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How Economies Collapse: Systemic Friction and Debt Are Self-Liquidating. Charles Hugh Smith

Posted on Tuesday, 5th August 2014 @ 01:14 PM by Text Size A | A | A

Paying for unproductive friction with borrowed money has generated the illusion that free to me is actually free–it isn’t.

We all understand how friction slows our progress: flatten the tires on a bicycle and it becomes much harder to maintain speed. If a brake pad is rubbing against one wheel, it gets even harder.

If we pile on additional sources of friction, eventually forward motion stops. In systemic terms, the system freezes up and collapses.
 
Here are some examples of systemic friction in the U.S. economy:
 
1. College degrees that cost four times as much but yield diminishing value in the job market.
 
2. Millions of needless medical tests performed to maximize profit or deflect future lawsuits (i.e. defensive medicine).
 
3. Weapons systems that cost four times as much as the system they replace while being less effective and more costly to maintain/repair.
 
The list of such sources of friction is essentially endless. Why is this so?
 
The answer is: rentier skims and offloading risk onto the system are forms of friction, and as noted yesterday in The Slide to Collapse Is Greased with Self-Interest, rational self-interest is best served by transferring personal risk of loss onto the State (i.e. taxpayers). Influencing the State to protect one’s private skims, job, income, pension, profits and gains offloads risk onto the taxpayers.
 
All this systemic friction adds cost and precious little increase in output or productivity. Nobody’s actually healthier or more productive because millions of useless tests have been performed, just as nobody actually learned more as a result of their college costs soaring from $25,000 for a bachelor’s degree to $100,000 for virtually identical courses, professors, curriculum, etc.

These charts shout diminishing returns and unsustainable expansion of debt borrowed by uncreditworthy borrowers.
 
In effect, we’ve paid for all this systemic friction by borrowing vast sums of money–money that has been squandered paying for unproductive friction under the guise of “investing in education, healthcare and national defense.” But since there is no systemic mechanism for discovering the price of this friction or disciplining unproductive spending on friction, there is no structural restraint on this Status Quo “solution” other than the debt itself.
 
The ultimate discipline in using debt to fund friction is the rising cost of interest on all this debt. Even at low rates, interest absorbs an increasing percentage of national income.
 
As long as the interest rate on debt is low, the path of least resistance is to keep borrowing to support politically untouchable programs, cartels and  constituencies. Eventually, the cost of servicing the debt overwhelms the diminishing returns on using debt to pay the soaring costs of friction.
 
Here is the Federal debt, not including the bogus inter-governmental debts (money owed to the illusory Social Security Trust Fund).
 
 
Everyone knows Federal debt has skyrocketed, but so has the debt of state and local governments: state and local government debt has risen by 250% just since 2002.
 
 
If we add up all debt–household, finance, corporate and government–we see debt has soared and growth has stagnated: this is a classic case of diminishing returns as more debt is required to add each additional increment of GDP.
 
At some point, additional debt is taken on to simply make interest payments; at that juncture, there is no consumption/buying taking place with the new debt: it’s simply keeping the borrower out of default.
 
In other words, by using debt to pay the rising costs of friction, we’ve added another layer of friction: interest payments. In effect, we’ve “solved” the problem of rising friction by borrowing money that creates its own friction.
 
Paying for unproductive friction with borrowed money has generated the illusion that free to me is actually free–it isn’t. It’s also generated the illusion that piling up debt is risk-free as long as interest rates are low and the government backstops all the debt.

The final illusion is that there is no mechanism to brake the expansion of debt: that the “solution” to rising interest costs is to borrow more money.
 
We will discover, to our detriment, that friction and debt are both self-liquidating:that is, they bring about their own liquidation via systemic collapse.
 

 

 

 

 

 

 

The Slide to Collapse Is Greased with Self-Interest   (August 4, 2014)Self-interest is intrinsically self-liquidating on a systemic level.One enduring if rarely stated principle of Neoliberal Democracy is that the single-minded pursuit of self-interest magically produces an equilibrium which serves everyone’s interests well enough to avoid the destabilization of rebellion or systemic collapse.Let’s start by defining Neoliberal Democracy: neoliberalism sees markets as the only efficient, fair and durable method of organizing resource extraction and the social order: governance, employment, distribution of income, etc. Turning every social and economic function into a marketplace ensures that market forces provide the discipline and transparency participants need to make prudent choices and investments.

