One of the problems in economics, an academic discipline that consists of little else but problems, mostly intractable, is that the models used to describe human activity tend to be static.
There is little attempt to alter the models as the system changes. History is ignored. Instead, there is an attempt to establish supposedly timeless rules, to mimic the physical sciences.
One example of the folly of this approach is the emergence of the absurd casino that has taken over the global monetary system, the so-called derivatives market (gambles ‘derived’ from conventional transactions). This has never been seen before, and it undermines traditional economic theories.
The global stock of derivatives, according to the Bank for International Settlements, is about $700 trillion, an unthinkably large (albeit notional) amount. It is so large that traditional economic theories about money supply, and its relation to factors like inflation and growth, have been undermined. It has become difficult to define what money actually is. That is why the US monetary authorities jettisoned M1, the most commonly used measure of money supply. It meant that one of the most popular economic theories, monetarism, was rendered useless because it is no longer possible to be confident about what money supply is.
Another example of the shortcomings of conventional economic theories is identified by economist Alan Nasser. He does something that is unusual for economists. He observes history, noting that as industry has matured, the fundamental rules of economics have changed.
The argument is that in the nineteenth century, during the early phases of industrialisation, growth was dependent on the level of investment and the formation of capital (China is still in that phase). Up until about 1920s, that net investment was necessary to keep economies growing.
But as companies became more efficient and innovative, their requirement for surplus net investment eased. Once the basic infrastructure of industrialisation was established the need for additional funding eased. The cost of producing goods also declined because of technical innovation. Capital formation became less significant because businesses became more innovative, a process that has continued ever since.
But economics has stayed firmly fixed in the nineteenth century, focusing on capital formation and its relationship to output. Nasser questions this assumption, which continues to underpin most economic policies in the developed world: 'We are to believe that the surplus that is currently channelled into financial speculation in derivatives and foreign exchange markets, or sitting idle in the coffers of giant private enterprises, should be diverted back to productive investment, which in turn would make possible economic restoration.'
What Nasser calls the 'atrophy of net investment' means that in the late stages of capitalism, capital is in excess and investing it in productive capacity will not generate sufficient profits (he is talking mainly about goods, the argument seems less compelling with services, which have not been subject to the same level of innovation).
He cites the economist Keynes, from Economic Possibilities For Our Grandchildren, who imagined the discarding of a social system premised on giving money a special status, which creates a financial elite. Keynes wrote: 'When the accumulation of wealth is no longer of high social importance, there will be great changes in the code of morals. We shall be able to rid ourselves of many of the pseudo-moral principles which have hag-ridden us for two hundred years.'
It is a challenging idea. Nasser claims that government investment and consumption, and not what the capital markets do, are the only viable means of catalysing growth. This is exactly the opposite of what has happened since the global financial crisis. Governments in developed economies have savagely cut their investment, and consumption has been anaemic. Meanwhile, the financial sector has continued to grow and create extreme wealth. In America, the concentration of wealth in the hands of the top 1 per cent of the population is a reflection of financiers’ success. In Australia, finance is now the largest industry sector.
Why have the controllers of capital thrived when, if Nasser is correct, the importance of private capital in late stage capitalism has declined? The reason is that the finance sector has become skilled at the art of making money out of money. Investing capital in productive capacity is not a good option because the returns are not there. That is why American corporations are sitting on mountains of cash.
But finding ways to manipulate the financial system to create more money from money – such as the derivatives casino – can pay off handsomely. Sure, it may look like a Ponzi scheme, it is a Ponzi scheme, but on its own terms at least it is profitable. Far from the democratic re-ordering of society and the weakening of the money class that Keynes imagined, what has happened is the opposite: an increasing polarisation of wealth and the entrenchment of a financial elite.
This polarisation is less extreme in Australia, where we still have a middle class. But we have our own capital-driven Ponzi scheme – the residential property market. This, too, has become an exercise in making money out of money. In the 1970s, only a third of Australian banks’ loans were on real estate. Now, well over half of the banks’ lending is on real estate, especially residential mortgages, which are basically investments in unproductive land. Meanwhile the banks are less reliant on business loans, which are an investment in productive capacity. These loans attract a significantly higher interest rate than mortgages and most require property as collateral.
The implication is that the financial sector is becoming progressively disconnected from the reality of economics in late stage capitalism. And the mainstream economics profession is aiding this detachment from the real by pursuing timeless scientific principles that do not exist.
The consequences of allowing such a parallel universe to develop became clear enough during the global financial crisis. But the basic lesson, that the money class should not be allowed to set its own rules, has not been learned.
David James is a business journalist with a PhD in English literature. He edits Personal Super Investor.
Money examination image by Shutterstock.