Easy Credit and the Environment

Edward J. Dodson

[A response to the article, "Carbon on Credit," by Jim Cochran, WorldWatch magazine, May/June, 2007. Reprinted from WorldWatch magazine, September/October, 2007. Mr. Cochran's article is included below. The reader is urged to first read Mr. Cochran's article before looking at my response.]

Carbon on Credit: Global Warming and the Derivatives Markets by Jim Cochran LINK TO ARTICLE

Jim Cochran points us to a corner of the global economy not well-understood by most of its participants and a good many of its analysts. I am reminded of the book, Lost Prophets, published in 1994 by the Harvard Business School Press, written by the former economics editor of the Wall Street Journal, Alfred Malabre, Jr. His assessment of the economists whose writings he scrutinized is worth repeating:

“Credentials … seemed to matter little. Most economists, then as now, were degree-laden, typically sporting a doctorate as well as a master’s degree in economics. But there was little relationship between the accuracy of individual forecasts and the academic backgrounds of particular forecasters. Few economists could match the credentials of Milton Friedman, … Yet, his performance as a forecaster was abysmal.” [p.119]

There is one main reason why so few economists are able to accurately forecast changes in any economy. Neo-classical economic theory has evolved to describe almost everything as a form of capital. The environment is described as natural capital, just one more category of assets brought to the market by the price mechanism. Treating nature as capital may help to structure solvable equations but causes a serious misunderstanding of real world markets and forces. Nature is more accurately described as the first factor of production, the factor with a zero cost in terms of labor and capital goods. Nature has been provided to us for our use and exploitation without charge by whatever forces created the universe. The supply curve for nature is vertical because locations on the earth are finite. Economists ignore the fact that as price increases there is a very strong tendency on the part of those who control locations on the earth to hoard them (and whatever resources are contained therein or thereon) in anticipation that curtailment of supply will drive up price (and profits) even higher. Monopolists have practiced this art of cornering control over the supply of essential natural resources for centuries, with governments often as their willing partners. Their strategy is to get in when the markets are just at the bottom, ride the markets to the point where they see widespread (and very irrational) exuberance, then get out before the inevitable crash. And, if they miscalculate, they rely on their political influence to have their losses absorbed at public expense.

The origins of global financial instability are intimately linked to speculation in land and in natural resources. Bankers have always periodically forgot about the repeating nature of the so-called business cycle and all of the bank failures of the last downturn. They repeatedly provide the credit that adds fuel to the speculative fires already burning. Agriculture provides us with a consistent example. Disruption of food production during the First and Second World Wars drove up prices for food crops, and farmers competed for additional acreage to expand production. Agricultural land prices skyrocketed during the war years, and banks made loans based on these war-inflated values. When peace returned and the farmers of the warring nations were able to get back to business, global commodity prices fell. Many farmers then found themselves highly leveraged, unable to generate sufficient revenue to service their debt, and thousands of individuals lost their farms. After several cycles, the world is solidly under the control of corporate agribusiness. In many nations, high income individuals looking for tax shelters and government subsidies have purchased agricultural land minimally operated to meet government requirements.

In the mid-1970s, the bankers were absorbed by the prospect of huge double digit returns on loans made to resource-rich nations, such as Mexico and Brazil. Then, when oil was discovered under the North Sea, the supply-side of the equation stabilized. Developing nations could no longer service their debt and the banks were faced with huge losses. The banks that survived called for deregulation so they could achieve maximum diversification and thereby reduce the risk of market failures (and their own poor judgment).

Some time was required for the financial services industry to recover from meltdowns, such as that of the savings and loan collapse in the United States, a crisis caused mainly by government regulation that allowed creation of the money market funds without simultaneously allowing the savings institutions to compete on a level playing field. Add to that the Fed’s abandonment of interest rate controls in favor of trying to manage the money supply, and the result was years of declining portfolio values for institutions that had been making long-term, fixed rate mortgage loans. Around 1983, the banks were granted authority to issue certificates of deposit at rates competitive with the money market funds. Adjustable rate mortgage terms were introduced, followed by mortgage-backed securities issued by Fannie Mae and Freddie Mac, and sold by Wall Street firms. Today, securitization expands every time there is interest rate volatility. Mortgage-backed securities and their commercial equivalents are far more liquid than portfolios of whole loans. The derivatives market has evolved because of the complexity of tax law rather than any legitimate business purpose I have ever been able to identify.

The secondary markets have brought many benefits to the users of credit and to investors. Yet, as Jim Cochran paraphrases the view of some worried economists, “this perception of stability has encouraged greater risk-taking than has traditionally been seen to be prudent.” All one has to do is follow what is happening in the housing sector – and with second and third mortgage lien lending, particularly -- to be convinced this is a remarkably calm understatement.

Those of us concerned with protection of the earth’s ecosystem have great reason for worry over the economic and financial crisis into which we are being drawn. Thanks to the policies of the current U.S. administration and the laws passed by the previous Congress, the U.S. government debt is fast approaching $10 trillion. At a 5% rate of interest, the Federal government will have to raise $500 billion annually just to service this debt. In the past, when governments found they could not raise enough revenue to meet their obligations, they simply exchanged government I.O.U.s for central bank notes. We in the U.S. are likely headed into another period of stagflation, with serious consequences for the environment.