Financialization of the economy

When financial markets have more liquidity than can be invested in the real economy then it goes into speculation. The speculators, which includes banks, other financial institutions such as hedge funds and some wealthy individuals, are plainly getting rich so if it isn't coming from producing valuable products and services for consumers then it is necessarily extractive; i.e., it comes from claiming a bigger share of the pie. Better regulation is a fine idea but by itself it will be largely defeated because ways to speculate will always be found as long as liquidity is excessive.

Why is liquidity excessive? It has been at least since the 70s when the last link between the US Dollar and gold was severed allowing the Fed freedom to manage the money supply mainly for the purpose of avoiding recessions. The strategy for accomplishing this was to aim for a steady, moderate rate of price inflation. In an economy without a fiat money supply a certain amount of price deflation is natural due to technological advance and accumulation of capital resulting in rising productivity. I believe persistent excess liquidity resulting in speculation, excessive debt and the financialization of the economy is due precisely to the anti-recessionary strategy of the Fed, (also adopted by other central bankers). Unless we find a better way to either avoid or live with recessions, speculation and anti-productive financialization of the economy is sure to continue regulatory reforms notwithstanding.

What we are looking at now

After the real estate and financial bubbles burst in 2008 there was an awful lot of denial, mainly by politicians and pundits but even among many government, business and academic economists who should have known better. (Of course, there were a few who even saw the catastrophe coming, but they were routinely dismissed). The truth all along has been that there was no easy way out from the Great Recession. Serious mistakes were made and somebody would have to pay, the only real question being who.

Government policy, monetary and fiscal, is basically up against the logic of the "misery index". For being quite crude the MI is remarkably effective at measuring the over all health of the economy. Invented in the 70s by economist Arthur Okun, it is calculated by simply adding the unemployment rate to the inflation rate. It tells us that there are basically three tracks the economy can follow after a crash, all bad, and government can pretty much choose its poison.

One track is to do little or no stimulus and let the economy fall to the very bottom with very high unemployment and liquidation of debt through defaults, business failures and bankruptcies. This course may seem to have little to recommend itself but savers would benefit from deflation and capital would be find its way most efficiently to new allocations. This leads, eventually, to the soundest recovery, (if insurrection doesn't happen first).

Another track is that of hyperinflation through very high levels of fiscal and monetary stimulus. This course also features rapid debt reduction but this time by devaluation rather than default. Savers are severely punished but more businesses stay afloat, consumer spending is stimulated and unemployment falls. This sets up the next bubble.

The third way is "stagflation", a middle course designed to avoid the worst extremes, but only the worst extremes, of the other options. Debt reduction is slow with minimal defaults, favoring creditors. This comes at the cost of delaying eventual recovery and there is some permanent residual weakness due to prolonged unemployment. It is what we are looking at now. 

Trouble for the Dollar

A MarketWatch headline reads: "Chinese official urges buying of gold, U.S. land: report". This is, of course, a recommendation to get out of US dollar denominated financial assets and is not the first indication that China and other foreign holders of such instruments are worried.

As "AdammSmith", (underscores not allowed in screen names at this site), I posted a reply which I will copy here:

Blame for the fate of the dollar may fall on the housing and mortgage banking industries, unregulated derivatives and government's "ownership society" social engineering that created a class of weak mortgagors. All that, however, is only responsible for determining the sectors in which extreme bubble conditions occurred. The more nearly correct explanation lies with the decades long excessive use of credit and lack of savings by households, businesses and government alike guaranteeing that a bubble of some sort would be inevitable. This was enabled by persistent monetary ease by the Federal Reserve, but that, in turn, was required to maintain labor employment in an economy which could not sustain acceptable employment levels on the basis of production for consumption alone. The ultimate cause of today's economic turmoil and the dollar's falling attraction is the decades of diversion of real resources to economically unproductive use -- specifically, maintenance of US military industrial global hegemony, a relatively subtle form of empire.

Arguably, this was a justifiable cost of winning the cold war up until the collapse of the Soviet Union but since then it has been nothing but blow-back producing geostrategic games playing for the satisfaction of politicians and citizens with a lust for meddling abroad with financial benefit concentrated in defense related companies and other industries helped by an internationally bullying government in the securing of cheap foreign resources, including labor.

Empires may be very profitable for the few in the short term but are not economically sustainable for the long term. The long term results are coming into view now.

Inflationary policies mask, for a time, but do not eliminate the cost of empire. The inflation itself need not appear as a large general price increase if it is concentrated in one commodity or class of commodities, such as financial assets. That is the essence of a "bubble". A general price increase in the aftermath of a bubble burst can be avoided by a sharp monetary contraction but won't be because that is the formula for a deep recession. It can also be avoided by funds finding a speculative investment to inflate into a new bubble. This could happen with gold if there is a panic flight to perceived safety in that commodity. To some extent, not very much I think, real estate values might be re-inflated. Most likely, however, there will be inflation in prices generally. Right now this is being delayed by a classic liquidity trap. That is the meaning of the reports you see that banks are not lending. They are unintentionally preventing general price inflation by hoarding massive quantities of essentially idle funds. In time they will start to invest, since they aren't totally stupid, in inflation hedges -- mainly companies that produce basic commodities. Then excess liquidity will begin to spread to the broader economy.