The ABCs of Paulsonâs Bailout Michael Hudson Information Clearing House October 22, 2008 "Treasury Secretary Paulsonâs bailout speech on Monday, October 13, poses some fundamental economic questions: What is the impact on the economy at large of this autumnâs unprecedented creation and giveaway of financial wealth to the wealthiest layer of the population? How long can the Treasuryâs bailout of Wall Street (but not the rest of the economy!) sustain a debt overhead that is growing exponentially? Is there any limit to the amount of U.S. Treasury debt that the government can create and turn over to its major political campaign contributors? A generation ago Hyman Minsky gained a following by describing what he aptly called the Ponzi stage of the business cycle. In times past, national debt typically was run up by borrowing money from private lenders and spent on goods and services. The tendency was to absorb loanable funds and bid up interest rates on the one hand, while spending led to inflationary price increases for goods and services. But the present giveaway is different. Instead of money being borrowed or spent, interest-yielding bonds are simply being printed and turned over to the banks and other financial institutions. The hope is that they will lend out more credit (which will become more debt on the part of their customers), lowering interest rates while the money is used to bid up asset prices â real estate, stocks and bonds. Little commodity price inflation is expected from this behavior. The main impact will be to reinforce the concentration of wealth in the hands of creditors (the wealthiest 10 percent of the population) rather than wiping out financial assets (and debts) through the bankruptcies that were occurring as a result of âmarket forces.â Is it too much to say that we are seeing the end of economic democracy and the emergence of a financial oligarchy â a self-serving class whose actions threaten to polarize society and, in the process, stifle economic growth and lead to the very bankruptcy that the bailout was supposed to prevent? Everything that I have read in economic history leads me to believe that we are entering a nightmare transition era. The business cycle is essentially a financial cycle. Upswings tend to become economy-wide Ponzi schemes as banks and other creditors, savers and investors receive interest and plow it back into new loans, accruing yet more interest as debt levels rise. This is the âmagic of compound interestâ in a nutshell. No ârealâ economy in history has grown at a rate able to keep up with this financial dynamic. Indeed, payment of this interest by households and businesses leaves less to spend on goods and services, causing markets to shrink and investment and employment to be cut back. Banks cannot make money ad infinitum by selling more and more credit â that is, indebting the non-financial economy more and more. Government officials such as Treasury Secretary Paulson or FederalReserve Chairman Bernanke are professionally unable to acknowledge this problem, and it does not appear in most neoclassical or monetarist textbooks. But the underlying mathematics of compound interest are rediscovered in each generation, often prompted by the force majeur of financial crisis. A generation ago, for instance, Hyman Minsky gained a following by describing what he aptly called the Ponzi stage of the business cycle. It was the phase in which debtors no longer were able to pay off their loans out of current income (as in Stage #1, where they earned enough to cover their interest and amortization charges), and indeed did not even earn enough to pay the interest charges (as in Stage #2), but had to borrow the money to pay the interest owed to their bankers and other creditors. In this Stage #3 the interest was simply added onto the debt, growing at a compound rate. It ends in a crash. This was the flip side of the magic of compound interest â the belief that people can get rich by âputting money to work.â Money doesnât really work, of course. When lent out, it extracts interest from the ârealâ production and consumption economy, that is, from the labor and industry that actually do the work. It is much like a tax, a monopoly rent levied by the financial sector. Yet this quasi-tax, this extractive financial rent (as Alfred Marshall explained over a century ago) is the dynamic that is supposed to enable corporate, state and local pension funds to pay for retirement simply out of stock market gains and bond investments â purely financially and hence at the expense of the economy at large whose employees are supposed to be gainers. This is the essence of âpension-fund capitalism,â a Ponzi-scheme variant of finance capitalism. Unfortunately, it is grounded in purely mathematical relationships that have little grounding in the ârealâ economy in which families and companies produce and consume. Paulsonâs bailout plan reflects a state of denial with regard to this dynamic. The debt overhead is self-aggravating, becoming less and less âsolvableâ and hence more of a quandary, that is, a problem with no visible solution. At least, no solution acceptable to Wall Street, and hence to Paulson and the Democratic and Republican congressional leaders. The banks and large swaths of the financial sector are broke from having made bad gambles in the belief that money could be made to âworkâ under conditions that shrink the underlying industrial economy and stifle wage gains, eroding the market for consumer goods. Debt deflation reduces sales and business activity in general, and hence corporate earnings. This depresses stock market and real estate prices, and hence the value of collateral pledged to back the economyâs debt overhead. Negative equity leads to bankruptcy and foreclosures. By increasing Americaâs national debt from $5 trillion earlier this year to $13 trillion in almost a single swoop by taking on junk loans and other bad investments rather than letting them to under as traditionally has occurred in the âcleansingâ culmination of business crashes (âcleansingâ in the sense of clean slates for debts that cannot reasonably be paid), Paulsonâs bailout actions increase the interest payments that the government must pay out of taxes or by borrowing (ore printing) yet more money. Someone must pay for bad debts and junk loans that are not wiped off the books. The government is now to take on the roll of debt collector to âmake a profit for taxpayersâ by going around and kneecapping the economy â which of course is comprised primarily of the âtaxpayersâ ostensibly being helped. It is a con game. Financial gains have soared since 1980, but banks and institutional investors have not used them to finance tangible capital formation. They simply have recycled their receipt of interest (and credit-card fees and penalties that often amount to as much as interest) into yet new loans, extracting yet more interest and so on. This financial extraction leaves less personal and business income to spend on consumer goods, capital goods and services. Sales shrink, causing defaults as the economy is less able to pay its stipulated interest charges. This phenomenon of debt deflation has occurred throughout history, not only over the modern business cycle but for centuries at a time. The most self-destructive example of financial short-termism is the decline and fall of the Roman Empire into debt bondage and ultimately into a Dark Age. The political turning point was the violent takeover of the Senate by oligarchic creditors who murdered the debtor-oriented reformers led by the Gracchi brothers in 133 BC, picking up benches and using them as rams to push the reformers over the cliff on which the political assembly was located. A similar violent overthrow occurred in Sparta a century earlier when its kings Agis and Cleomenes sought to annul debts so as to reverse the city-stateâs economic polarization. The creditor oligarchy exiled and killed the kings, as Plutarch described in his Parallel Lives of the Illustrious Greeks and Romans. This used to be basic reading among educated people, but today these events have all but disappeared from most peopleâs historical memory. A knowledge of the evolution of economic structures has been replaced by a mere series of political personalities and military conquests.