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10/16/08 Deleveraging

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Deleveraging. That’s a word that we are likely to hear over the near term as the bailout and rescue plans around the world attempt to stabilize the financial system but have little effect on the contraction of economies. In less obtuse terms, the wealth that was created on paper without any underlying assets is going to see a steady decline in value. Insurance policies (CDS’s) purchased to hedge against these losses will be settled for far less than their face value. Companies that used derivatives and debt financing to bolster their bottom lines will see a decline in their profits and their stock value.

None of the plans that the central banks are implementing will stop this process from happening. The efforts that are currently underway are designed to “unclog” the credit system but even Mr. Bernanke admits that this will take some time; banks are actually looking at creditworthiness with a high degree of skepticism and they will likely be very choosy about who they lend their money to for some time to come. In the meantime, we are starting to hear proposals that will directly affect people who are struggling to stay in their homes. The economics of this makes sense although we will likely hear cries of “socialism” from some of the political class and we will find that there is some resentment from those who have been paying their fixed rate mortgages for the past twenty years. One way or another, we are going to reduce the level of debt in the United States. Some of it will be very painful.

As we go through this process it is very important that we understand how our financial system works and whether or not there are fundamental changes that we want to make as we go forward. One of the key components of the existing system is interest. Banks make money by charging for the use of capital. The problem is that when a bank loans money it “creates” the principal (to understand how this creation is done see ) but it does not create the interest. Here’s a simple example:

You go to the bank and borrow $1,000. The interest rate is 10%. The bank puts the $1,000 in your account but does not create the $100 that you will need to pay back the loan – it doesn’t exist. If you multiply that small transaction by hundreds of millions you can easily see that there is a great deal of money missing in the economic system; it necessarily becomes out of balance. A “bubble” is the only way that the economic system can right itself – it inflates the value of something (internet companies, real estate, etc.) in attempt to generate the money necessary to pay the interest. Viewed from this perspective it becomes clear that bubbles are a necessary component of the current economic system. It is no surprise that they occur with regularity.

I would suggest that it is not useful to argue about whether this is a conspiracy theory or some grand design by the few to control the many. I’m not particularly enamored with seeing myself as a victim and I don’t think that approaching these issues from the perspective of an aggrieved party is particularly useful. What is constructive is understanding how something works and making a determination as to whether it should remain the way it is or be changed.

Banks need to make money to function. The economic concept of charging for the use of capital is not going away anytime soon but perhaps we should consider creating the money to pay for that use at the same time that we allow people to take out a loan. In a new model for banking that would significantly reduce the need for bubbles, the interest could be created at the same time that the loan was created. In our very simple example above, instead of creating only $1,000, the bank would create $1,100. It would keep the $100 and either loan it to someone else or use it to go out and buy printer paper or pencils. In doing so the interest would be in the system and available to be earned by the borrower and paid back to the bank.

A more fundamental concept is also in play here. The lack of money available to pay the interest has a divisive effect on all of us. We are competing in an environment of scarcity. People tend to behave badly when there isn’t enough to go around.

The solution to this problem is not more regulation (although there is no doubt that the rules for ethical participation in the marketplace need to be reinstated). The history of regulation is that it slows this imbalance from accelerating in the early stages of implementation, but then human beings become very creative in finding ways to develop markets where the regulations don’t’ apply. Furrowing our brows and vowing to do better, while perhaps not ingenuous, won’t work. The system is designed to create bubbles.

In the meantime, we have deleveraging. We are discovering that all the wealth that was created is evaporating and the system will continue to reduce the value of real and derived assets until it approaches some level of balance. And then, unless we change something, we will start all over again.
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It has been brought to our attention that Margaret is being portrayed as a psychic on $1.99 sites. These sites are doing so without Margaret's permission. Margaret has not claimed she is a psychic. - MW