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In this part 3 in the series explaining the unique characteristics of Great (aka Epic) Recessions the focus turns to how excess Debt, when combined with Deflation, leads to Defaults (by banks, corporations, or both), which exacerbate and intensify the negative feedback effects of overlapping financial cycles and real business cycles. The contraction of both accelerate and deepen. Deflation spreads from financial asset securities to real goods and services to labor and other input prices (wages). Falling prices lead eventually to defaults–i.e. failure to pay principal and interest on prior debt loads. Deflation in fact raises the real cost of the prior debt. So debt continues to rise in real terms as the ability to ‘service’ that debt (pay principal and/or interest) declines as prices deflate and revenues and cash fall. The interaction of debt with deflating prices and defaults creates a mutual feedback effect among the three factors–debt, deflation, default–and hence creates what I call the ‘debt-deflation-default’ nexus.

Here’s Part 3 describing the processes, which create within the capitalist system a condition of ‘fragility’. That is, the increasing likelihood of a major financial instability event–i.e. stock or bond market crash, commodities futures crisis, derivative securities super-contagion and contraction, property values collapse (residential and/or commercial), and so on. (In the final Part 4 to follow, it will be explained how this process and multiple feedbacks, and ‘nexus’, occurs not just in the financial side of the economy, but may occur as well in the household consumption sector and the government sector. When all three sectors–financial, households, government–become ‘fragile’ as their separate ‘nexuses’ intensify, then the entire economic system may become ‘systemically fragile’.

Debt As Driver of Deflation

The prior debt levels created by excessive leveraging and the shift to speculative investing over the business cycle mean that, once prices of speculative assets begin to fall, the greater volume of debt previously accumulated over the cycle will result in a longer fall in the price of the assets. And the poorer the quality of that debt, the more rapid the fall. Thus the level and quality of the accumulated debt will determine the asset price deflation. Speculative investing works through the medium of accumulated debt in depressing asset price deflation, by creating excess debt as a result of creating ‘tiers’ of speculative instruments, ‘layered’ leveraging, and creating a false sense of reduced risk. Details of the debt-deflation process work something like this:

During the boom cycle, debt servicing payments are not considered a major factor to the investor. He intends to sell the asset after a price rise before the debt payments are due in any great volume. But this works only so long as the price of the asset continues to rise. When it doesn’t, if it declines, and sometimes even if it just slows in its rate of rise, then debt servicing payments come due and may become a burden. That debt servicing cost burden may prove significant if a large volume of debt was taken on in the original process of asset purchase and/or if the additional debt over time was of a poorer quality (i.e. shorter term and higher interest). Rising debt servicing costs may represent only one part of the growing cost pressure on the investor. Terms of borrowing for investors are often such that, should the value of the asset purchased fall below its original purchase price, the borrower is required to ‘make up the difference’. That is, put in more money assets or put up other assets as collateral. When that point is reached the investor typically tries to ‘dump’ the asset and sell it. But that may pose a problem as well, when most investors are trying to dump the asset and sell it at the same time. The more savvy investors quickly exited the market early in order to avoid the inevitable rising debt servicing cost and losses and write-downs that can quickly follow once prices start falling. Their exiting, however, accelerates further declining asset prices and rising debt servicing costs. Unable to sell the assets for which prices are deflating, the investor may turn to selling off ‘good assets’ (i.e. other classes of assets not losing value due to price declines) in order to make the rising debt servicing costs. In this manner asset price deflation may spread between classes of assets as well. A company as investor, for example, may have to sell its better assets in order to raise cash with which to service its rising debt costs. It can all become a self-fulfilling downward spiral; general asset price deflation can quickly set in.

Deflation Feedback Effects

It has been explained how, in the runup of a financial boom rising debt and excessive debt leveraging may result in excess demand for financial assets that drives asset price inflation to extraordinary levels. But speculative investing may also drive product price inflation in several ways. Speculation in food commodities and oil drives up futures options prices for these commodities which are passed on to what is called ‘core inflation’, energy and food prices, at the food and energy wholesale and consumer levels. Rising commodity prices for metals also causes a rise in product prices of crude, intermediate and finished producers goods, as metals and other raw materials prices are passed through producer goods prices. In turn, rising producers goods prices are eventually passed on in part to consumer products made from those producer goods. The consequence is a speculative investing-debt driven asset, as well as product, price inflation. Rising debt thus drives inflation. But the opposite may occur as well. That is, asset as well as product price deflation may actually result in a still further rise in debt levels and thus debt servicing stress.

The reverse scenario in which falling prices result in rising debt works something like the following: Once a financial bust and crisis has occurred, businesses don’t only sell assets that have started to collapse in price. First, the assets rapidly collapsing in price may prove difficult. The prices of the falling assets may have declined so far that their sale provides little revenue gains with which to make debt service payments. So the company may simply hold onto the asset that might be now virtually worthless instead of selling it. That is what, in effect, happened to many banks and shadow banks after 2007 that were caught holding collapsed securitized assets. The dollar value had fallen to as low as 10 cents on the dollar. In that situation, banks just held onto the collapsed and now nearly worthless assets. But they still had to make debt servicing payments, and perhaps as well make up for the lost value on those collapsed assets on their balance sheets. They therefore first sold other ‘good’ assets that had not yet fallen in price. That applies to non-finance companies that found themselves in a similar situation. For example, GMAC, the financing arm of General Motors, had speculated in securitized assets and lost billions. It played a major role in GM’s ultimate financial decline. GMAC had to sell off ‘good’ assets to compensate for the collapse in value of the ‘bad’ assets it couldn’t sell. Similarly, GM itself had to sell at ‘firesale’ prices real assets of several of its product divisions to cover the losses in assets at GMAC.

This, by the way, is also an example of a transmission mechanism illustrating how asset price declines can spread from asset class to asset class, eventually infecting good assets and setting off a general asset price decline. Cash flow must be raised in some manner in order to service debt payments coming due from debt accumulated during the boom phase. Selling ‘good’, as well as ‘bad’, assets is one response. But selling company assets, good or bad, is not the only way to raise cash with which to cover debt payments coming due. Reducing product prices to raise revenue and cash flow is another.

If the company is a non-financial institution, another alternative available is to sell more of the company’s inventory of real products in order to raise cash to make debt payments. But with a weakening real economy, selling more products requires lowering the prices of those products in order to increase sales revenue and raise the needed cash flow for debt servicing. This is an illustration of another transmission mechanism describing how asset price deflation can spread to product price deflation.

But lowering product prices in order to raise cash to service debt payments means the company’s real debt levels rise. Specifically, falling product prices results in rising real debt and thus a rise in the servicing costs of that real debt. The company’s original debt obligation and payments have not risen, but the company’s income and cash flow available with which to make the debt payments has fallen—i.e. the real debt load for the company has risen. Sometimes referred to as the ‘Fisher Effect’, this is an important process by which paying off debt by raising cash by lowering prices actually results in rising debt. It represents the process by which deflation can feed back and cause a rise in (real) debt, just as debt can result in deflation. If left unchecked, deflation results in a spiraling down of debt and deflation as they both feed upon and further exacerbate each other.

This debt to deflation and deflation to debt spiral is typical of Epic Recessions. If not checked early in the process, it may lead to a deepening and extending of Epic Recession. And if allowed to become particularly severe and protracted, it can play a central role in transforming an Epic Recession into depression.

Asset and product price deflation may also ‘spill over’ into wage deflation as well, further exacerbating the process. As product price deflation occurs and company revenues and cash flow eventually decline further, the natural management response is to cut operating costs as well. That is typically employment and wages for those left still employed after layoffs. In fact, it is not necessarily sequential. That is, asset firesales leading to product price deflation, then to wage deflation. A company facing particularly severe debt servicing stress may engage in all three forms of deflation at the same time more or less, selling assets, reducing product prices to raise more revenue, and cutting operating costs. However, cutting product prices will eventually lead to wage deflation. First as reductions in hours of work for a company’s labor force and in the form of layoffs. Both constitute forms of wage deflation for the general labor force at large. Total wage payments decline for workers as a group. For those still employed, wage deflation can assume more traditional forms of hourly wage rate reduction, suspension of bonuses, reductions in company contributions to benefit plans, etc. In Epic Recession, resort to non-traditional forms of wage cutting frequently occurs as well, such as ‘forced monthly furloughs’ (days off without pay), cuts in paid sick leave, vacation, and holiday pay, and other forms of supplemental compensation. The key point, however, is that product price deflation eventually spills over to wage deflation in a general way in Epic Recessions.

