it is not government spending that stimulates an economy, but a sense by consumers and manufactures that sustained spending will increase.  Consumers need confidence to take money out of savings or borrow to make a purchase.  They get this confidence when they feel their wealth is stable or increasing.  This  additional spending is stimulative since it expands the Money Supply by an amount equivalent to the profitability created.  Likewise, Manufacturers need confidence of increased consumer spending so they will take risk to expand their business and hire new employees.  Government spending actually discourages consumers and manufactures since government spending implies a problem in the economy and likely increased taxation.  It also implies a consumer or manufacturer's wealth is unlikely to increase and might actually decrease.  Government can spend us into a recession, but never out of one.

Gravitas

 In the midst of the 2012 Republican Presidential Primary Governor Romney has been declared the “most electable” candidate.  Why is that?  One reason may be that he possesses “gravitas” and the other candidates do not.  Gravitas is not charisma.  Charisma is a sort of attractiveness derived from our animal nature.  It is a magnetism derived from our heavily dominated sexual being.  It is the quality Hollywood looks for in a leading man and People magazine seeks for their cover.  Gravitas on the other hand is a quality we look for in our leaders rather than someone we look at and drool over.  Gravitas is a seriousness and intellectual focus that we seek in someone who will help us to understand or solve an issue.  Charisma is a quality of someone we want to be around, but it is not a quality that we expect to help us do anything.  Charisma is about making us feel warm and fuzzy inside.  Gravitas is the quality of confidence.  People with gravitas exuded intellectual superiority.  People with charisma exuded physical superiority. 

In a society that needs to overcome economic difficulties would be wise to select a leader with gravitas rather than charisma.   Many economic theorists possess gravitas.  Keynes certainly had gravitas.  Alan Greenspan had gravitas.  It is difficult to determine if historical figures had gravitas.  Without video tape it is difficult to speculate, but it seems so.  The importance of gravitas cannot be overlooked by a society seeking solutions to their problems.  The most brilliant of observations and the best advice might be overlooked when delivered by a messenger without gravitas.  

Therefore, Wall Street and Pennsylvania Avenue are not wrong to seek people to lead their corporations and country that possess appealing qualities.   But careful selection of traits is as important as choosing the potential candidates.  Often qualities like physical attractiveness are given as much weight as gravitas by the selectors.  This is a backwards approach.  The proper approach is to evaluate the position and determine what qualities the position requires rather than comparing the candidates side by side before meeting basic standards.  Comparing the candidates without providing a filter of personal qualities required for the job ends up skewing the criteria for selection.   For instance when the candidates are compared a quality like sense of humor or compassion might propel one candidate to the top of the pack even though those qualities are not significant requirements of the job.  Job skills need to be weighted and evaluated for each candidate before they are placed side by side for comparison.

If you are an American and will be voting to select the next United States President, first evaluate what five hurdle qualities a Presidential candidate should possess.  While you are mulling that over here are my minimum requirements:

·         Experience raising a child

·         Graduate school experience (could be as a perceptive janitor)

·         Three years of experience in a minimum wage job

·         Ten years of Private Sector experience

·         Gravitas

With that type of experience a candidate would have knowledge of all the most significant activities of human life: child rearing; higher education; the bottom of the economic ladder; understanding of the operation of the economy; and the ability to convey ideas.  Note, I do not think any experience in political life is necessary.  What is your list?

Need for New Economic Theory

I just came across a paper published in April 2010 that shares a number of the same assumptions underlying N Theory.  It is the work of three economists: Orio Giarini working in Switzerland; Garry Jacobs an American working in India; and Ivo Slaus working in Slovenia.  Their paper is titled: "Introductory paper for a programme on The Wealth of Nations Revisited."

Like N Theory they begin by recognizing that our economic system is a social system created by humans and therefore, can be modified by humankind.  Similarly, they point out the world has changed in the past couple of hundred years and yet out current economic theory is "constructed on a foundation laid more than 200 years ago."  The authors of the paper point out that "today the world suffers from excess production capacity backed by insufficient purchasing power."  N Theory starts from this same point showing an insufficient supply of money in the hands of people.  A supply inadequate to support the productive capacity available to fulfill all wants and needs.  N Theory states this is the problem with conventional economic theory.  It does not achieve the purpose of economics: wealth creation adequate to provide for basic necessities.  As Giarini, Jacobs and Slaus note "classical and neo-classical economic theory incorrectly focus on the central importance of supply and demand, rather than on the central importance of human welfare."  In the Rule of Money a couple of chapters are dedicated to showing the inadequacy of supply and demand theory.

N theory makes wealth creation central to the goal of a new economic system since implementation of effective change will require financial resources.  In N Theory the Wealth Rule: The purpose of a monetary system is to create wealth, plays a dominant role in deciding among what sector of the economy should be in charge.  The three authors of the paper cited above agree with this approach when they state; "The goal of economic systems is the generation of wealth to promote human welfare." 

