Wednesday, April 03, 2013

The Proper Use of Credit

Great fortunes are built on the proper use of credit. Improper use of credit leads to mal-investment and wealth destruction.

We cannot understand our fundamental financial problems if we do not understand the proper use of credit. Credit has a key role in capitalism; credit-starved economies are underdeveloped economies, as economist Hernando De Soto explained in his masterwork, The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else.

In the chronically underdeveloped economies De Soto describes, households have assets--land, dwellings, small businesses--but since the assets do not have legally recognized status as "property" (because the system for recognizing and registering property is both cumbersome and corrupt), they cannot act as collateral for borrowed capital, i.e. loans.

As a result, the majority of the assets are "dead capital," difficult to sell, pass on to future generations or use as collateral.

Great fortunes are built on the proper use of credit. The borrower needs capital to expand his/her enterprise, and the lender needs a fast-growing enterprise with collateral and an income stream to support a low-risk, high-yield loan.

We can profitably look to Colonial America as an example of a credit-starved economy. In the wake of the Revolutionary war and the ratification of the Constitution (1789), the U.S. financial system was a mess: debts left by the war burdened the new government, which historian Thomas McCaw noted "started on a shoestring and almost immediately went bankrupt."

Differing views on the role of the central government, central bank and credit splintered the political elite, with Hamilton squaring off against Madison and Jefferson (though Madison's views were by no means identical to Jefferson's).

Meanwhile, in the real economy, ordinary farmers and entrepreneurs were desperate for long-term credit to fuel their rapidly growing enterprises. Though states were banned by the Constitution from issuing their own currency, states got around this prohibition by granting bank charters. The banks promptly issued the credit that an entrepreneurial economy needed.

The political elite, regardless of their differences, were appalled by this explosion of privately issued and essentially unregulated credit, but this access to credit--turning "dead capital" into collateral--fueled the astonishing growth of the U.S. economy in the 1790s and early 1800s.

The American economy in this phase was anything but orderly or well-regulated.Wild and risky better describe the financial and commercial chaos of the era, but this untamed capitalism led to more successes than failures, and the bankrupt enterprises and busted banks were absorbed by the fast growth of the real economy.

This chaotic explosion of credit and entrepreneurial drive was the opposite of central planning. Risk was everywhere; security in today's meaning did not exist.

The key to the proper use of credit is that it is invested in productive enterprises at a high rate of return. Risk cannot be eliminated, it can only be suppressed or transferred to others. This is the lesson of Benoit Mandelbrot's masterpiece, The Misbehavior of Markets: A Fractal View of Financial Turbulence.

All the complex machinations of the financial magicians in the 2000s to eliminate risk failed, for the profound reasons Mandelbrot explains.

A high rate of return (i.e. a high interest rate) leads lenders to transparently accept risk, and entrepreneurs to only borrow for the highest-return enterprises. A low-yield, high-risk investment is not worth funding. We call these mal-investments or unproductive uses of capital.

In our era, the Federal Reserve and Federal policies have massively incentivized mal-investment and unproductive uses of capital. Low interest rates destroy the needed discipline on both lenders and borrowers to only risk capital in the highest-return, lowest risk uses.

The Keynesian Cargo Cult's blind spot is they do not distinguish between productive and unproductive uses of capital. A bridge to nowhere is equally as worthy as a truly productive investment to Keynesians, because their cult believes that any borrowed-and-spent money is equally good at boosting their false idol, "aggregate demand."

But a truly productive investment of capital has a multiplier effect; it stimulates not just consumption but increased output and productivity. Mal-investments (duplicate MRI tests, McMansions built in the middle of nowhere, etc.) have no multiplier effect because they are simply forms of consumption--they are not even investments, though they are presented as investments by those feeding at the Federal/Federal Reserve trough of zero-interest credit and "free money" distributed by the government.

For credit to be productive, there must first be productive uses for the capital. In an economy with over-capacity in virtually every sector, a massive surplus of labor, a predatory financial sector and a grossly inefficient government in thrall to crony-capitalist cartels, truly productive investments are few and far between.

Instead we borrow trillions of dollars to squander on wasteful consumption and claim it's an "investment." Consumption is not investment, but this simple truth is taboo in our financialized, centrally planned Empire of Mis-Allocated Capital.

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Things are falling apart--that is obvious. But why are they falling apart? The reasons are complex and global. Our economy and society have structural problems that cannot be solved by adding debt to debt. We are becoming poorer, not just from financial over-reach, but from fundamental forces that are not easy to identify or understand. We will cover the five core reasons why things are falling apart:

go to print edition1. Debt and financialization
2. Crony capitalism and the elimination of accountability
3. Diminishing returns
4. Centralization
5. Technological, financial and demographic changes in our economy

Complex systems weakened by diminishing returns collapse under their own weight and are replaced by systems that are simpler, faster and affordable. If we cling to the old ways, our system will disintegrate. If we want sustainable prosperity rather than collapse, we must embrace a new model that is Decentralized, Adaptive, Transparent and Accountable (DATA).

We are not powerless. Not accepting responsibility and being powerless are two sides of the same coin: once we accept responsibility, we become powerful.

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