Wage deflation also has the effect of feeding back upon and exacerbating debt. In this case it is consumer debt levels that are affected. When workers’ experience reduced income from job loss and wage cutting, in effect their ‘cash flow’ also is reduced. Their real debt thus rises as well, as does their debt servicing stress. There is also a further feedback effect. Rising real debt for consumers means less consumption and therefore less demand for products. Product prices are in turn reduced further, causing additional rising real debt for business. In other words, rising real consumer debt results in a further rise in business real debt. Debt drives debt.

Finally, as business real debt rises and reducing product prices reaches its lower bound limits, businesses’ only option is to turn to selling more assets. Thus, deflation in wages and product prices drives a second round of asset price deflation. We now have a generalized process of the three types of prices—asset, product, and wage—each driving the other in a downward spiral through the medium of rising real debt for each. The more generalized and the more multiple feedbacks that occur, the more severe the condition of Epic Recession.

Debt-Deflation As Driver of Default

These processes of deflation and debt ultimately lead to a condition of default. When a business can no longer reduce wages (beyond a point it results in an insufficient workforce to produce its product), can no longer reduce product prices (further reductions would mean producing products for a price consistently below the cost of producing those products), and has few or no remaining real assets to sell to raise cash flow to finance debt payments—then the only alternative for the business is to default. That default may be on its debt servicing payments. Or it may take the form of a more serious company level default, meaning a bankruptcy.

Default may be postponed, however, by various means. Lenders may allow the business to ‘roll over’ its debt due—in effect reducing its debt payment levels in exchange for a longer term debt obligation. The business may simply borrow additional debt in order to make the payments on the original debt. Or it may convince lenders to accept stock in exchange for debt. If it is fortunate enough, it may invoke prior ‘covenants’ that allow it to suspend or slow its debt payments. Or perhaps the company’s original lender (financial institution) is itself near insolvent so it chooses not to take the company into bankruptcy court in response to the debt default, since doing that would require the lender to register even greater losses on its own balance sheet which it may be loathe to do. There are a host of measures that are designed to ‘buy time’ for a company facing default as bankruptcy. Most measures take the form, however, of the company taking on additional levels of long term debt amortized over a longer period in order to pay for increasingly unaffordable short term debt. A favorite option in 2009, for example, was for companies having difficulty making debt payments to sell more junk bonds to cover immediate debt. But this represents a temporary solution only. It means raising long term debt levels in order to finance short term debt payments.

A similar process to that described above occurs for consumers and consumer default. Falling consumer income from job losses, wage cuts, and growing inaccessibility to credit (wage deflation) means a greater difficulty paying for debt incurred during the boom phase (real debt rise). However, unlike businesses there are fewer temporary solutions available to consumers facing default on their debt as debt servicing burdens rise dramatically. Their options are default via foreclosure, default via credit card nonpayment, default via auto repossession, or default on student loans resulting in wage garnishing by the lender.

Unlike non-financial businesses and consumers, the so-called ‘big 19’ U.S. banks and shadow banks avoided default by the U.S. Federal Reserve or Treasury giving them interest free loans to cover their debt payments (and then some). In fact, frequently the Federal Reserve ‘paid’ banks to take its loans, in effect offering negative subsidized interest loans to banks. This amounted to the U.S. government making the debt payments for the banks. This largesse did not extend, however, to the 8200 smaller regional and community banks, several hundred of which by the end of 2009 were allowed to default and were subsequently reorganized by the FDIC.

Notwithstanding possible short term or government subsidized solutions, the more protracted the period of deflation, and the greater the prior debt levels and poorer the debt quality, the more likely is default—either in its severe form of company asset liquidation or in the partial form of company restructuring involving selling off some assets and downsizing. Once again, the medium by which the rising debt is transmitted into default is deflation in either or all of its three price systems.

Default Feedback Effects

Defaults in turn provoke further price deflation. For example, bankruptcy means severe asset firesales. Bankruptcy in the form of a total liquidation of a company means all the remaining assets of the company are sold at auction at firesale prices. A good example is the late 2009 liquidation of the once hundred billion dollar valued communications equipment company, Nortel Inc. It sold its assets for less than $900 million in late 2009. Bankruptcy in the form of partial reorganization of a company, instead of total liquidation, also results in asset sales determined by the bankruptcy courts. The asset price deflation is not as severe but still quite significant. The very best assets are typically sold off at well below market prices.

Reorganizations also almost always result in a major downsizing of the company’s workforce and thus major layoffs of employees. The remaining workers are thereafter generally paid at reduced wages and extremely reduced benefits. Wage deflation thus occurs as job, hours of work, and earnings are reduced. As the restructured company re-enters the market, it typically must offer lower product prices in an effort to re-establish a new foothold once again in the market. Defaults therefore translates into more intensified deflationary pressures across all three price systems—asset, product, and wage.

While a restructured and reorganized company no longer has the burden of excessive debt and debt servicing payments, employees of that company—those laid off and those remaining—in contrast end up with less income. Their income is less but their prior incurred debt levels have not changed. In other words, their real debt has risen and their debt servicing difficulty has grown. All things equal, employees of the company must reduce their level of consumption. Lower consumption feeds back into lower product demand and further pressure to lower product prices and cut wages.

Non-bank defaults can provoke bank defaults, as well as vice-versa. When a non-financial business defaults, it means that the debt previously borrowed from its lender, a bank or other financial institution, becomes virtually worthless. The bank-lender must then write off the now ‘bad’ debt on which the non-bank defaulted. With a loss now on its own books, the bank needs to make up the loss by either adding more capital, selling more of its stock, borrowing from the government (i.e. Federal Reserve), or getting bailed out by the U.S. Treasury. Sufficiently widespread and numerous defaults by companies it lent to may result in the bank-financial institution itself defaulting. Until its losses can be offset by other measures, like asset sales, the bank or financial institution in question is generally reluctant to loan or issue credit to its business customers. Unable to obtain credit, the non-financial customers necessarily turn to asset, product and wage deflation solutions, thereby continuing the cycle. In short, debt drives deflation, which in turn drives defaults that subsequently feedback upon deflation.

A rising level of consumer defaults—housing, auto, credit card, other loans—may lead to losses and write downs and subsequent defaults of financial institutions as well. But consumer defaults more often negatively impact secondary levels of the banking system—i.e. thrift institutions, credit card companies, smaller community and regional banks, auto finance companies (GMAC, Ford Credit), credit unions, small business and consumer installment credit, etc. The effects are thus not necessarily direct on the tier one banking and financial institutions. They also impact what are called secondary credit markets as well. In the U.S. these include the securitized markets for credit card, auto, student and other loans which after 2007 virtually shut down and, at the present, have still to revive.

Epic Recessions occur when the debt-deflation process results in an increase in defaults that are sufficient in scope and magnitude to feed back upon and exacerbate debt and deflation—and in turn cause a further deterioration in both financial and consumption fragility. An Epic Recession evolves and grows in momentum, bringing it closer to depression, when the scope and magnitude of defaults significantly exceed historic averages, and when business and consumer defaults feed back upon financially fragile banks and institutions and precipitate a second round of major financial instability. In contrast to Epic Recessions, depressions are characterized by a series of banking-financial crises that take place in the context of a further deteriorating financial and consumption fragility.

Debt-Deflation-Default Nexus and Financial Fragility

This dynamic interactions and feedback effects between debt-deflation and, as debt-deflation intensifies, between debt-deflation and default as well, result in a further deterioration of both financial and consumption fragility.

Recall that both forms of fragility are a function of levels of debt, of the quality (terms and cost) of that debt, and of cash flow (business) or disposable income flow (consumer)—all three factors ultimately combined in the ratio of debt servicing to available cash-income flow. As debt rises or deteriorates, financial fragility rises; as the latter (cash flow) slows or declines, financial fragility rises as well.

Asset deflation drives a company toward more debt accumulation, thereby raising financial fragility. When a company’s assets are declining in value, it is not able as a rule to raise liquidity through new stock issuance. Existing stock prices in such situations are normally stagnant or declining due to public negative perceptions of the company’s future economic performance potential. Thus that door to raising cash flow to make debt payments is largely closed. In addition, the company lacks by definition necessary internal funds in such conditions. If it had sufficient internal funds it wouldn’t have to sell off assets in the first place to make debt payments.

