by Eric Zencey
Tue Mar 11th, 2008 at 12:20:16 PM EST
The subprime mess is generally treated as a crisis, a catastrophe, one of those unpredictable pathologies that happen in our economy because the ingenuity of corporate and financial types outpaces regulatory understanding and control. Sure, innovative self-interest will always be out ahead of regulation, as it was here. But what the subprime mess isn't is unpredictable or pathological.
When you understand the thermodynamic roots of economic life, and when you understand how our financial system flouts thermodynamic law, you can see that regular crises like these are a structural requirement of our system.
Current econmic wisdom treats phenomena like inflation, bankruptcy, and the failure of bond issuers to meet their obligations as economic pathologies: wouldn't it be nice to see an end to these things? Maybe with good management we can cruise along without them.
But inflation, bankruptcy, and the failure of bond issuers to meet their obligations are all forms of debt repudiation, and our system has a built-in requirement for some form of debt repudiation, because it lets debt (which is a claim on future real wealth) grow faster than real wealth.
Debt grows through the charging of interest. In the neoclassical economic paradigm, charging interest is normal, but bankruptcy, bond failures, and inflation are not. Paradox, huh?
Here's how the charging of compound interest leads to a need for debt repudiation.
A loan at interest is made in the expectation that the borrower will be able to pay back the loan out of increased income in the future. If we scale that expectation up to the whole system--the economy as a whole--we can see that the obligation to pay back more than you borrowed can be met only if the economy as a whole grows by a percentage equal to the (average) interest rate.
An example? Say I borrow the price of a gallon of milk and promise to pay you the price of a gallon and a pint next year. (Multiply by billions, and apply this to lots of things besides milk: cars, houses, food, clothing, whatever you might borrow money to buy. Which is, basically, all goods and services.) The deal works out fine, if the economy grows enough so that where there was a gallon of milk this year there will be a gallon and a pint next year.
What if there's insufficient growth in real wealth?
I could repudiate the debt--simply fail to pay it. (If I do this systematically, I'm declaring bankruptcy.) But I can stay out of trouble if there's inflation: if prices go up--if a gallon of milk next year costs the same as that gallon and a pint I promised to pay you--I can pay you back the price of this year's gallon and a pint in inflated dollars, which lets you buy only a gallon. I've met my monetary obligation to you but haven't paid you the real gallon and a pint, the increased claim on real wealth that you thought the deal was going to bring you.
Debt is a claim on future wealth--a claim on real wealth, actual things, not just "monetary wealth." Frederick Soddy was the first to distinguish between these; he was a Nobel Laureate in Chemistry who wrote a series of books in the 1920s arguing that economic theory ignored physical reality--the reality described by the laws of thermodynamics. As he put it:
"Debts are subject to the laws of mathematics rather than physics. Unlike wealth, which is subject to the laws of thermodynamics, debts do not rot away with old age and are not consumed in the process of living. On the contrary, they grow at so much per cent per annum, by the well known mathematical laws of simple and compound interest."
Soddy was dismissed as a crank for proposing remedies that fell way outside conventional wisdom in the 20s. His five part program:
- Get off the gold standard; recognize that money is an abstraction, and that we can control the amount of it in circulation.
- Let exchange rates float against each other.
- Use governmental budgets (deficits and surplusses) to achieve macroeconomic goals.
- Collect economic data (on unemployment, consumer spending, factory orders, etc. etc.) to facilitate #3.
- Stop the practice of letting banks create money through making loans at compound interest.
Notice that of the five, four are now conventional wisdom. It's a nice lesson about how outliers -- those voices in the wilderness--are sometimes right. And it makes you wonder if he was onto something with that fifth policy proposal.
Daly, following Soddy, explains what happens when society pits a mere convention (our practice of letting interest compound infinitely) against the physical reality of finite planet ruled by the laws of thermodynamics. Debt, he says, can theoretically grow forever, but real physical wealth cannot, "because its physical dimension is subject to the destructive forces of entropy....Since wealth cannot continually grow as fast as debt, the one-to-one relation between the two will at some point in time be broken- i.e. there must be some repudiation or cancellation of debt. The positive feedback of compound interest must be offset by counter acting forces of debt repudiation, such as inflation, bankruptcy, or confiscatory taxation" -- all of which are seen as pathological phenomena in economic systems.
So: a system that lets debt grow faster than real wealth grows is a system that needs periodic bouts of debt repudiation: bankruptcy, inflation, failed bonds, or other financial events in which claims on real wealth are wiped out.
Within the limit implied by the rate at which real wealth can grow from year to year, this holds true: other things being equal, anybody who "makes money" in investments at a larger rate than that has to be offset by someone in the system who loses out--who holds debt that is repudiated by inflation, bankruptcy, or other failure of investment instruments. If we hold inflation in check then the system needs more bankruptcies and bond failures.
So within this theoretical perspective--Ecological Economics, it is called--the subprime crisis is no surprise. It stands in a series of crises over the past few decades--the Savings and Loan crisis, the Enron affair--in which vast quantities of debt were "repudiated." That's a technical term for something that is very ugly: people invested savings and saw those savings disappear.
One implication of this theoretical perspective is that there is a quantifiable and discoverable relationship between several variables:
Debt Repudiation = growth in debt minus real economic growth
Thus, other things being equal, we'd expect to see more bankruptcies in eras when inflation is low, and vice versa.
Unfortunately, I haven't been able to find good data or the time to play with them in order to tease this out and demonstrate it. It's probably a Ph.D thesis amount of work, or at least a Master's degree. Anyone want to tackle it?
For further reading, see Herman Daly's review essay on Soddy's work, "The economonic thought of Frederick Soddy," in an academic journal, The History of Political Economy, back in 1980.
A good short intro to the subject of thermodynamics as it relates to (and underlies and explains) economic activity can be found in Herman Daly's and Joshua Farley's textbook, Ecological Economics. (I wrote about the book in a diary for the Daily Kos.) A paper by Cutler J. Cleveland on the history of "Biophysical Economics" covers some of the same ground and is available on the internet; see esp. pp. 5-9.
And if you can find it through ProQuest, there's a chapter in my dissertation, "Entropy as Root Metaphor," that discusses Soddy, Daly and others as founding a new paradigm in economics. The work is 20 years old, but the history is still accurate. I gave a precis of that work in an article, "Some Brief Speculations on the Popularity of Entropy as Metaphor," which is available on the internet and has a short discussion of the application of the idea of entropy to economics.