Wednesday, October 15, 2008

Imaginary Worth, Empire of Debt: How Modern Finance Created Its Own Downfall

Longtime contributor Zeus Yiamouyiannis has managed the difficult task of explaining the arcane world of credit default swaps (CDS) in the four-part series below. Here is his overview/introduction to the series.

This week's theme is "the positives" in our current situation, and the positive here is this: we can place the sources of our problems in the proper contexts.

Those bent on "manufacturing consent" must first de-contextualize reality so the targets of the propaganda are shaken free from any mooring to reality. Then the propaganda invokes fight-or-flight emotions (fear) or triggers the defense of some base values.

So rather than accept the propaganda "explanation" of the bailout and accept our elected official's bleating excuses for their consent, we can understand the reality operating beneath the sludge of the Mainstream Media's parroted "official version."

Imaginary Worth, Empire of Debt: How Modern Finance Created Its Own Downfall
"How did we get here? The current global financial unraveling and meltdown has brought us face-to-face with a stark and uncomfortable truth: with all its reassuring numbers, our financial system is a human system, based on human frailties and desires, resting almost completely upon imaginary notions of worth.

Historical financial innovations have led us piece by piece into a phase shift from ownership of real assets to control of concocted wealth that no longer has a credible authoritative connection to productivity, life needs, or the day-to-day requirements of commerce.

From the bartering of material goods and services, to the convenient exchange of dollars no longer backed by anything but faith, to "creative" financial vehicles that leverage essentially symbolic wealth to an infinite degree, we have progressively departed from the foundation of what was once considered financial worth—the competent stakeholdership, ownership, and stewardship of real property involving labor, earnings, investment, risk, reward, and responsibility.

In other words, we’ve reached the "asymptote," the mathematical limit whereby even an infinite increase in concocted value produces no growth of worth on the real level. We are now caught in a circle of absurdity-- lending and borrowing derived from credit derived from collateral derived from inflated assets derived from future returns derived from “marked to model” value derived from unlimited growth and ability to pay. This last assumption is not only wrong but could never be right. The pyramid scheme has reached its limit. Finite goods cannot play out in infinite terms.

The problem comes from a reverse engineering of the world, amid global capital premises designed to extract, exploit, and concentrate wealth through the maximization of profits, profits, which have become increasingly dependent on maximum short-term competitive returns. This has accelerated the saturation of the global economic system. Much like a biological cancer single-mindedly programmed to take over the body, rogue financial instruments and players have mindlessly aimed for growth at all costs. Faced with the limits of growth to real wealth, the financial system has manufactured what has been called a "shadow banking system" that creates "value" out of whole cloth by simply assigning and exchanging it. This has culminated in a 70 trillion dollar market for credit default "swaps" (CDSs), an unregulated insurance, which is the subject of the following essays.

In the following essays I also point to several basic natural laws of systems, that were simply ignored or overridden in the greed-driven frenzy to manufacture growth:

Infinite growth is impossible in a finite system. One can be very creative about assigning worth and developing unlimited growth in assigned worth, but real worth remains constrained to its moorings—can it create quality of life, can it feed, shelter, and clothe, can it produce clean air and water, can it create lasting fulfillment? Even the magic of percentages and myths about "houses always going up in value" assume unlimited growth in environmental and financial systems with limits. Infinite growth premises are demonstrably false in finite systems. What they really seem communicate is, “Let the next generation deal with the consequences as long as I get my maximum returns now.” Infinite growth can happen in non-finite systems, and I indicate some of those possibly pro-social non-finite systems of exchange in my last essay.

There is no such real thing as "externalized" liability in a global system. As with the exploitation of natural resources, there is always a cost to any action, which seeks to extract value. Someone has to pay the price. The more interconnected a system, the more readily and strongly that price will turn up to affect all the players including the initial beneficiaries.

Finance systems need to be straightforward and transparent. This one would seem a no-brainer, but objectively speaking non-transparency has been a very large part of late capitalism, aiding concentration of wealth and enabling the unfair and sometimes illegal benefit of some players at the expense of others. This isn’t just about something obvious like insider trading.

Corporations have started shell companies to hide off-the-balance deficits. As explained in these essays, financial institutions marked their assets "to (their own) model" without fully revealing their assumptions. Rating agencies assessed junk as AAA, facilitating the sale of that junk to pension funds, who were only interested in secure investments. All this was hidden behind so-called "complexity" (a mantra repeated brainlessly in the media), a Rube Goldberg device of financial levers whose sole real purpose was to hide unscrupulous and unreasonable practices.

Debts are not assets. As I explain in the following articles, buying debt can appear to be a good investment on paper, but this rests on ability to pay. When debts are so constructed to create unreasonable re-payment (fast accelerating interest and principal payments rapidly outstripping the equity of collateral) they will fail.