Without internal funding or stock equity funding available, the company is necessarily driven to debt financing. Declining asset prices thus mean the company must seek more debt financing in order to make debt servicing payments. New levels of debt are added to existing debt. And if company is already overloaded with debt in the first place, new debt is normally only obtained at greater cost than old debt, which means debt quality declines and fragility rises as well. The company becomes even more financially fragile over time from debt, as asset deflation eventually forces it to acquire more debt.

But product price deflation similarly results in more financial fragility. Price deflation works on financial fragility from the cash flow side. If a company chooses to reduce product prices instead of selling assets to raise necessary cash flow, it may grow revenue and improve cash flow in the short run in order to service debt payments, but it does so by weakening its revenue base and future cash flow in the longer run. Albeit not as rapidly as asset price deflation, product price deflation therefore also eventually results in reduced cash flow to finance debt and consequently a deterioration in financial fragility.

The company can buy some time from having to resort to asset or product deflation. It may avoid reducing product prices initially by reducing planned real investment or by cutting production and operating costs, especially labor costs. Yet all three—suspending planned investment, cutting labor costs, and cutting other costs of production—also translate sooner or later into reduced revenue and cash flow. Wage cutting and wage deflation may serve as a temporary substitute for price deflation and thus delay a further deterioration of financial fragility in the short run. But wage deflation will eventually result in less productivity and thus higher costs and less cash flow. Cutting back on new investment and production also reduces productivity, with the same effects on rising costs and less cash flow. Because wage deflation’s impact on cash flow is less immediate than product price deflation, that is why businesses typically pursue wage deflation first before product price cutting. And wage cost reduction via layoffs before other forms of wage cutting, since layoffs affect productivity of remaining employees less than wage cutting for those that remain.

To summarize, there are a combination of effects from the interaction of debt-deflation-default that result in a deterioration of financial fragility. Sell off assets is the quickest way to raise liquidity with which to make debt service payments. But asset sales and asset deflation eventually lead to the need to raise more debt, locking the company in a cycle of asset sales to offset rising debt. Reducing product prices are an alternative to raising cash to cover debt payments. But it takes longer than asset sales to raise the cash and is also more uncertain. It also means the company’s real debt servicing in effect rises. Paying debt by product deflation means raising real debt. Companies if possible therefore initially turn to shutting down planned real investment and cutting operating costs, especially labor costs—first by reducing hours of work, then layoffs, then other forms of wage cuts. However, all three of these measures may result in immediate cash to service debt but ultimately result in a reduction of cash flow. All forms of deflation therefore exacerbate debt and debt servicing problems. In the real world, companies with rising debt servicing stress and facing default undertake all measures in some combination, as well seek to raise more debt (even if more costly) and delay if possible making debt payments.

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A couple weeks ago I wrote an article, ‘The Forgotten Working Class’, which is posted on this blog and other public blogs. In it I asked why aren’t we honoring those workers who are keeping the entire system from collapsing, not just honoring with nice words but with appropriate compensation to recognize the key role they’re playing keeping society going. And not just the obvious first responders, healthcare workers, fire and public safety workers–but many other categories of occupations just as critical. Workers who keep going to work despite the conditions and the increasingly obvious failure of the national government in Washington to manage the crisis. Just as critical occupation category is utility workers–gas, electric, water, waste pickup, and so on.

I recently received a ‘thank you’ comment from a water utility worker for writing the article. I’m posting his comment here. And posting as well my reply to him. In my reply I close with the comment that should the crisis worsen, we will depend on folks like him even more. Management and owners of many companies may abandon their operations. In such cases, the workers themselves must take over and ensure their utilities continue to function to keep society from imploding further. Yes, they’ll have to self-manage their companies. In the utility sector this will be more imperative and necessary than in most other industries. We can’t go without electricity, water, heat, waste pickup, no less than can we go without food production & delivery.

Readers should not think a further deterioration will not occur. Anything is possible given the political mismanagement of the country we’re now experiencing. US politicians are not getting control over the effects of the virus pandemic. In many ways, it’s getting worse, especially in the now politically dysfunctional US society and economy. There is virtually no testing (only 1% of the population has been tested). But Trump and the business forces behind him are pushing to open up the economy prematurely. They are willing to accept a certain number of deaths in order to keep their revenues and profits coming.

There are already signs that countries that thought they had the virus contained are now experiencing second waves of infection (e.g. So. Korea, Japan). This virus is not a simple respiratory virus like a flu. It increasingly appears as a virus affecting the blood-hemoglobin system in humans, causing breakdowns in multiple organ systems within the body via contagion through the circulatory system. There is little understanding as yet as to the nature of the virus. Nevertheless, Trump and his business buddies are in a hurry to open up the economy. That makes a possible second wave later this year likely. How will the economy stabilize should that occur? Not well.

History shows in crises like this–caused by war, disease, and social collapse–that capitalists and their managers often abandon their posts. Workers then must save their own jobs and take over the management of the operations of their companies. They must do this not only to protect their jobs, but in the case of utility workers, food workers, health workers, in order to protect all of us.

Here’s the ‘thank you’ comment from a water utility worker, followed by my own reply to him, thanking him far more and not just in nice words.


Hello dr. Rasmus,

I have just read through your much apricated article about the forgotten working class. I myself have worked in a water plant as a operator for the past 7 years and we were essential before it even because a popular word, we have to drive to work in level 3 snow emergencies when only first responders are supposed to be on the road because our job is ESSENTIAL. it has really burned me up of late that myself and other utility workers be it water, gas, or electric are completely forgotten about. They keep talking about fast food, and grocery workers getting more and more “rewards” but not a single thing about utility. In the essential workers wear capes bill that was purposed I didn’t even notice any mention at all about utility workers. It seems as long as someone has running water, lights are on, and heater kicks on… we don’t exist. I tried contacting my local senator about the issue, but as you can imagine was impossible. Then I came across your article and it was so refreshing seeing someone bring up these issues. Its about to get so bad at my plant that we are in talks discussing the operators live at work.. yes live in the plant for weeks on end. We have had our personal time canceled, and being able to take a sick day causes cascading issues to the other operators who have to pull extra hours to cover it even though we have a cover shift at all our plants they are already working extra hours as well. People say “your lucky you have your job” , well I have severe asthma and I go to work everyday risking infection like the other people who get noticed do.. But we get no credit at all, while we keep your utilities going. I signed up for this job knowing we were considered essential and had to go to work everyday no matter what was going on, but its so disheartening to see that no one in the utility field getting any sort of recognition during this time where jobs before weren’t considered essential while we were. It just goes back to the saying we have, As long as they have running water, they don’t even know we exist, but soon as it stops they yell to the heavens about it. Anyway, thank you for giving us some credit in your article, it was very apricated.


I agree with you. And there should be not just appreciation but there should be special compensation for utility workers. Not just words but action. Without you (especially water) the entire economy would collapse in less than a week. Faster than if even the food supply were disrupted. Here’s the simple rule of thumb: humans can survive for only 3 minutes without air and oxygen. They can survive best case for 30 days without food. And they can survive only 3 days without water. 3 days. Sometime between 3 and 7 days, without water, the entire society enters chaos. Thanks to you and your brothers and sister utility workers, chaos is still held at bay. But you ought to be rewarded for it. At least time and one half emergency pay for all hours worked. And extra paid time off when (if) the current crisis is over, so you can do some R&R and recuperate from the stress.  At let me say one more thing: if this crisis gets worse, companies and their senior management may walk away from the job. In that case, you workers must rescue us. I’m talking about taking over your operations and keep them going, for the benefit of the rest and indeed civilization itself. Don’t let them close it down. Take it over and managed it yourselves. You know how. Just keep that in mind.  Dr. Rasmus

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Epic or ‘great’ recessions are caused by the overlapping or congruence of financial-banking crashes and the deep contraction of the non-financial real economy. A contraction in the financial economy can precipitate and exacerbate a contraction in the real economy. And vice-versa. By ‘real’ is meant GDP–that is, investment in buildings, equipment, inventories, etc., and household consumption. By ‘financial’ is meant financial assets like stocks, bonds, derivatives, options, futures, etc.

In a ‘normal’ recession, forces cause the ‘real’ economy to contract–i.e. GDP to go negative. Such real contractions are typically short lived, however, typically less than a year. And there is no corresponding financial asset price crash, credit crunch, defaults or bank failures.

