Global Resilience Solutions > How the Economy Works… and Why It Isn’t Working For YOU

How the Economy Works… and Why It Isn’t Working For YOU

For a society that watches (or mutes) economists on the evening news, we have never been more mystified about how the economy really works.  We tend to be even more confused about how it impacts our own personal financial situations.  You could say with some justification that the economists are equally mystified, but there’s a more basic reason we just aren’t clear on what we should do in order to prosper in this economy.

The reason is simple: we’re kept busy debating hot-button issues like government spending, free trade, regulation, laissez-faire economics, stimulus economics and more so that we don’t realise that we, the people, are the chumps in this system.  Let’s start peeling back the layers of the onion with a few simple questions that can do a lot to clarify where we really stand in this economy.

 

Why is it so easy to get credit and so hard to get out of debt?

Believe it or not, it is now more profitable to lend money than to invest it in productive activity.  Back in the day, your bank, credit card company or loan service was on the hook for whatever they lent you.  That meant they were very careful about your credit-worthiness.  Now, they can sell your debt, or a share in your debt and the aggregate debt of everyone they serve, to shadow financial institutions.  That way, it’s off their books, and they don’t have to worry about it.

And those people who have bought your debt (we’ll get to them in a moment) aren’t looking for timely repayment.  They want you paying penalties, compounded interest and so on.  That’s what makes the credit business profitable.  And if you default, they can sell the collection rights to yet another organisation.

All of this becomes a shell game that obscures the real health of any particular loan, and even of whole markets.  It allowed the mortgage market to take off, but when it crashed, only a few people, many of them risk-management officers who had been ignored for years, saw it coming.

The value of transactions revolving around debt products exceeds the value of world GDP by a considerable amount!  (If that doesn’t shock you, it should).  Remember the 2008 financial crisis?  The derivatives market collapsed when it began to look like a large portion of the debts held by a particular organisation were unlikely ever to be paid.

So why did they all go into it?  It’s simple.  Rich people with offshore holdings want their money in funds that will make absurdly large returns.  The stock market can’t meet that expectation.  It’s much quicker to go fishing for your future earnings.  To learn more about this dynamic, Richard Westra’s work is a good place to start.

 

Why is it so much more profitable to invest than to be in business?

If it’s more profitable to invest in debt products than in productive activity, it is more profitable in general to invest than to be in business.  There are a couple of reasons for this.  One reason is that in many places capital gains are taxed lower than revenue and earned income.  Another is that the stock market is dominated by the big money of the already-rich, whose money is managed by those who promise the biggest return.  Stock market money migrates toward the highest return.

Unfortunately, the highest return is very seldom in productive activity (we’ll get to the big exception in a minute).  The Shift Index, a longitudinal study of 20,000 US companies shows a drastic decrease in return on assets, including invested capital, among top US firms over the decades.  We’re barely producing a third of the return rate seen in 1965.  And yet, executive compensation per dollar of net earnings quadrupled between 1990 and 2000, partly absorbing increased individual productivity.  The economic value captured between the financial sector and the executive class goes a long way to explain lower returns, though there’s certainly more to it.

One major factor is the tyranny of stockholders and the groups that represent them in corporate governance.  Under the Friedmanite ethos of recent decades, the obligation of a corporation is to make money for its shareholders, with no other stakeholders – employees, community or the nation itself – even recognised.  A CEO under these circumstances is incentivised to do whatever he can to show an increase in the value of his company’s shares.  That means:

–          selling off the company’s productive assets to show a profit

–          buying up smaller companies, which have to sell because their stockholders won’t let them refuse a lucrative buyout

–          outsourcing production to the cheapest bidder

–          driving competitors out of business

–          establishing local and national monopolies

–          downsizing

–          acquiring start-ups that have developed valuable products and ideas, often in order to make up for the corporation’s sold-off or downsized research assets

In other words, the incentive is to extract money – from acquired companies, from cannibalising one’s own company, from communities whose productive businesses you’ve destroyed – because all of that falls under capital gains.