Democracy is a political marketplace in which votes replace investor and consumer decisions as the mechanisms that enforce discipline and transparency.

The melding of these two ideologies is clearly natural, as both see a transparent market as the best possible system for both governance and and the economy.

The key characteristic of a market is that all participants exclusively pursue their own self-interest. No one need sacrifice their own self-interest for the good of the whole system because by definition the system of competing interests naturally organizes itself to maximize the choices of each individual and the equilibrium of the system.

The transparency, fairness and stability offered by this ideological system is very compelling: the advantages of a system that transparently discovers the price of everything while offering roughly equal opportunity to all participants to seek self-fulfillment (i.e. the pursuit of happiness) via a dogged focus on self-interest are self-evident.

Looking out for Number One is thus the foundation not just of personal self-aggrandizement but of systemic stability and fairness.

 

But let’s move from ideological abstraction to the pragmatic–what happens in the real world? What we find in the real world is that participants seek to transfer their own risk to others while minimizing their productive work and maximizing their gain/skim.

Risk inevitably introduces the possibility of loss–both fair and unfair. Let’s say a participant in the market invests in a scheme to produce the Acme Brand widget. Unfortunately, the widget fails to find a market and the enterprise closes its doors. The investors lose their investment: this is fair because any enterprise in a market is at risk of losing favor from changes in fashion or the emergence of more agile competitors.

Unfair risk is loss incurred through no fault of one’s own. Let’s say an employee of Acme Widget Corporation gave his all to the company, and was laid off anyway–not through some failing in his efforts or talents but as a result of dynamics beyond his control: the marketplace found little value in the Acme Widget.

The rational, self-interested participant will naturally seek to offload risk of loss to other participants. Employees of the state (i.e. the government) transfer most of the risk of being laid off to the larger group of taxpayers: in a recession, the state can raise taxes on everyone in the system to guarantee its employees get paid. In effect, the risk of loss is distributed to everyone paying taxes in order to guarantee the employment of state employees.

Financiers have learned that making bets big enough to render their enterprise too big to fail effectively transfers the risk of loss to the taxpayers. We see the same mechanism in action: those who manage to transfer the risk of loss to others guarantee their self-interest can be pursued risk-free.

The rational, self-interested participant will also naturally seek to minimize his productive contribution while maximizing his income/gain. The state employee will (for example) game the system to retire early on a fake disability claim, or manage to evade work, accountability or responsibility with little risk of loss because the system makes firing a slacker employee almost impossible.

A financier will use free money for financiers issued by the Federal Reserve to buy assets everyone needs to live: private water systems, rental homes, parking meters, etc.–what are known as rentier assets because the financier isn’t adding or creating any value in his ownership; he is skimming a fee from those who pass through the gate he owns.

The rational, self-interested participant will minimize his own expenses and maximize his income/gain by exploiting the commons–assets shared by all participants. The rational, self-interested participant will thus let his sheep out into the common pasture to graze for free, dump his waste into the river and the smoke from his works into the air, all free of charge.

This dynamic of everyone pursuing their own self-interest destroying the commons was articulated by Garrett Hardin in his paper The Tragedy of the Commons.

There is another dynamic at work called tyranny of the majority.

Imagine a ship with 100 passengers and crew drifting down a river that eventually cascades over a 1,000 foot waterfall. It’s easy to plot the ship’s course and the waterfall ahead. You might think 100% of those onboard would agree that something drastic must be done to either reverse course or abandon ship, but before we jump to any conclusion we must first identify what each of the 100 people perceive as serving their self-interest.

If life onboard is good for 60 of the 100, they may well rationalize away the waterfall dead ahead. Why risk the treacherous river currents by abandoning ship? As a result, the majority vote to tweak the ship’s course slightly, thus dooming the 40 others who can hear the thundering cascade ahead but who are powerless to change course in a democracy.

This is the tyranny of the majority feared by some of the American Founding Fathers.

If 60% of the voting public is dependent on government spending, then they will vote to continue that spending regardless of its unsustainability, source or unfairness to those who will suffer most when the entire contraption collapses in a heap.