In contrast, in an ‘epic’ or ‘great’ recession, either a financial crash precipitates and drives a real economy lower than ‘normal’ for a recession; or a real recession leads to an eventual financial crash and a deeper recession. In both cases, the dual contraction results in both the financial and real side of the economy exacerbating each other. The contraction thus goes deeper, and therefore lasts longer–typically in a great recession 12 to 24 months; sometimes longer, with short shallow recoveries followed by short, brief re-recessions. The latter describes Europe after 2009, with a double dip recession 2011-13 and weak recoveries followed by stagnant barely 1-2% growth. It reflects even more the case of Japan after 2009, which experienced three recessions over the next ten years and very weak recoveries between.

To understand the dynamics between financial cycles and real business cycles, it is necessary to understand the relationship and causal interactions between financial asset investing in stocks, bonds, etc., on the one hand, and real asset investment in buildings, structures, plant, equipment, inventories, etc. In both cases of financial and real investing, the growth of excess debt is a ‘marker’ of the growing potential for instability (contraction). Debt grows in late capitalism at double the normal rate. Credit is extended, creating a debt, for the expansion of real investment; but it also grows, increasingly and ever-more rapidly in the 21st century, to fuel financial asset investment. Understanding how debt makes both forms of investment ‘unstable’–or to use an alternate term ‘fragile’ and prone to crisis–is central to understanding how and why financial cycles and real business cycles overlap and exacerbate each other, in the process creating more severe downturns called ‘great recessions’.

But debt levels by themselves are not the cause of crises. What matters is the ability or inability to ‘service’ that debt–i.e. pay its principal and interest when due. So long as prices for financial assets continue to rise, and prices for real goods and services continue to rise as well, debt levels may rise in turn without creating a crisis. However, when prices deflate, and revenues and cash flow with which to ‘service’ the principal and interest on debt collapse in turn, then debt levels matter. In other words, it is the relation between debt and price deflation, and revenues/cash that is central to fragility. A third element is critical as well. Defaults, which mean failure to pay interest or principal on the debt coming due. Defaults lead to further declines in price (deflation), revenues, and available cash with which to service the debt. A downward spiral of both financial asset and real asset investment follows, the one exacerbating the other in a mutual negative feedback effect.

The following Part 2 excerpt from my 2010 book, ‘Epic Recession: Prelude to Global Recession’, described these basic relationships between financial asset and real asset investing, debt accumulation, deflation, and defaults in the run-up to the 2008-09 dual financial-real economy crash. It is the causal interaction of these variables that drive the deep, dual contraction called great recessions. In 2008-09 it was the financial contraction that precipitated and drove the real contraction; today, 2020, it appears more likely this will be reversed, with the real side driving the collapse of the financial side.

Real Investment As Basis for Financial Investing

Financial investment begins on a base of real asset investment. For example, a property, i.e. a real asset, must be built before a mortgage, or financial asset based upon that real asset, is in turn issued. Thereafter, additional financial assets may be issued based upon the initial financial asset. These are called derivatives. A mortgage forms the basis for the issuance of a mortgage bond composed of various individual mortgages or parts of mortgages. The growth in real assets thus initially provides the basis for subsequent expansion and growth of financial assets. But the process of financial asset creation soon diverges from its real asset base. And the more they diverge, the more asset price inflation is driven by forces independent of original real asset investment. And as asset inflation becomes more independent it also becomes more volatile.

Concerning the real investment side: in the early phase of a business cycle, opportunities for profitability from real asset investment are greater than in late stages of the cycle. Prices for materials and intermediate goods, and therefore costs, are relatively low. There are few pressures in labor markets to raise wages. Costs are therefore minimal and possibilities for rapid gains in productivity higher. All things equal, lower costs mean higher expected profits and therefore plans for increasing real asset investment. Expectations that prices will increase as the business cycle develops means additional expected profits and plans for investment. Product development preparation during the recession, in anticipation of recovery, provides an additional potential boost to investment. In short, expectations of profitability are higher than average in the beginning of a boom phase and therefore plans for, and actual, investment higher than average. But over the course of the business cycle, the above positive elements weaken, profitability ebbs, and with it plans for, and actual levels of, real asset investment. But that does not necessarily inhibited financial asset price inflation from accelerating.

As investment in real assets initially rises, the foundation for financial speculation also rises. In the beginning, speculative investing is based on prior real asset investing. For example, residential and commercial property real assets must be created first, before subsequent speculation on those assets is possible. Similarly, a supply of commodities—whether food, oil, metals, or in other forms—must be created before speculation on those commodities can occur. Issuing new stock with which to finance real investment results in stock price volatility, upon which speculators may then enter the market. Similarly for bonds created from bundling of mortgages. Whereas the initial mortgage represents a first tier financial instrument, the stock price appreciation and bond yields represent second tier financial instruments.

To summarize, real asset investment initially provides a basis for speculative financial asset investment. As the latter accelerates, it creates a new for additional real assets on which to create further financial assets. It may thus artificially stimulate real asset investment to a degree. But as will be described shortly, increasingly over the boom cycle speculative asset investing becomes based less on real asset investment but more on previously created financial assets. As a consequence of this shift, disproportionality grows between real asset investment and speculative asset investment.

Financial Asset Speculation As Driver of Excess Financial Investing

The preceding described how the real asset provides the basis for a speculative financial asset. The house creates a first tier ‘mortgage’ and mortgages of various homeowners are bundled to create a ‘mortgage bond’ (RMBS), a second tier financial instrument. But there are further ‘tiers’.

A third and even fourth tier occurs when yet another layer of financial instrument is created on the preceding layers. Stimulating the demand for third and fourth tier financial assets are the availability of extreme ‘leveraging’, as well as the spread of securitization and widespread availability of secondary markets in which to sell the third and fourth tier of financial products.

In the third tier, previously created second tier financial instruments are repackaged, then mixed with other short term financial issues like asset backed commercial paper, or ABS. The new repacked financial issue is marked up in terms of price, and then resold once again in other secondary markets. These resales are often global, since the product itself has no distribution costs and is available electronically. These financial ‘products’ also have virtually no production costs. Supply is not a factor and plays little or no role in pricing of these products. Price movement of third tier instruments are even more independent of the original real asset. They become virtually demand driven, and thus quite unlike prices for real asset products, where tightening supply and slowing demand over the course of a business cycle eventually constrain further price increases. Financial asset prices, in contrast, have no supply constraints and are driven by ever greater demand almost exclusively.

As prices for second and third tier financial assets begin to diverge from real asset prices, supply and demand forces begin to slow real asset price increases as expectations of profitability weaken and decline. Declining expectations for profitability leads to slowing real asset investment. Real asset investment slows, just as financial asset investment begins to accelerate. More liquidity and credit subsequently flows into speculative investing and out of real asset investing. In other words, an imbalance and disproportionality begins to emerge between real asset investment and more speculative forms of financial asset investing, as well as between their respective price systems.

In this situation, creators of financial instruments are confronted with a dilemma: either get more physical asset investment into the pipeline or create more speculative financial instruments from other financial instruments. This is what precisely occurred during the subprime mortgage boom in the U.S. Banks and other financial intermediaries in the U.S. needed a continued flow of mortgages loans in order to create their residential and commercial property mortgage-based bonds, RMBS and CMBS financial instruments, to securitize and resell into secondary markets. So they sent people into the field to instruct mortgage lenders how to develop a greater volume of mortgages and loans. This was called ‘originate and distribute’. Quantity of mortgages was all that mattered, not quality.

First and second tier financial assets are mortgages, bonds, stocks, etc., whereas third tier financial assets are even more highly leveraged, further securitized, and resold in global secondary markets. These include typically collateralized debt obligations (CDOs), collateralized loan obligations (CLOs), asset backed commercial paper (ABCPs) and other asset backed securities (ABS)

There is a fourth tier of financial instruments as well, however. That is the creation of credit default swaps (CDS) and other insurance instruments as cover for the increasingly risky character of second and third tier instruments’ quality and quantity. But CDSs quickly become more than mere insurance. There are, in effect, essentially ‘bets’ on the likely degree of failure of the prior tiered instruments. As profitability from financial speculation rises with financial asset inflation, it in turn fuels even more speculation in various ‘higher level’ derivatives like CDSs. Other fourth tier instruments include interest rate swaps, currency swaps, and other over the counter derivatives. These are all forms of ‘casino investing’, or investment as pure ‘betting’.