Money is accumulated and siphoned into the cash value of the company, and therefore the stocks; it’s used for acquisitions of other companies (or parts thereof), but not deployed in new R&D, new production, new sustainable business lines, because those earnings would be taxed at a higher rate.  Capital gains are better than dividends as far as the stockholders are concerned.  The result is a constant game of mergers, acquisitions, cannibalising your own company and so on, taking the company from one sector to another to another so that it looks like it’s growing.

The catch is, productive activity isn’t really growing.  And, as you might guess, companies run this way are always destroying sustainable business – their own and other people’s – in exchange for short-term quarterly gains.  It is smash-and-grab at its worst.  Since executives are both highly-paid and often have stock in the company, and since they tend to hop from one company to another very quickly, their only real focus is momentary profit.

 

Why did all the productive jobs go overseas?

While free trade is always sold to the public as opening up new export markets, its financial backers have quite another goal in mind.  This is to escape not only regulation, but responsibility for the workforce, the environment, production standards and so on by fleeing to the cheapest and least-regulated market.  Once the big companies go that route, it becomes impossible even for socially responsible companies to compete without doing so as well.

The cost to the host country is forced labour, unsafe labour, environmental degradation, pollution, corruption, fraud and many other social and environmental costs.  The growth of the new economies parallels the income inequality of the developed world, but with even starker disparity.  This is not a reality passively accepted by the people.  In the case of China, 2015 was a record year for strikes with 2,774 recorded incidents, many the result of non-payment of wages.  Protests in general, reported by the Chinese government as “mass incidents”, numbered over 180,000 in 2010.  These are provoked by labour and environmental abuses, land grabs by companies and local governments, corruption and other abuses of power.  And since it’s in the interests of local governments to hush these incidents up, those that are officially reported can only be a subset of the real figure.

Meanwhile, the developed world haemorrhages jobs – first blue-collar workers, then, increasingly, research and development and white-collar jobs.  R&D in particular is captured through reverse-engineering, corporate espionage and so on, often with state support.  Large areas of industry are simply destroyed with very little chance of ever being rebuilt.  The corporations which are ostensibly American or Canadian or European are increasingly uninterested in doing anything to benefit their home countries.  They are simply umbrellas for commissioning subcontractors in the developing world to make, package and ship the products they ultimately sell.  The net result is that the dollar you spend in the shops not only doesn’t go to workers in your own country, most of it doesn’t go to workers in any other country – it is captured by the stump of a company that no longer makes any of its own products, its executives and shareholders.

This capacity to produce cheap goods allows chain stores to move into an area, drive many small businesses out of business, and claim the short-term profits in their quarterly reports.  The fact that those communities then become economic wastelands unable to keep their store profitable doesn’t matter to the CEO of the moment – an unprofitable store is soon closed.

The point is not that free trade is always automatically bad, or that bringing business to the developing world is bad.  It’s just that in a system shaped by perverse incentives, we can’t do either of these things sustainably.

 

Bottom Line: Short-term gains trump long-term sustainability with disastrous consequences

These truths are difficult to hear.  They challenge our treasured myths about an economy that rewards hard work and contributions to the general good.  They show us a system that is leveraged against our future earnings and yet is siphoning off vast amounts of wealth into the pockets of a very small percentage of people and companies.  They show us a system that is absolutely unsustainable in the long term.

This is a system conditioned by perverse incentives, above all to short-term thinking, at every level, and we have to be aware of that as we negotiate it.

One comment
  1. Posted 1 year ago
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    Excellent discourse on the psycho-social dysfunctionality engendered by inequality presented by Richard Wilkinson. Also raises interesting questions on the effects of the move away from progressive taxation to a flat rate on society and human behaviour. Which is the real equalizer? Perhaps this is an area for further study.
    The effects of the incentives for short-term gains/profits on human behaviour would be hilarious if it were not for the devastating long-term effects. Sanity in our endeavors is needed. How can human behaviour be moulded so that it is productive but not detrimental to the planet? Can enlightened societal interest trump individual greed? If it does not, human existence as we know it can be in jeopardy.

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