Financial breakdown

Capital pays for buildings and machines, energy and raw materials, transport and advertising, and it pays wages and taxes. But, on the market, capital obtains more than it has spent, it makes a profit. Capital has the capacity to get more value out of the market than it puts in, an extra value that is supplied by consumer debt. In other words, labour and government must borrow to pay capital’s profits.

The essence of capitalism is accumulation. Profits are invested for increased returns. And this growth in production and profits needs an equivalent growth in borrowing. So debts pile up – paying them back would reduce demand – until their sheer quantity smothers everything. When everyone is in debt, it gets harder to lend them more.

Present profits are paid for with future incomes, more spending today and less spending tomorrow. Growth is said to attenuate this drop in spending, but growth generates more profits that must be matched by more borrowing. The historic solution to excessive levels of debt has been the double effect of inflation. It reduces the value of past debts and, by raising interest rates, it discourages new ones. Inflation is also the ruin of debt holders who see their incomes and capital melt away. Periods of high inflation occurred in the 1910s, 40s and 70s. The first two are associated with world war, and the third with rising oil prices. But their regular recurrence suggests a common mechanism and the likelihood of an overdue repetition in the near future.

Inflation is said to occur when too much money is chasing too few goods. But it also occurs when prices are raised to compensate rising wages, taxes or production costs such as energy. And when there is inflation and when labour is organised enough, there is a struggle to maintain the buying power of wages. This upward movement of wages and prices can lead to hyperinflation. At present the very opposite is happening. Instead of spending people are paying back debts, a lot of production is well below capacity, wages have shrunk in real terms to where they were forty years ago, and prices are being pushed down by competition. The trend is deflationary, with too little money being chased by too many goods.

Inflation measures variations in the prices of a “basket” of goods and services. Its contents vary from country to country and from one index to the other. They do not necessarily include housing. This price comparison goes up constantly at varying speeds. Though some contents of the basket may fall in price, the general move is up and deflation is exceptional. However, without actually going negative, low inflation is a symptom and a cause. It shows that demand is slack because incomes are stagnant or shrinking, and it means that production must comply by stabilising or constraining its output. Investments and job creations are postponed.

Other price inflations in real estate, stocks, commodities and bonds are called bubbles because they inflate and deflate, while their long term prices tend to follow that of the basket. These bubbles are driven by speculation with money made and money lost. They jump from one domain to the next, from New York to Chicago, to Miami and back again, and are the consequence of vast quantities of cash and credit moving around in search of profit. It is a game where some, such as Warren Buffet or Ray Dalio, win and many lose. Buffet has made billions from other people’s miscalculations. It is as though he had raked in the nation’s savings at an average rate of one hundred million dollars a month for the past forty years or, starting with a million, had compounded more than thirty per cent yearly profit for the same time period. That is an amazing and unequalled feat, but it confirms that gambling is the only way to get rich.

Capital needs debts to pay its profits and allow it to accumulate. This accumulation takes the forms of productive investments and debt. The profits of industry and commerce compete with the interest on debt. In times of monetary stability (low inflation), the fixed interest paid by debts offers more security than the contingent profits of enterprise. In times of monetary instability (high inflation), past debts are devalued whereas profits are a function of market prices that are going up. In the first case, demand for security brings down interest rates (they are actually at historic lows, verging on the negative). This low interest is compared to corporate dividends, and the difference is reduced by rising share prices. As the price of bonds and shares increases, the income they generate per unit invested shrinks. This is a problem for pension funds, insurance companies and banks, as they hold a lot of both and draw much of their income from interest and dividends. They are tempted by riskier more profitable investments. In the second case, the value of money is constantly being degraded. This means that all those who can will raise the price of their goods and services. But bonds and debt in general, like banknotes and coins, have their numerical value printed on them, and the interest paid is based on that number. Inflation devalues past loans and their incomes, and it pushes up interest rates on new debts as lenders try to compensate the future devaluation of their investment. Prices are rising and wages are struggling to keep up, so demand concentrates on essential food and fuel. The result is that many companies find it hard to maintain their sales and their profits. They tend to contract in size and value.

Low inflation piles up debts and reduces returns on investments. The sheer mass of accumulated capital makes its remuneration increasingly difficult. Demand slows down, but the drop in income has less effect on those who had excess income than on those who were already living frugally. The rich get by as usual, while the middle classes suffer and take on more debts. Prices go down, forcing businesses to restructure and cut their spending, while cheap borrowing facilitates mergers and acquisitions. High inflation devalues existing debts and makes new borrowing more expensive. Rising prices are constantly ahead of wage rises. Profits are threatened by the growing cost of inputs and by slackening demand as household spending focuses on essentials. The devalued currency helps exports and hinders imports. The process exists because debts accumulate to pay for profits, and then inflation erodes them to the point where they can grow again. The question is, how is monetary stability disrupted, why does inflation suddenly push up prices and why is that not happening now?

Past bouts of inflationary fever have been blamed on war and oil prices. Today’s wars, though extensive, do not mobilise national wealth the way they did during the two World Wars, and the ups and downs of oil prices these last two or three years have had little impact on the general cost of living. Prices are dismally stable or falling, wages have regressed forty years, so debts are rolled over and interest is paid, and future prospects are just more of the same. Except that when debts stop growing, so do demand and profits. This explains the present price competition, notably in the steel industry and the retail sector. Falling demand pushes down prices and eliminates the less competitive. This in turn reduces employment and shrinks demand even more, in a sort of downward spiral. The only way out is a cancellation of debts, and the usual tool is inflation. In the past it seems to have taken hold by itself, but nowadays governments and central bankers are striving unsuccessfully to reach a very modest 2% inflation. In fact today’s globalised finance may be subjected to another form of debt cancellation, default and bankruptcy, a subprime crisis hitting over-leveraged businesses and countries around the world. One thinks of Puerto Rico, Venezuela and China, but the rest of the planet is in the same bag. It would be unprecedented and more sudden than the gnawing away of inflation. This chain reaction could well occur this year. It might even spoil the Olympics (if the Zika scare does not cancel them), as Brazil is among the closest to the brink.

Five or six years ago I was expecting inflation, it never came. This alternative prediction may also be wrong, but the problem of debts has not been resolved and everyone realises that something has to give way. It is the what, the how and the when that are illusive. It is conceivable that massive defaults on debts will result in inflation. If businesses and countries fail production will fall, GDPs will shrink and all the existing debt, credit and fiat will swamp the markets and push up prices. And, if high inflation were to set in early, a global default might be avoided. The richest 1% may be able to save their situation and start all over again. Whereas a worldwide bankruptcy would level the playing field, except for weapons, resources and technology. Considering the aftermath of a financial breakdown, it looks pretty bleak. Even today’s abhorrent status quo may be looked back on with nostalgia in a decade or two, but it is moribund and resuscitation with quantitative easing and other monetary sleights of hand is only prolonging its agony.