To partly sum up, real asset investment initially enables speculative asset investment. But as the general business cycle develops, the much greater price-driven profitability of financial speculation begins to feed upon itself. Financial speculation creates more financial speculation, thus increasingly diverting capital from real investment just at a time when growing supply constraints begin to raise costs of real asset investment, lower its expected profitability, and in turn consequently slow real asset investment. The falling real returns, actual and expected, from real investment diverts liquidity and credit even more to speculative investing, which drives the demand and price of the latter still further. Speculative asset prices begin to accelerate while real asset prices slow. The former becomes relatively and increasingly profitable and the latter less so. .

As professional investors and their ‘shadow’ institutions grow in number, weight and the liquidity they control, the overall effect is an increase in demand for speculative assets and a slowdown of the demand for real asset investment over time. Speculative forms of investing therefore have over the longer run a relative net negative impact on non-speculative asset investment. It is not that speculative investment ‘crowds out’ real investment, but that it diverts and distorts it. It over-stimulates some forms of real investment, while it slows other forms of real investment while the net effect is negative. Major disproportions and imbalances are the consequence—which become major contributing forces to financial instability.

Financial Investing and Acceleration of Excess Debt Accumulation

There are at least two ways in which speculative investing accelerates the accumulation of debt. It does this first by transforming debt simple leveraging into a kind of super ‘layered-leveraging’. By layered-leveraging is meant securitized leveraging. As previously noted, speculative investing by definition relies heavily on leveraging per se, just as it does on opportunities that are short term and price driven. However, securitization significantly increases leveraging even further (and thus levels of debt) by enabling multiple ‘tiers’ of leveraging. That is, at each tier of financial investment, the purchase of each repackaged financial asset is leveraged. Leveraging thus occurs multiple times. For example, mortgage bonds are rolled into collateralized debt obligation (CDO) securities. Those CDOs are repacked into and resold as part of a ‘synthetic’ CDO—a CDO created out of bundling other CDOs. Credit default swaps are created to ‘insure’ against the risk of the preceding. Along this chain of ‘financial instruments created out of financial instruments’, additional leveraging and borrowing—and thus debt creation—takes place at each level. In short, securitization multiplies the volume of debt by enabling levels or ‘tiers’ of leveraging. We have debt and leveraging based upon previous leveraging and debt.

Securitization additionally promotes greater investor risk taking, all things equal. With the possibility of quickly selling the asset after a short term on a secondary market, the investor develops a false sense of reduced risk that encourages further speculation and leveraging. If there’s a secondary market, investors believe they can quickly dump the asset by reselling it should its price stop rising or begin to fall. The very existence of secondary markets for securitized assets therefore encourages excess risk taking. As Keynes put it, they believe they can determine what the average investor will do better than the average investor can and that they can ‘get out’ before the market slows or collapses.

In short, securitization and secondary markets serve to increase the trend toward speculative investing by appearing to reduce risk and by enabling layered-leveraging. The greater leveraging and false sense of reduced risk translate into a greater volume (and reduced quality) of debt than otherwise would occur. The problem is that secondary markets for securitized assets work as an exit only when asset prices are rising. As soon as asset prices begin to fall rapidly, there is no secondary market in which to exit from. Everyone is trying to sell and no one is buying—and by definition there is no market when no one buys and everyone tries to sell.

(In Part 3 to follow: The Debt-Deflation-Default Nexus & Great Recessions)

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Much can be learned about the trajectory and nature of the current 2020 Great Recessions 2.0 underway by understanding what went on in similar deep economic contractions that are combined with financial-banking instability and crashes. The so-called ‘Great Recession of 2008-09’ was one such ‘dual’ crisis. Another occurred in early years of the Great Depression of the 1930s, from 1929 to 1931. Another is the financial crash of 1907-08 and its aftermath of four years of stagnant growth and re-recessions. What follows is an excerpt from my 2010 book, ‘Epic Recession: Prelude to Global Depression’, specifically the chapter 3 entitled ‘The Dynamics of Epic Recessions. (Note: what others called the ‘Great Recession’ I alternatively called ‘Epic Recessions’ to distinguish them from ‘normal’ recessions). In it I explain how excessive liquidity injections by central banks feeds financial instability and excess debt accumulation throughout the economic system. Excess debt build up during the ‘boom’ period makes the economic system ‘fragile’–meaning sensitive and prone to deep contractions. The contractions, when they come, generate deflation in both financial and goods prices that, together with the debt unwinding, lead to widespread defaults, in both financial and non-financial sectors of the economy. That condition drives the economy into a further deeper contraction. Banking and financial crashes follow. All great (aka epic) recessions are made of such dynamics, which differentiates them from ‘normal’ recessions. Great Depressions are when defaults provoke a sequence of multiple financial-banking crashes.

In a number of ways the current 2020 events are increasingly similar to prior ‘great’ recession events. The process is still, of course, in early stage and evolving. But the special, very severe contraction underway as of spring 2020 portends an especially severe form of Great Recession. The Fed and other central banks are desperately trying to head off a financial-banking crash by throwing unprecedented magnitudes of free money at the financial institutions. And now at the non-financial sector as well for the first time historically. Whether this ‘all in’ strategy can succeed in preventing defaults, deep financial asset price deflation, and a system wide credit crash remains to be seen. The process will take months, not weeks, to work itself out. But against the system stabilizing as a result of tens of trillions of dollars of free money is the US and world economies were especially weak on the eve of the virus impact–not strong as some politicians like to argue. Moreover, monetary policy was largely spent stabilizing the 2008-09 crashes, and thereafter in continuing to subsidize capital incomes and profits instead of preparing for the next cycle. Ditto for fiscal policy, that continued to subsidize capital incomes with massive tax cuts for investors and businesses alike–in the US no less than $10 trillion in such tax cuts, to which Trump added another $5 trillion in 2018-19. Budget deficits surged to more than $1 trillion. In short, fiscal policy like monetary policy on the eve of the current crisis was rendered largely ineffective for the coming crisis. The global economy is also decidedly much weaker this time around as well, with a global manufacturing recession the case in 2019 and trade wounded by Trump’s global trade war launched in 2018.

What follows is the excerpt from my 2010 book, ‘Epic Recession’. Its themes were picked up and developed thereafter further in my 2016 book, ‘Systemic Fragility in the Global Economy’ concluding chapter. Further excerpts from the 2010 book will follow this posts; and after that the updates in the 2016 book. So here’s Part 1 on liquidity, its role generating excess debt, and what I called at the time in 2010 the ‘debt-deflation-default nexus’.

The Dynamics of Epic Recession

The two preceding chapters addressed static quantitative and qualitative characteristics of Epic Recession. This chapter is concerned with the dynamic characteristics of Epic Recessions—i.e. those characteristics that explain the processes by which Epic Recessions evolve over time.

At the top of the pyramid is the explosion in global liquidity. Liquidity is cash and near-cash forms of liquid assets that can be relatively easily and quickly converted to investment. That investment may take the form of real physical assets, like structures, equipment, inventories of products, etc.; or the form of financial assets, like bonds, commercial paper, stocks, derivatives financial instruments, and so forth. Whichever the form, the point is liquidity is the basis for investment. It is the source for issuing credit and thus debt. The extension of credit becomes the debt of the borrower of that credit. Liquidity enables banks to issue loans, corporations to issue bonds, speculators to purchase derivatives, etc.

There are several major sources responsible for the exploding liquidity in the U.S. and global economy over the last several decades. All have contributed to the growing volume of liquidity, such that today there is now a flood of liquidity awash in the global economy. The unprecedented surge in liquidity is the source of credit and corresponding debt accumulation. And it is that credit and debt acceleration that has fueled and enabled the run-up in speculative investing to historic, record levels in turn.

One source of the global liquidity explosion has been the U.S. central bank, the Federal Reserve. Since the dollar became the de facto global currency in 1944 (and the virtual de jure global currency since 1971 when the last fiction of a gold standard was abandoned), U.S. monetary policies for more than half a century have been injecting trillions of dollars into the U.S. and global economies. That’s trillions of dollars of excess liquidity that has accumulated globally in the hands of investors public and private, corporate and sovereign, individual and institutional.

It represents a record volume between $20 and $40 trillion of investible money capital that cannot lie idle and must find an outlet.

The Fed enables the expansion of credit in the commercial banking system by means of buying government bonds back from the banks, changing their minimum reserve requirements of those banks, or loaning money to individual banks directly through the Fed’s ‘discount window’. Since December 2007 it has added a fourth new ‘tool’ for injecting liquidity into the economy called targeted ‘auctions’ designed to provide massive bailout funding for banks, shadow banks, and even non-financial corporations. By means of these special auctions over the last two years, the Fed has injected or committed to provide between $2 and $11 trillion, depending on which accounting approach one chooses. But Fed actions since December 2007 constitute only the latest of a long string of liquidity pumping actions by the Fed.

