The monster and the sausages
By Spengler
Germany's President Horst Koehler has denounced the world financial market as a "monster" using "highly complex financial instruments" to make "massive leveraged investments with minimal capital". Koehler, formerly head of the International Monetary Fund, seems perplexed about the causes of the present crisis, but I can explain them in a way any German can understand. Derivatives are like sausages. You take the low-quality parts of the pig that you don't want to look at while you are eating them, and grind them up into a package that seems more appetizing.
The German financial system wanted to consume low-quality American assets, but did not want to look on what it was eating. German banks have written down about US$25 billion in securities derived from low-quality ("subprime") American mortgages, and
doubtless will lose a great deal more. But it is silly to blame the sausage-grinder. Why didn't the Germans and all the other overseas investors buy mortgages in their own countries, instead of scraping the bottom of the credit barrel in the United States? It is because there aren't enough Germans, or Italians, or Frenchmen or Japanese starting families and buying homes. There weren't enough Americans, either, and therein lies a tale.
The aging pensioners of Europe and Asia must find young people to pay interest into their pensions, and they do not have enough young people at home. Germans aged 15 to 24, on the threshold of family formation, comprise only 12% of the country's population today and will fall to only 8% by 2030. But one-fifth of Germans now are on the threshold of retirement and half will be there by mid-century.
It is fashionable these days to blame the Americans for borrowing instead of saving. In effect, Americans borrowed a billion dollars a year against the expectation that the 10% annual rate of increase in home prices would continue, producing a bubble that now has collapsed. It is no different from the real estate bubble that contributed to the Thai baht's devaluation in 1997, except in size and global impact.
The monster is not the financial system, crooked and stupid as it may have been. The monster is the burgeoning horde of pensioners in Germany and other industrial countries. It is easy to change the financial system. The central banks can assemble on any Tuesday morning and announce tougher lending standards. But it is impossible to fix the financial problems that arise from Europe's senescence. Thanks to the one-child policy, moreover, China has a relatively young population that is aging faster than any other, and China's appetite for savings vastly exceeds what its own financial market can offer.
There is nothing complicated about finance. It is based on old people lending to young people. Young people invest in homes and businesses; aging people save to acquire assets on which to retire. The new generation supports the old one, and retirement systems simply apportion rights to income between the generations. Never before in human history, though, has a new generation simply failed to appear.
As the above chart makes clear, America's population profile is far more benign than Germany's, but it is aging nonetheless. There simply aren't enough young people in America to borrow money from Europe's and Japan's aging savers.
The world kept shipping capital to the United States over the past 10 years, however, because it had nowhere else to go. The financial markets, in turn, found ways to persuade Americans to borrow more and more money. If there weren't enough young Americans to borrow money on a sound basis, the banks arranged for a smaller number of Americans to borrow more money on an unsound basis. That is why subprime, interest-only, no-money-down and other mortgages waxed great in bank portfolios.
America's financial market could not produce enough pork chops, so the Europeans bought Spam and scrapple. America's rating agencies assured them that derivatives created from subprime mortgages, second-lien mortgages and other dubious parts of the pig were the equivalent of pork chops, and foreign investors wolfed them down. Humbug and duplicity as I argued in The devil and Alan Greenspan (Asia Times Online, October 2, 2007), regulators, bankers and investors all looked the other way, and now all point the finger at each other.
Coddled by an undeserved claim on the world's savings, Americans have done a very poor job of creating wealth. America had the right idea about how to create wealth, but the wrong kind of people. The Ronald Reagan administration took office in 1981 after the worst period of value-destruction in postwar American history. A dollar invested in the S&P 500 index of large American stocks would have bought 50 cents' worth of consumption goods a decade later, as the chart below indicates:
Between 1981 and 2001, however, $1 invested in the stock market would have grown to $6 inflation-adjusted dollars. That was the greatest period of wealth creation in the past century of American finance.
In Reagan's way of looking at things, ingenuity was more important than savings. Removing tax and other barriers to innovation and investment allowed Americans to create new products - computers, microwave ovens, cell phones and a dozen other items unknown in 1981. The wealth generated by innovation would more than make up for big budget deficits and rising indebtedness.
What went wrong? There is no one to blame but the Americans themselves. If free elections give people the sort of government they deserve, free markets give them the sort of economy they deserve. The stock market bubble of the late 1990s presumed that the Internet would transform American life according to a pop-culture template. In my maiden essay for Asia Times Online on January 27, 2000 (What if Internet stocks aren't a bubble?) I wrote: What if it isn't a bubble? What if consumers want to double or quadruple their spending on whatever it is the Internet has to offer every year for the next 20 years? What if they will pay a premium to watch their favorite episode of Pee-Wee Herman or the Lone Ranger rather than the latest sit-com? What if they will spend heavily to explore the cutting edge of anatomical possibility on the porn sites?
Recall the dying, drug-addicted Howard Hughes, a recluse in the penthouse suite of a Las Vegas hotel, hair and fingernails untrimmed for months. That was in the 1960s, and Hughes passed the time watching film after film in his private screening room, a plutocrat's privilege. With the wonder of the Internet, cable hookups, and the Time Warner-AOL film library, every Internet user can turn into a dissipated freak like Hughes. That's American democracy at work. After inflation, an investor who bought $1 worth of the S&P 500 in early 1998, just as the bubble was getting underway, would be able to sell this position and buy $1 worth of consumption goods today. America's feckless plunge into capitalized pop culture did not pan out.
America is in the midst of another wave of wealth-destruction. The Federal Reserve has sought to devalue its way out of a financial crisis, giving foreign investors all the less reason to buy American risk-assets, although foreign central banks continue to buy American government bonds for lack of an alternative. The result, as I argued recently in Rice, death and the dollar (Asia Times Online, April 22, 2008), is an epidemic of commodity bubbles raging from rice to petroleum. A few countries have won the lottery, for example Brazil, while energy importers are suffering.
Koehler's indignation is understandable, but it is pointless to blame the sausage-maker. Economics simply does not offer a solution to a lapse of the will to live among some of the world's richest economies. The Europeans are paying for their own nihilism. Having invented the perfect post-Christian society with cradle-to-grave services, they have not found anyone willing to live in it, except for the immigrants who well may inherit it from the disappearing locals.
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