 

To the degree that government revenue is a form of public commons, then the siphoning of that resource to serve individual gain leads to the loss of the commons, as well as the loss of any notion of the common good.

With 60 of the 100 voting to continue the present course of State borrowing and spending to support their piece of the largesse, the ship is doomed to end up in pieces at the bottom of the waterfall, despite the utter obviousness of the catastrophe just ahead.

In other words, democracy functions when a sustainable equilibrium can be maintained with slight adjustments in course/policy. But when a dramatic change of course is required to save the system, a change that upends all the rentier skims and redistributes risk of loss to all those who reckoned they’d successfully offloaded all risk onto others, then there is no political support for the necessary radical change of course.

Those collecting a piece of State spending will vote to keep the ship firmly heading for the waterfall, because they fear the consequences of changing course or abandoning ship. Any radical change of course reintroduces the risk of loss that each self-interested participant offloaded onto the system itself.

Enterprises that haven’t offloaded risk or secured guarantees from the State are forced to make radical changes when their survival demands it. Recent history is full of examples of corporations that were riding high and then failed to change course radically enough; those companies lost their way and were acquired for a sliver of their former value.

The political marketplace of democracy fails when the State has transferred risk and guaranteed the skim of enough voters.

The political marketplace of democracy also fails because self-interest is best served by influencing the State to protect one’s private rentier skims and gains. The highest-leverage, highest-return investment is buying political favors and influence from politicos.

If average citizens could buy a semi-permanent escape from taxes for, say, a $20,000 “contribution” to the right politico, anyone with a tax burden of $10,000 or more annually would make this easy calculation: in a single decade, I’m going to pay $100,000 in taxes if I do nothing. If I buy the political favor for $20,000, I will save $80,000 over a decade.

That’s a four-fold yield on the initial investment. Where else can you reap that kind of guaranteed return?

It turns out to be remarkably easy to evade the transparency required to make democracy and the market function fairly. The political favor is buried in hundreds of pages of legalese jargon in a legislative bill or regulatory statutes. No one will ever discover the favor unless they know where to look.

Self-interest is intrinsically self-liquidating on a systemic level, something I analyze in depth in Resistance, Revolution, Liberation, for without an understanding of the distorting mechanisms of self-interest, we cannot understand why people will continue supporting a visibly imploding Status Quo: they will do so as long as they are getting a piece of that Status Quo that is free to them.

This is how systems collapse: those who have offloaded risk (a.k.a. skin in the game) to the system itself and guaranteed their job, income, pension or rentier skim via the State will continue to support the Status Quo that has benefited them so handsomely even as the ship tumbles over the waterfall to its destruction.




Get a Job, Build a Real Career and Defy a Bewildering Economy (Kindle, $9.95)(print, $20)
go to Kindle edition
Are you like me?
Ever since my first summer job decades ago, I’ve been chasing financial security. Not win-the-lottery, Bill Gates riches (although it would be nice!), but simply a feeling of financial control. I want my financial worries to if not disappear at least be manageable and comprehensible.
And like most of you, the way I’ve moved toward my goal has always hinged not just on having a job but a career.You don’t have to be a financial blogger to know that “having a job” and “having a career” do not mean the same thing today as they did when I first started swinging a hammer for a paycheck.Even the basic concept “getting a job” has changed so radically that jobs–getting and keeping them, and the perceived lack of them–is the number one financial topic among friends, family and for that matter, complete strangers.

So I sat down and wrote this book: Get a Job, Build a Real Career and Defy a Bewildering Economy.

It details everything I’ve verified about employment and the economy, and lays out an action plan to get you employed.

I am proud of this book. It is the culmination of both my practical work experiences and my financial analysis, and it is a useful, practical, and clarifying read.

Test drive the first section and see for yourself.     Kindle, $9.95     print, $20

“I want to thank you for creating your book Get a Job, Build a Real Career and Defy a Bewildering Economy. It is rare to find a person with a mind like yours, who can take a holistic systems view of things without being captured by specific perspectives or agendas. Your contribution to humanity is much appreciated.”
Laura Y.

Gordon Long and I discuss The New Nature of Work: Jobs, Occupations & Careers (25 minutes, YouTube)

 

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