When there’s a recession, the Fed injects liquidity. That occurred in response to the normal recessions that happened in 1966, 1970, 1973-75, 1980, 1982, 1990, and 2001. In addition, every time there’s a financial instability event, the Fed injects still more liquidity to offset banks’ anticipated losses to keep them from insolvency and lending. That occurred 1987-1988 in response to the stock market crash of 1987; in 1989-1992 to bail out the savings and loan and junk bond markets; 1997-1998 to rescue the Long Term Capital Management hedge fund and Asian banks and financial institutions with ties to U.S. banks; in 1999 to counter fears about computers coming to a stop with the change in the millennia (a phony mini-panic called the Y2K or ‘year 2000’); 2000-2001 to counter the tech-driven stock market bust, and 2002-2004 to keep the housing market going as the rest of the economy faltered. On occasion the Fed has even injected liquidity to assist Presidents in their election bids or war policies, such as in 1971-72 in the case of Nixon and 2003-04 for George W. Bush.

In contrast to its long term policy of pumping liquidity into the economy, the Fed has done little in the way of successfully retracting that same liquidity after recessions, major financial instability events, or following the accommodation of Presidents’ political demands. The roughly twenty years of Fed ‘net’ liquidity injections into the U.S. economy, from 1986 to 2006 under the chairmanship of Alan Greenspan, has become known as the Greenspan ‘Put’. Since 2007, an even greater net liquidity injection has occurred under its current chairman, Ben Bernanke. It will no doubt eventually become known as the ‘Bernanke Put’—i.e. a far greater amount in a much shorter period of time.

The Fed’s decades-long, pro-liquidity policies not only contributed to a build-up of liquidity within the U.S. economy, but did so throughout the global economy as well. To the extent easier credit from the Fed was accessible to U.S. banks with operations and dealings abroad—which has become the case increasingly since the early 1990s—some of that Fed-provided liquidity to those U.S. banks was undoubtedly diverted offshore. Similarly, loans to non-bank U.S. companies with foreign subsidiaries no doubt resulted in liquidity flowing offshore to those subsidiaries, as well as for those multinational companies’ growing acquisitions of additional offshore assets since 1990. The latter is called Foreign Direct Investment, or FDI, and that too has been fueled by Fed monetary policies’ creating excess liquidity in the system.

Other U.S. government policies have also contributed to the growth of dollar liquidity globally. U.S. government policies providing foreign aid to sovereign countries for decades increased the flow of dollars and liquidity from the U.S. into the global system. So did funding of U.S. military bases and operations around the world. And policies of free trade, that resulted in chronic and rising U.S. trade deficits since the 1980s. Trade deficits have meant net annual outflows of hundreds of billions of dollars every year from the U.S. economy since the 1980s, culminating in more than $700 billion trade deficits for four years running during the mid-2000s alone. A further consequence of U.S. free trade policies has been the expansion of U.S. companies’ foreign direct investment, or FDI, which, as previously noted, have transferred additional billions of dollars offshore. Then there’s the major structural changes that have occurred in the U.S. tax system since 1980 that have permitted wealthy U.S. investors, individual and institutional, to shift decades of money capital from capital gains, dividends and interest income into offshore tax havens to avoid tax payments to the U.S.—in dozens of small or island nations from Cayman Islands to Seychelles to Vanuatu to Switzerland and beyond. All the above developments have combined to enable a flow of trillions of dollars into offshore venues—going into foreign central banks, private banks and financial institutions, offshore hedge and investment funds, personal and corporate accounts in tax havens, etc. Thus, while the Fed has obviously been a major contributor to the steady growth of liquidity in the U.S. and the global economy, it hasn’t been the only source. U.S. government military, trade and tax policies have contributed as well.

In addition to the Fed, and U.S. military spending, trade and tax policies, at least two other major forces have additionally contributed to the historic expansion of liquidity worldwide in recent decades. One is what is sometimes called the ‘global savings glut’.

There are different interpretations of the meaning of the ‘global savings glut’. For former Federal Reserve chairman, Alan Greenspan, the ‘global savings glut’ represents the accumulated reserves held by foreign central banks, private banks, and investors.
It is the global savings glut, as Greenspan defines it, that caused the flood of liquidity into the U.S. between 2002-2005 that drove down mortgage interest rates, which in turn caused the subprime market boom. It wasn’t the Fed lowering short term rates to 1% and keeping them there for nearly two years that caused the speculative boom in residential housing. The housing bubble occurred worldwide, not just in the U.S. It was the excess global liquidity that flooded into the U.S. housing market that was the culprit. The cause therefore was the glut—sometimes referred to as another sanitized term, ‘global imbalances’—that was responsible. The bubble was thus beyond the Fed’s or any central bank’s control. But even if it is true, as Greenspan maintains, that the post-2002 boom occurred simultaneously in many global markets not just the U.S. and the Fed therefore could not have been responsible; even if one were to agree with him that the global savings glut washing back onto U.S. economic shores circa 2002 was the sole cause the U.S. subprime housing bubble—what then explains the origins of that ‘global savings glut’ itself?

First, data is irrefutably clear that the U.S. housing price bubble began in 1997, not in 2002. The speculation in residential housing markets preceded the Fed’s 2002 lowering of rates as well as the alleged 2002-05 foreign investment inflows by at least five years. Both the Fed’s low 1% rates and the simultaneous global liquidity inflows contributed to the subprime housing bubble. But neither was the originating cause. The subprime boom of 2002-2005 was just the culminating phase of the housing bubble. What set off the start of housing speculation and the beginning of the run-up in housing prices around 1997-1998 is the fundamental question Greenspan must answer, but doesn’t. In addition, Greenspan must explain further why the dot.com technology stocks bubble originated around 1997 as well, and why the speculative bubble in Asian currencies that led to the Asian financial meltdown in 1997-1998 (that in turn spread to Russia and Latin American economies, and required the bailout of the big hedge fund, Long Term Capital Management in 1998) occurred as well circa 1997-1998? What was beginning to happen circa 1997-1998 that precipitated all three bubbles? Was it just coincidental that all three speculative bubbles commenced around the same time? Or is there a common thread and origin to all three?

The global savings glut begins with the river of dollars with which the U.S. flooded the world for decades as a direct consequence of its monetary, fiscal, and military policies. But that flow of dollars was only the start—a kind of priming of the global liquidity pump. The ‘global savings glut’ has been equally important factor contributing to the global liquidity explosion. The glut is the product of the past three decades of unprecedented profits, income and wealth accumulation. But it is not faceless ‘savings’ or ‘reserves’, as Greenspan and others call it. Those are misleading terms that function for the purpose of obfuscating a deeper meaning. The ‘glut’ is in fact the accumulation and concentration of income and wealth among certain strata of investors worldwide, taking the form of excess money and credit capital, that is now increasingly seeking out and flowing into speculative investment opportunities globally at an increasing rate. The glut therefore has a face: the rising global ‘investor elite’ of individuals, funds, investing institutions, corporations, banks, shadow banks and central banks.

The income-wealth accumulated by that elite more than three decades now has derived from both real asset and speculative asset investment, but increasingly in recent years from the latter and decreasingly from the former. The real asset investment has concentrated in manufacturing and infrastructure investment in the so-called ‘BRIC’ countries—i.e. Brazil, Russia, India, and especially China—and to a more limited extent in certain industries like energy extraction and commercial building the petro-economies. The rising share of accumulation of income and wealth from speculative investing has come from commodities, oil, gold, metals, currency and stock speculation, futures and options trading, land and commercial properties, funding of mergers and acquisitions, infrastructure bonds, buying and selling in secondary markets, securitized financial assets, credit insurance, and a host of other derivative based financial instruments.

Once again, the ‘glut’ is therefore not really about ‘savings’ or foreign investors’ reserves. That is a misnomer for what is in essence a concentration of income and wealth among a global strata of investors with a unique control of new, as well as old, forms of money capital. The glut represents global income inequality—not between nations but between the investor classes within most nations and their non-investor countrymen. This investor elite of course includes members in the advanced economies of North America, Europe and Japan, just as it does those in Singapore, Hong Kong, Dubai, Soeul, Shanghai, Rio, Bangalore and elsewhere. It is not about third world or ‘emerging markets’ investors. It reflects a global transformation of capital, as well as a restructuring of the various constituent elements of the class in control of that capital.