Monopolies and concentrations of wealth ruin economies by binding up the flow of goods and services and freezing exchange. Healthy systems both natural and financial depend upon high diversity and exchange among distinct entities each offering something of real value. This is why a rain forest is considered a very rich system—many niches, many species all participate in the web of life.

This is why Henry Ford said he needed to make his wages high enough and his cars cheap enough for his own workers to buy them. This is why a large middle class is the bedrock of a functioning democracy. As I mentioned in the following essays, debt instruments had the effect of swallowing the normal citizen and worker’s paycheck paralyzing his or her ability to spend after the borrowing value of his or her assets (i.e. houses) were tapped out. This has been exacerbated in America by declining real wages, non-compensated increased productivity, and outsourced jobs. This has been further demonstrated by banks’ unwillingness to lend to each other. When the flow of money stops, financial systems seize up.

Without regulation and actual risk involving real consequences the financial system and its leaders will run wild. This one would again seem to be obvious, yet this law was ignored as well. Myths about the superiority of a market based on greed and acquisition to regulate itself don’t make any sense even on the face. Yet the world system, and in particular the American system driven by neo-conservative ideology, hailed deregulation as the triumph of "freedom."

Chief executive officers of large corporations could take huge risks for their companies and reap hundreds of millions of dollars of salaries, or completely run their companies into the ground as those risks came home to roost and get "only" tens of millions of dollars of golden parachutes. Reckless behavior is guaranteed if it is rewarded more than prudent, intelligent behavior in an economic system. From an acquisition standpoint, this is individually "rational" behavior, even though it is unhealthy and irrational from a system standpoint.

The question might be asked, "Why were all these very simple and obvious maxims ignored? What were people thinking?" I think much of it centers around the fact that people’s education and identity still has its roots in a long-past industrial age. People still tend to make their meaning and choices based upon largely myopic, compartmentalized, and stratified knowledge. Even well educated people rarely look deeply into the big picture and to whether their particular perceptions, assumptions, and knowledge reasonably fit with other parts of a system. Generally, if we can make some money, feed our families, and have some fun, we don’t really care what the system is doing. Now we are invited to engage bigger-picture thinking as a necessity in our day-to-day life.

I confess that I am not a financial wizard. I have a Ph.D. in philosophy of education (with an emphasis in cultural studies and psychology) with a natural sciences and math undergraduate background. This has allowed me to gain the tools to look at systems and the specialized skills to examine the various parts of systems. Natural sciences helped me apprehend existing systems, both natural and human. Psychology helped me to investigate motive. Philosophy helped me to question assumptions and test "common sense" thinking. Cultural studies helped me understand context. Math helped me check the actual numbers and formulas that financial systems were using. It is my small hope that these essays can help revive a liberal, integrated, imaginative, and critical examination and creation of the world around us.

Thank you, Zeus. Please read the entire series of essays below.

Reader Essays:
(all essays by Zeus Yiamouyiannis, Ph.D., copyright 2008)

Part I: A 70 Trillion Dollar Counterfeiting Ring(Zeus Y., September 23, 2008)
According to several sources the market for so-called "credit default swaps" last year alone was nearly equal to the total global GDP, around 70 trillion dollars by some estimates. Yet these derivatives have no discernible "origin" or value.

Part II: How the Credit Default Swap Scam Works (Zeus Y., October 13, 2008)
Instead of asking the obvious, complex, and obscuring question, "What value DO they have?”, one should ask the elegant and simple question, "What value COULD they have?" Even a cursory examination would seem to indicate that the answer is either zero or less-than-zero.

Part III: Credit Default Swaps Create Less-Than-Zero Value (Zeus Y., October 13, 2008)
Now, how can a supposed "asset" like credit default swaps have a “less-than-zero” (negative) value. First, credit default swaps were insuring debt. Debt is not an asset as I explained in previous essays, but a liability. Mistake number one was to confuse asset and liability.

Part IV: There Is Ultimately No Gaming the System: When the Micro Crash Reflects the Macro Crash (Zeus Y., September 29, 2008)
The proposed 700 billion dollar bailout cannot really “work” from a system level. I know it’s real intention is to cover the butts of Wall Street investors, but you have the same problem in macro that homeowners have in micro. Nobody knows what homes are worth right now, so buyers are sitting it out. It isn’t about restricted credit (even though that is a factor). It isn’t about being too cash strapped to make a down payment (though that too is a factor). It’s about not wanting to be suckered into buying something that may still be overpriced.

Sarah Palin, Queen of the Red party. The lyrics helpfully pop up for your reading pleasure.

Thank you, Rudolf C. ($5), for your very welcome donation to this site. I am greatly honored by your ongoing support and readership.

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