Agreement among economists about the idea of wealth creation alone would provide a benchmark for evaluating economic policy.  Much of economic policy activity surrounds fixing holes in the dyke rather than understanding the goal is to keep seawater out of the wetlands.  If the repair is inadequate and results in the collapse of the dyke then a new system needs to be constructed.  We can do that since as the paper points out, "As distinct from physical systems, social systems are man-made and purposeful.  They are capable of conscious adaption and evolution."

N Theory is a new purposeful system that intends to create more worldwide wealth and distribute in a fair and equitable way.  Along the way this process will eliminate the special privileges that the influential and powerful possess.  N Theory is just the first step, but it is a map that can point the way.

It is encouraging to see prominent economists from Europe are along on this journey.

Upside Down Asset Pyramid

The Icelandic Banking Crisis is a good lesson for every financial manager to remember.  In a country of 300,000 people the banks grew assets from $1 billion in 2000 to $140 billion in 2006.  Little of this money came from depositors.  Most of the funds came from the issuance of bank bonds.  All of which needed to be paid back with interest.  It was attractive to bond investors to make these purchases since the market prospects for the banks looked so positive.  The bonds looked extremely secure since the bonds paid a 3% interest in Yen or Euros, and money could be lent at 15% in Icelandic Kroner (the prevailing interest rate for Icelandic loans).

Unfortunately, the interest spread is only stable if the currency values do not change relative to each other.  When the inevitable currency collapse occurred the loans in Kroner were returning less than the interest due.  Unfortunately, without a central bank Iceland had no way to protect their currency. Since the bank depositors were making deposits in Kroner and the bank needed to pay back their loans in Yen and Euros the situation only got worse and worse.

Although the poor financial decision making of the Icelandic banks caused the crisis, their decisions like the investments in RMBS during the housing boom of the early 21st century were not egregious or fraudulent.  The time for throwing stones should come to an end and be replaced with a thoughtful strategy to avoid the problems reoccurring.  The easy, but incorrect solution is to throw the bums out.  The problem with that approach is there are always going to be bums.  It is human nature.  What we need is a system that prevents the bums from getting into positions of authority.   That is probably impossible also.  Our next best alternative is a system that prevents the bums from taking advantage of the system.

I suggest we return to the original solution that led to the creation of central banks, spreading the risk.  The original purpose of central banks was not to control the Money Supply or set interest rates or the most ridiculous of all, increase employment, it was to spread the risk of a bank run across the entire banking industry. 

What we are discovering with the European Debt Crisis is even a continent is not larger enough to absorb the losses of a financial mistake of a single country.  Therefore, why not expand the community of banks to include the entire world.  The banking industry could achieve this without government assistance.  It would simplify regulation and with a large Private Sector insurance agency providing the backstop for the banks it would remove government from a business they do not understand and they could focus their resources or building missiles and outfitting Presidential jets.

Government spending & economic growth

As politicians argue back and forth about how to stimulate the economy with government spending the Republicans are beginning to challenge some of the basic assumptions of Keynesian economics.  The most basic assumption is whether government spending actually does stimulate the economy.  One assumption Keynes made about economic growth was the fact it could occur without a profit.  We know this since he stated government spending would stimulate economic growth.  Governments do not have profits.  In N Theory economic growth requires a profit event.  N Theory states an entity that spends money without making a profit does not contribute to economic growth.

The argument in N Theory is that spending without making a profit is equivalent to a barter transaction.  It is simply moving the current money supply from one hand to another.  Economic historian Robert Higgs noted this is equivalent to taking water out of the deep end and pouring it into the shallow end.  Would more buckets of water moved from end of the pool increase the amount of water?  Would a line of people stretching from one end of the pool moving water from the deep end to the shallow end rapidly increase the amount of water in the pool?  Economists believed in just such an absurdity for over 100 years.  In fact, the U.S. Federal reserve still abides by this theory.  These examples are an adequate description of the theory of the Velocity of Money (MV=PQ) upon which our understanding of the supply of money rests.   The speed upon which this transfer is made is suppose to increase the wealth in the economy.  Without disparaging the work of Irving Fisher and Alfred Marshall (mentor to Keynes) it amazes me anyone would accept such nonsense.

Such absurd concepts also underlie the idea of redistributing the wealth of the rich.  The Democratic party in the United States does not understand taking money from the hands of  people who know how to make a profit and putting it into the hands of people who will spend it, does nothing to expand the Money Supply of the country. It is just a transfer.  It is barter level economics.  A barter economy never grows.  It simply stagnates as profit making economies grow and inflate the value of their money.  A redistribution economy is doomed to failure.

This brings us to the absurdity of government investment.  N Theory states government investment is an acronysm, because the government does not make a profit.  Without a profit making possibility an investment cannot increase in value.  By definition purchasing something that does not grow in value is not an investment. Infrastructure investment is always pointed out a bright star of government investment, but even that is not valid unless the investment helps a Private Sector business earn a profit.  Some infrastructure investment do in fact enhance the profit making potential of the Private Sector.  Some do not like new police cars, public building parking lots, school construction, parks, improvement government buildings, new computer systems for public agencies, etc.  This is one of the strongest arguments for privatization since all these capital investments do have value in the Private Sector since they make profitability possible.