In addition to the Fed and U.S. military spending, trade and tax policies, and the global savings glut, there is yet a fourth major source of the global liquidity explosion. The policies of the Fed and U.S. government that since 1945 flooded the world economy with dollars, and the policies that since 1980 set in motion the concentration of income on a global scale do not, by themselves, fully account for the explosion of liquidity of recent decades. That record liquidity was also the consequence of the revolution in credit creation that has been unleashed in large part by the shadow banking system.

Normally liquidity is created in the banking system when the central bank of a country injects money into its banking system. That money injection increases the reserves on hand in the banks with which to extend credit to borrowers. As the banks lend the money to customers the money supply increases in the economy. The actual process of credit creation occurs when the private banks actually extend loans—i.e. credit—to borrowers who subsequently make investments. This describes a traditional process by which a central bank (Fed) determines the amount and timing of liquidity injection and credit. But that liquidity creation process has been giving way progressively over recent decades to a different kind of credit creation system that is growing relatively more independent of the central bank and whatever action it may take. Central banks’ injection of money into the banking system may lead to an increase in credit as banks loan out the money to borrowers. But banks’ credit extension is not limited to this process. Banks and shadow banks provide credit, but have been doing so increasingly independent of the money supply and central banks (e.g. Fed) money supply management processes. In other words, credit is becoming unhinged from money.

In the new system of credit, financial instruments themselves are used as the basis of credit extension and thus borrowing and debt. For example, when a financial instrument, like a collateralized debt obligation derivative, is created based on a subprime mortgage, and the market value of that derivative rises, that increased market value is then used as the basis for issuing further credit to purchase yet more financial instruments. Investments are not made based on the central bank increasing or decreasing the reserves banks may have on hand. Loans and credit extension have now little or nothing to do with banks’ existing levels of loanable excess reserves. Because these financial instruments are tradable immediately on secondary markets short term, they are more or less ‘liquid’; that is, can be used like money to purchase other financial assets. And as such financial instruments grow in volume and value, they are in effect increasing the overall liquidity within the system. Such credit financing is especially appropriate for investing in financial instruments. As the value of financial instruments rises (which presumes a continued rise in their price), it enables investing in still more similar financial instruments. The process would not be possible without the development of ‘securitization’ and highly liquid secondary markets for speculative financial instruments. In a sense, therefore, securitization and secondary markets create liquidity for financing still additional speculative investing.

A couple additional concrete examples: credit default swaps (CDS) derivatives and ‘naked short selling’. With CDS an investor may speculate that a company will default, so he ‘buys’an insurance contract (a CDS) to protect against that failure. But the speculator does not actually ‘buy’ in the sense of putting real dollars up to purchase the CDS contract. At most, he may put up a very small share of the actual cost of the CDS and leverage the rest—i.e. owe it as debt. All derivatives financial securities are in a similar way ‘leveraged’. That is, credit (and debt) far beyond what is invested in real money is extended to the borrower. Credit, and corresponding debt, is created independently of bank reserves and Fed efforts to manage levels of bank reserves.

The case of what is called ‘naked short selling’ of stocks by speculators is even more blatant. Short selling has been around for some time. It is associated with stock selling. Professional stock traders borrow to buy stock at its current price with the expectation of selling it later once the price declines and pocketing the difference as pure speculative profits. The borrowing incurs a short term debt for which an interest charge or fee must be paid. The borrowing also creates downward pressure on the stock price in question.

‘Naked’ short selling takes the speculative practice one step further. ‘Naked’ means traders don’t even borrow the funds in order to buy. Naked short selling amounts to buying stock without putting a penny down—i.e. 100% leveraging. Naked short sales amount to selling something you never owned. In other words, it’s another extreme form of speculation, more like pure ‘betting’ or like ‘betting’ when purchasing credit default swaps than buying and selling of a stock per se. Naked short selling results in even greater downward pressure on a stock’s price. Naked short sellers played a major role in the collapse of Bear Stearns, Fannie Mae, and Lehman brothers in the intensifying financial crisis during 2008, as speculators turned increasingly toward ‘naked’ short selling.

Naked short selling has the eventual result of causing a rise in corporate debt for those companies targeted by the short sellers. To the extent short selling drives down stock prices it makes it increasingly difficult for corporations to raise capital by means of stock issuance. That forces them to borrow and increase their debt, or to forego real investment activity altogether, which often means a reduction in real investment and jobs. As the recent financial crisis spread globally, the practice of short selling was banned or severely restricted in many places in Asia, Australia, Europe—but not in the U.S. Naked short selling might also be considered a form of ‘financial cannibalism’, in that investors in shadow banks prey upon investors in real asset institutions like non-financial companies.
As shadow banks, hedge funds and their investors have been particular active in naked short selling during the recent financial crisis. According to the premier market research source tracking the hedge fund industry, Hedge Fund Research, hedge funds involved in short selling (including the increasing practice of naked selling) accounted for about 40% of the $3 trillion in global hedge fund assets in 2007-08.

Investing in CDSs and naked short selling represent ‘investment as betting’ and thus an extreme form of speculative investing. But they would not be possible without the new forms of liquidity creation with which they are financed. These new forms of speculative investing typically often result as well in an increase in debt levels for companies with real assets and therefore negative affect levels of real asset investment in those companies. On the other hand, profits and returns to speculators are often significant. Driven by asset price inflation, speculative profits are often several magnitudes greater than profits from investment in real assets, so long as prices continue to rise. Speculative profits also have the added enticement that they can be realized in a much shorter time period. That capital-profit turnover time makes such investments further attractive. And so long as the price of the asset continues to rise, the expectation of profitability is more certain compared, say, to investing in real assets and real products for which demand may or may not materialize at all. Despite the frequency of financial crises in the past twenty years, it appears that profits from speculative investing have grown significantly faster than from real asset investing. For every speculator who waits too long to exit a bubble, and thus loses capital, there are on net more that gain from the run-up and price bubble. That net growth in profits and wealth in turn adds to the ‘global savings glut’ and global pool of liquidity available for subsequent investing.

Financial deregulation has increased the rate and geographic spread of speculative investing. It opened up and accelerated global capital flows. It permitted and stimulated the growth of shadow banking-financial intermediaries as the prime distribution channels for speculative investing and allowed the regulated banking system to play in those same channels and markets. But it did not create the fundamental requirement for speculative investing. That fundamental requirement was the explosion of liquidity. Without that liquidity, and the new forms of leveraging that accompanied it, there would be nothing to speculate with. The new forms of leveraging that expanded it, the new financial instruments that productized it, the new forms of institutions that distributed it, and the new markets in which those financial instruments were sold—are all predicated on the creation of a massive global pool of excess liquidity.

To sum up, there exists today a massive global pool of liquid and near liquid money capital that must find an investment outlet. Estimated roughly in the range of $20 to $40 trillion worldwide, it is thus so excessively large that it cannot find sufficient real, fixed investment opportunities to absorb all of it. There is far more liquidity than real physical asset investment opportunities—notwithstanding the infrastructure growth in China, India, Brazil and the like. More critically, real asset investment may not be as profitable as speculative investing in any event. Meanwhile, that liquidity pool cannot and will not remain idle. It is therefore prone to seek out new price driven speculative opportunities, which are more easily and quickly exploited, with faster turnover and often with greater returns, than physical asset investment in structures, equipment, inventories and such.

The Global Money Parade

The flooding of both the U.S. and global economy with U.S. dollars, the global savings glut, plus new forms of credit creation have produced a historic growth in available liquidity in the global economy. The volume of liquidity is only part of the story, however. Where that liquidity resides and to what uses it is being put are equally important. In what institutions is that liquidity ‘deposited’? In what asset types is it invested? Who are the investors—institutional, corporate, and wealthy individual?

How much of the estimated $20 to $40 trillion in outstanding liquidity today resides in the global network of commercial banks, like J.P Morgan Chase and Bank of America? How much of it in those institutions referred to as ‘shadow banks’ or financial intermediaries—i.e. the investment banks like Goldman Sachs and Morgan Stanley? Giant hedge funds, like Citadel, and the hedge fund sector, which grew from just several hundred in the 1990s to more than 10,000 by 2008 with nearly $2 trillion in assets? Private equity firms like Carlyl or Blackstone that controlled several trillions more at their peak? Finance companies like GMAC and GE Credit? GSEs like Fannie Mae and Freddie Mac? Or in the allegedly more conservative investing institutions like the $4 trillion money market funds, the multi-trillion dollar pension funds, emerging market funds, sovereign wealth funds of the oil rich economies, etc.?

