The Crisis and The Econochemist Frederick Soddy

The Crisis
by Herman Daly, Tom Green, AdBusters, 19 Nov 2008
Groundbreaking economist, Herman Daly, zeroes in on the root cause of our financial meltdown.

The turmoil affecting the world economy unleashed by the US sub-prime debt crisis isn’t really a crisis of “liquidity” as it is often called. A liquidity crisis would imply that the economy was in trouble because businesses could no longer obtain credit and loans to finance their investments. In fact, the crisis is the result of the overgrowth of financial assets relative to growth of real wealth— basically the opposite of too little liquidity. We need to take a step back and explore some of the fundamentals that growth-obsessed economists and commentators tend to neglect.

After winning the Nobel Prize for chemistry, Frederick Soddy decided he could do greater good for humanity by turning his talents to economics, a field he felt lacked a connection to biophysical reality. In his 1926 book Wealth, Virtual Wealth and Debt: The Solution of the Economic Paradox, (a book that presaged the market crash of 1929), Soddy pointed out the fundamental difference between real wealth – buildings, machinery, oil, pigs – and virtual wealth, in the form of money and debt.

Soddy wrote that real wealth was subject to the inescapable entropy law of thermodynamics and would rot, rust, or wear out with age, while money and debt – as accounting devices invented by humans – were subject only to the laws of mathematics.

Rather than decaying, virtual wealth, in the form of debt, compounding at the rate of interest, actually grows without bounds.

Soddy used concrete examples to demonstrate the flaw in economic thinking. A farmer who raises pigs faces biophysical limits on how many pigs he can take to market. But if that pig farmer took on debt – a promise to repay at a future date – he would in effect be issuing a claim or lien on his future production of pigs. If he borrowed the equivalent value of 100 pigs, he could represent the loan on his balance sheet as “-100 pigs.”

While debt as the farmer’s accounting entry is negative, negative pigs do not really exist. If the farmer should suffer a series of lean years and be unable to pay the interest, he might soon owe more pigs than could be raised on his farm. After a year, with interest looming, he’d show “-110 pigs”; in 5 years, “-161”; in 40 (assuming a patient bank), “-4526.” When the bank finally came to call on the pig farmer to collect repayment of its loan, it could well find that most of the virtual wealth that had grown so appealingly on its books had to be written off as a loss.

Soddy’s insights show us that the institutions of a growth economy lead to the type of crisis that hit the US economy in 2008. Real wealth is concrete. Financial assets are abstractions. Existing real wealth serves as a lien on future debt. For example, the 100 dollars of virtual wealth that I carry in my wallet are a lien on real wealth in that those dollars enable me to buy pork at the store.

The problem that we’re seeing in the US has arisen because the amount of real wealth is not a sufficient lien to guarantee the staggering outstanding debt which has exploded as a result of banks’ ability to create money, loans given out on shaky assets and the US government’s deficit, which has been stoked by financing the war and recent tax cuts. All of these factors are exacerbated by the compounding mechanism on debt. The debt is growing, and consequently, it is being devalued in terms of real wealth.

The conventional wisdom is that when faced with the threat of recession and business failure, the solution is to grow the economy so we can grow our way out of the crisis. But because the wrong diagnosis is made, namely that businesses are in trouble because access to credit has tightened, the wrong solution is proposed. Even if we could grow our way out of the crisis and delay the inevitable and painful reconciliation of virtual and real wealth, there is the question of whether this would be a wise thing to do. Marginal costs of additional growth in rich countries, such as global warming, biodiversity loss and roadways choked with cars, now likely exceed marginal benefits of a little extra consumption. The end result is that promoting further economic growth makes us poorer, not richer. The cost of feeding and caring for the extra pigs is greater than the benefit of eating extra pork.

To keep up the illusion that growth is making us richer, we deferred costs by issuing financial assets almost without limit, conveniently forgetting that these so-called assets are, for society as a whole, debts to be paid back out of future growth of real wealth. That future growth is very doubtful, given the deferred real costs, while the debt continues to compound to absurd levels.

What allowed symbolic financial assets to become so disconnected from underlying real assets?

First, our economy is based on fiat money (paper money issued by governments) that has value by convention but isn’t backed by any physical wealth. Second, our fractional reserve banking system allows pyramiding of bank money (demand deposits) on top of the fiat government-issued currency. Third, buying stocks and “derivatives” on margin allows a further pyramiding of financial assets on top of the already multiplied money supply. In addition, the financial sector was very inventive in coming up with new financial instruments that were designed to circumvent government regulation of commercial banks to protect the public interest.

The agglomerating of mortgages of differing quality into opaque and shuffled bundles that led to the sub-prime mortgage crisis should be outlawed. The US balance of trade deficit has allowed us to consume as if our economy was growing real wealth instead of accumulating debt. So far, US trading partners have been willing to lend the dollars they earned from running a trade surplus back to us by buying treasury bills but these treasury bills are liens on yet-to-exist wealth. Of course, they also buy real assets and their future earning capacity. Our brilliant economic gurus meanwhile continue to preach deregulation of both the financial sector and of international commerce (i.e. “free trade”).

How then do we clean up this mess?

A massive bailout – and having the US taxpayer take on billions in bad debt – is merely a way to keep the growth economy from failing a little longer while allowing it to continue degrading the planet. Propping up such a destructive system makes no sense. Instead, we need to redesign our laws and institutions to foster an economy that remains within biophysical limits.

I would not advocate a return to commodity money (such as gold), but would certainly advocate gradually increasing reserve requirements for banks. Commercial banks should act as financial intermediaries that lend other peoples’ money, not as engines for creating money out of nothing and lending it at interest. If every dollar invested represented a dollar previously saved, we could restore the classical economists’ balance between investment and abstinence. Far fewer stupid or crooked investments would be tolerated if abstinence had to precede investment.

Of course the growth economists will howl that such measures would slow the growth of GDP. I say so be it – growth has become uneconomic, and we have limited time to bring the economy into line with the biosphere’s carrying capacity.

Were Soddy still around, I doubt he would be surprised by the havoc wreaked by all these two-legged Wall Street pigs, given that they were left free to raid whatever troughs they could poke their snouts into while drawing on conventional economic thinking to disguise their mess as innovations in finance. But I also think he would be disappointed that 80 years after the publication of his book, we still haven’t figured out a way tether the economy to reality – to ensure that the number of negative pigs can’t grow without limit.

Further reading:
The Role of Money: What It Should Be, Contrasted with What it has Become
By Frederick Soddy*, George Routledge And Sons Limited, 1934

* M.A. (Oxon) ; LL.D. (Glasgow) ; F.R.S. ; Nobel Laureate in Chemistry, 1921 ; Author of " Science and Life " ; " Wealth, Virtual Wealth , and Debt " ; " Money versus Man " ; etc.