“Between June 1998 and June 2008 the notional[1]
value of outstanding over-the-counter derivatives exploded from $72 trillion to
$673 trillion … just under eleven times global gross product.”[2]
“The gross debt of the US financial system grew from 20
percent of GDP in 1979 to 120 percent in 2008. In the UK, the gross debt of the
financial system reached two and a half times GDP in 2007.”[3]
How is it possible to have so much capital?
One theory offered by people like former Fed Chairman Ben
Bernanke and Europe’s most respected financial commentator, Martin Wolf, is
that we have a savings glut. There is no way to distinguish between a savings
glut and an investment dearth but in either case, the supply of capital is
great enough that interest rates hit zero. (When something is scarce, its price
goes up. When there is a glut of it, the price goes down. Interest rates are
the price of capital and interest rates have been at or near zero for most of this new century.)
A glut of capital would have seemed like a fantasy to
people living in the second economy (1700 to 1900) when capital was the limit in the same way
that an all-you-can-eat buffet would have seemed like a dream come true to
medieval peasants. But excess can bring its own problems and the financial
crisis of 2008 that triggered the Great Recession was a reminder that a
financial system can be weakened by either too little or too much capital.
Capital was the limit to progress in the second economy. Capital
made the biggest difference and was the source of the most new jobs and wealth.
In most – but not every – instance, more or better capital was the answer to
the question of how to make progress. If we imagine the economy as requiring four factors of production, the second economy looked like this.
During the second economy, to make more capital was to
make more progress. Limits define the output of a system. The two-lane stretch of highway determines how many cars pass through in rush hour, not the three-lane stretch beyond it. In 1700, there were hardly any machines able to do work. Instead, work was manual. More machines, more factories, and more stocks and bonds to finance them all increased total economic output.
But with an investment dearth, capital is no longer the
limit. In the fourth economy, the new limit is entrepreneurship. Our economy
looks more like this now.
To create more credit, to generate more capital, is like
building up a glut of products between your second and fourth machine in the factory.
It is the equivalent of increasing the capacity of the capital without a
corresponding increase in knowledge workers or entrepreneurs. In the bubble
leading up to the financial crisis of 2008, financial markets were wildly
productive. That would have been a good thing had entrepreneurs been hiring
workers at record levels, but they were not. The result was a huge bump in capital
that simply bid up the price of existing assets (like homes and stocks) rather
than creates them.
This is akin to an increase in the rate at which we build
up inventory (the product that passes through machine two) without increasing
the rate of products that leave the factory (product that passes all the way
through machine four). Inventory can only stack up for so long before the
second machine has to halt production. This becomes the cycle of booms and
busts when the second machine is capital. More capital at the dawn of the
fourth economy created bubbles. Once we popularize entrepreneurship, this rise
in capital output will be hugely beneficial.
For now, though, we have trillions in capital sloshing
about the globe in search of returns that, like waves in a bathtub, can only go
so far in one direction before it will reverse direction. In the late 1990s, it
flowed into the stock market and drove up prices there, first creating a bubble
and then a bust in 2000 when it left. In the mid-2000s, it flowed in the
housing market, driving up prices there, first creating a bubble and then a
bust in 2008 when it left. Capital has become dangerous, driving up the price of assets every time it sees one as key to returns and then driving down their
price once it realizes the gains are the result of a surplus of capital
bidding up the price of a scarcity of assets.
That dynamic was at work in the 2008 financial
meltdown. When markets fell, assets as varied as real estate and stocks dropped tens of trillions
of dollars. About 30 million people
around the world
lost their jobs and millions lost their homes.
Until we get better at developing entrepreneurs and making
employees more entrepreneurial, we will have an investment dearth. We continue to get better at making capital but that is no longer the limit. Once we get
better at making employees more entrepreneurial, we will have a good use for
such huge amounts of capital. At that point, we might even shift from an
investment dearth to an investment glut (or savings shortage). At that point,
there will be an abundance of opportunities for capital. Until then, an excess
of capital will continue to create a series of bubbles and busts.
[1]
Notional value inevitably exceeds the market value of a derivative. You might
have a derivative based on a $100 stock price but would reasonably expect its
value to move only 5 to 20% of that, a fraction that would set the market value.
“Still, the market value of derivatives rose from $2.6 trillion to $35.3
trillion in December 2008, itself more than half global output,” Wolf writes.
[2]
Martin Wolf, The Shifts and the Shocks:
What We’ve Learned – and Have Still Yet to Learn – From the Financial Crisis,
[Penguin Press, Kindle Version, 2014] p. 128.
[3]
Wolf, The Shifts and the Shocks, p.
129.