As noted in a previous chapter, for the U.S. alone it is estimated the network of shadow banking institutions by 2007 accounted for more than $10 trillion, about equal to the assets of the commercial banking sector. And the U.S. share of the global shadow banking network is probably no more than 40% at most. Moreover, the commercial banks have over the last decade merged with shadow banks in various ways—at least the largest of the commercial banks. So it makes less and less sense over time to even refer to the distinction of the two banking sectors. Commercial banks have turned increasingly to the higher profitable speculative forms of investing. And they have long funded the shadow banks to significant extent, set up their own hedge funds and private equity firms, established private bank operations for their wealthiest clients, and acted in part like shadow banks in fact if not in name. So part of the big commercial banks must be considered a segment of the shadow banking sector as well, and a significant amount of their lending activity has no doubt been increasingly speculative.

A testimony to that latter point is the huge amount of lending by commercial banks that has occurred since May 2009 to speculators in foreign currency and emerging markets. The banks borrow from the Fed at 0.25% and loan at substantially higher rates to clients speculating in Asian, Latin American, and Russian currencies. Less involved in highly speculative ventures as general rule are the 8200 or so smaller regional and community banks and thrift institutions in the U.S., although to the extent this group has participated in financing subprime mortgages and highly leveraged commercial property deals they too have forayed into speculative investment in major ways. All these represent a short list of institutional ‘loci’ in which much of the world liquidity resides. Add to these institutionals investing on behalf of clients (as well as on behalf of themselves as institutions), very wealthy individuals who invest directly themselves rather than via institutions, and the thousands of corporations that, to some degree, also invest directly with their companies’ retained earnings.

These investors—individual, corporate, and institutional alike—have been shifting their liquidity increasingly in recent decades into speculative investments; that is, investment opportunities of a short term, price-driven asset nature rather than in longer term enterprise, equipment, and structures that payout with a longer, amortized stream of income. That is, investments in financial asset securities. The profits are greater due to the price volatility, the costs are lower since most speculative investing is in financial securities with no costs of production and low cost of sales, there are no potential supplier bottlenecks, distribution is instantaneous and the market size is global, the turnover in profitability is as short as the investor chooses, and the short term risk is less because the assets can be quickly resold in secondary markets most of the time.

These immense relative advantages in costs of speculative investing in financial securities, compared to investing in real physical assets, combined with the possible quick returns and the potential for excess price-driven profits, together result in a kind of ‘global money parade’ that sloshes around markets internationally seeking speculative opportunities—a financial tornado that causes speculative bubbles wherever it touches down.

That parade consists fundamentally of those investors globally that have become greater in number than ever before, controlling a share of total global liquidity that is at historic record levels, and that exhibit a growing preference for speculative investing. And where has most of the liquidity they control been going? Into foreign exchange trading, over the counter derivatives trading, buying and selling of securitized asset backed securities (ABS), collateralized debt (CDOs), collateralized loans (CLOs), residential and commercial mortgages (RMBS, CMBS), credit swaps (CDSs), interest rate and currency swaps, futures and options trades of all kinds, leveraged buyouts (LBOs), emerging market funds, high yield corporate junk bonds and funds, into stock market speculation world wide, into short-selling of stocks, landed property speculation, and global commodities of all kind from food and metals to gold and oil. A global money parade marching to and fro across global financial markets, from one short term speculative opportunity to another, at times exacerbating asset price volatility, at other times precipitating it, and sometimes even pushing asset inflation to the level of financial bust.

An important dynamic characteristic of Epic Recession is that it is typically preceded by a proliferation of multiple asset bubbles fueled by the global money parade that more or less mature in tandem. When one or more of the bubbles overextends and then collapses, it quickly precipitates similar collapses in other bubbles. The magnitude of the financial bust thereafter evokes a credit contraction well beyond that which may occur in a normal recession. How deep, fast and widespread the contraction depends in part on the degree of financial fragility that has developed at the time of the financial bust; and in part on the degree of consumption fragility as well. Both forms of fragility are a function of debt, debt servicing capability, and income. As debt levels unwind in the Epic Recession, the subsequent trajectory of the Epic Recession depends thereafter on the rate of deflation and defaults, and in turn on the ability or failure of government policies to check and contain the deflation-defaults and/or to reduce debt levels that exacerbate the deflation-default levels and rates.

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In just the past four weeks the US Congress and the Federal Reserve Bank (Fed) have introduced an array of of 3 Legislative Acts (Congress) and multiple Lending Programs (Fed) in response to the deepening economic recession. What are these programs in detail? How are the Congress-Fed programs inter-related? Which address the income needs of the real economy and which that of businesses and the banks. Who’s getting how much bailout from where? Will it be enough to prevent a further downturn of the economy? Will it be sufficient to generate a ‘V-Shape’ snap back recovery in the second half of this year–or is the economy now so wounded that a dynamic has set in that means whatever the outcome in controlling the virus, the US (and global) economy will continue to contract? And what, not least, is the likelihood that a financial-banking crash might eventually occur, thus making the recession even worse? Perhaps even paralleling the 1930s?

Listen to my Friday, April 10, Alternative Visions, radio show where I address and discuss these various questions.




In today’s show Dr. Rasmus unravels and explains the array of bailout measures being passed by Congress (3 Acts + 1 in the works) and the Federal Reserve Bank’s multiple programs to inject trillions of dollars into financial markets and non-financial businesses alike. How are the two bailouts—Congress and the Fed’s—integrated? How much of the trillions of loans, grants, tax cuts, subsidies, unemployment benefits, cash checks to households, etc. are actually getting into the economy and how much in bottlenecks. Is the magnitude of the bailout sufficient to prevent a great recession like 2008-09? What about the ‘composition’ (% spending, tax cuts, loans, grants, etc.)? Is it the right ‘mix’ to have an effect? Will the Fed’s trillions of liquidity injection be enough to prevent business, local government and household defaults that can lead to a financial crash? Why are many economists, following Trump’s lead, saying the economy will recover rapidly in the second half of this year despite the record collapse of the economy in this quarter? How does 2020 compare so far with 2008-09? With 1929-33?

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Listen to my 17 min. interview today on the US economy’s latest layoffs, now totaling well over 20m. And why the US economic crisis is taking on more characteristics similar to the great depression of the 1930s, and well worse already than the 2008-09 great recession. What’s happening in China, emerging markets and world trade. Why there’s no V-shape recovery going to happen. Why the virus only precipitated and accelerated the current crisis, not caused it. And even if the health crisis is resolved, economic dynamics will continue to contract the economy.
How Neoliberal policies created the financialization and globalization of the global economy and in turn has led to increasing, deeper, and global economic crises and financial instability. The new nature of 21st century capitalism.



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by Dr. Jack Rasmus
April 3, 2020

Listen to my take on today’s Jobs Numbers with a loss of 701,000 jobs–even before the loss of 10 million more in the last two weeks of March are counted. In the second half of the show the discussion is why a recovery from the current deep ‘Great Recession 2.0’ will not be V-shaped, i.e. won’t ‘snap back’ later this summer. What are the economic reasons and why media talking heads, politicians, and much of mainstream professional economists like Robert Reich, Larry Summers, and others are wrong.




Dr. Rasmus explains why a V-shape recovery from the current crisis will not happen, despite all the marketing spin by Trump, politicians and myopic economists. The show today addresses first the employment numbers reported by the Labor Dept. Rasmus explains those numbers don’t include the last two weeks of March and the 10m workers filing for unemployment benefits. The official unemployment rate of 4.4% reported is thus a gross understatement (and also useless since it always states job losses for only full time employed). Why aren’t those still working being rewarded for hazard work is the next theme of the show, based on Dr. Rasmus’ recently published ‘Covid-19 and the Forgotten Working Class’. The last half hour addresses the theme why a V shape recovery is not going to happen. Rasmus explains why uncertainty and negative expectations by business and households alike will mean more cash hoarding, savings instead of consumption, debt pay down, slow recovery of bank lending, decline in business and household demand for credit, global trade collapse, and business cost cutting carried forward—all mean a slow and tenuous recovery of business investment and consumer spending. Two additional ‘wildcards’ that could depress recovery still further as well might be politicians returning to austerity in 2021 to offset the massive deficits ($6.7T) and $30T (from $22T) national debt + the Fed’s possible failure to prevent a financial crash in coming months. (Check out Dr. Rasmus’ blog posts on the economy today at jackrasmus.com).

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