The Era of Fictitious Capitalism

When "real value" is no longer what seems to matter…you can be sure it matters more than ever…This classique, that ran on Dec. 2, 2003, is a must-read…


While doing radio interviews this fall regarding themes in our book, Financial Reckoning Day: Surviving The Soft Depression of the 21st Century , the question invariably arises: "France? Nice place to visit, but why the heck do you live there?"

The short answer is, of course, the wine is cheap and the woman are…um, elegant. The long answer is, we gain perspective. It’s the long answer, because it requires an explanation. One could gain perspective from just about anywhere, of course…but why not do it in a place where the wine is cheap and the women pleasing to look at?

An English reader, who also lives in France, recently passed on an interesting article written by a Chinese bureaucrat, published on a non-profit website hosted in Italy, sponsored by the government of Singapore. The aim of the site is to increase amicable relations between Asia and Europe in a U.S.-centric world. The purpose of the article: A strategic recommendation on how China ought to position itself while the United States and Europe – as the major players in the two-bloc international system the author predicts will eventually emerge – gear up for eventual war.

If we were writing our daily missives from our offices in Baltimore, would such a site, and such an article, be interesting? Probably. But we’d likely judge the origin of the site through Murdoch’s lens at Fox News, like so many TV-addled minds do, and dismiss it out of hand. Away from influence, living as foreigners, in a country where they don’t pronounce words as they are spelled, we take to the extraordinary like gnats to a sugar bowl. We are addicted to the taste and go there often to get a buzz going. But we are under no illusions that it has nutritional value.

Wang Jian: Clouds of War

What could possibly interest us about a Chinese bureaucrat’s white paper on impending global war? First of all, his conclusion: "In the last century," writes Wang Jian, "American people were pioneers of system and technology innovation. However, the interests of a few American financial monopolies now lead this country to war. This is such a tragedy for the American people.

"Clouds of war are gathering. Right now, the most important things to do for China are:

1.) Remain neutral between two military groups while insisting on an anti-war attitude.
2.) Stock up in strategic reserves
3.) Get ready for a short supply of oil
4.) Strengthen armament power
5.) Speed up economic integration with Japan, Hong Kong, Korea and Taiwan…"

It’s a rather unsettling idea. China as the neutral power in a war between the United States and a united Europe. How did Wang get there? That’s the subject of the second part of the article, which we find intriguing…and even more unnerving. Wang’s view is disturbingly similar to our own understanding of the way the global economy works.

"War is the extension of politics and politics is the extension of economic interests," Wang asserts. "America’s wars abroad have always had a clear goal, however, such goals were never made obvious to the public. We need to see through the surface and reach the essence of the matters. In other words, we need to figure out what the fundamental economic interests of America are. Missing this point, we would be misled by American government’s shows and feints."

Wang’s argument in a nutshell: By the mid 1970s, the United States, the United Kingdom, France, Germany, Italy, Japan and other major capitalist countries had completed the industrialization process now underway in China. In 1971, when Nixon closed the gold window, the Bretton Woods system collapsed, and the dollar – the last major currency to be tethered to gold – came unstuck. Economic growth as measured by GDP was no longer restricted by the growth of material goods production. Toss in a few financial innovations, like derivatives, and the "fictitious" economy assumed the central role in the global monetary system.

Wang Jian: A Plummeting Ratio

"Money transactions related to material goods production," writes Wang, "counted 80% of the total [global] transactions until 1970. However, only five years after the collapse of the Bretton Woods, the ratio turned upside down – only 20% of money transactions were related material goods production and circulation. The ratio dropped to .7% in 1997."

As we note in our book, since Greenspan assumed the central role at the most powerful central bank in the world, he has expanded the money supply more than all other Fed chairmen combined. From 1985-2000, production of material goods in the United States has increased only 50%, while the money supply has grown by a factor 3. Money has been growing more than six times as fast as the rate of goods production. The results? Wang’s research reveals that in 1997, before the blow-off in the U.S. stock market, mind you, global "money" transactions totaled $600 trillion. Goods production was a mere 1% of that.

"People seem to take it for granted that financial values can be created endlessly out of nowhere and pile up to the moon," our friend Robert Prechter writes in his book, Conquer the Crash. "Turn the direction around and mention that financial values can disappear in into nowhere and they insist that it isn’t possible. ‘The money has to go somewhere…It just moves from stocks to bonds to money funds…it never goes away…For every buyer, there is a seller, so the money just changes hands.’ That is true of money, just as it was all the way up, but it’s not true of values, which changed all the way up."

In the fictitious economy, the values for paper assets are only derived from the perceptions of the buyer and seller. A man may believe he is worth a million dollars, because he holds stocks or bonds generally agreed in the market to hold that value. When he presents his net worth to a lender, a mortgage banker for example, and wishes to use the financial assets as collateral for a loan, his million dollars is now miraculously worth two. If the market drops, the lender, now nervous about his own assets, calls in the note…the borrower once thought to be worth two million discovers he is broke.

"The dynamics of value expansion and contraction explain why a bear market can bankrupt millions of people," Prechter explains. "When the market turns down, [value expansion] goes into reverse. Only a very few owners of a collapsing financial asset trade it for money at 90 percent of peak value. Some others may get out at 80 percent, 50 percent or 30 percent of peak value. In each case, sellers are simply transforming the remaining future value losses to someone else."

Wang Jian: Deer in Headlights

As we saw in the 2000-2002 bear market, in such situations, most investors act as if they were deer being approached by a speeding truck at night. They do nothing. And get stuck holding financial assets at lower – or worse, non-existent – values. Anyone suffering glances at their pension statements over the past few years knows their prior "value" was a figment of their imagination.

Back to Wang: "In the era of fictitious capitalism, a fictitious capital transaction itself can increase the ‘book value’ of monetary capital; therefore monetary capital no longer has to go through material goods production before it returns to more monetary capital. Capitalists no longer need to do the ‘painful’ thing – material goods production."

Real-life owners of stocks, bonds, foreign currency and real estate have increasingly taken advantage of historically low rates and applied for mortgages backed by the value of these financial assets. Especially since the rally began 8 months ago, they then turn around and trade the new capital on the markets. "During this process," writes Wang, "the demand of money no longer comes from the expansion of material goods production, and instead it comes from the inflation of capital price. The process repeats itself."

Derivative instruments, themselves a form of fictitious capital, help investors bet on the direction of capital prices. And central banks, unfettered by the tedious foundation set by the gold standard, can print as much money as is required by the demands of the fictitious economy. You can, of course, trade the marginal values of these fictitious instruments and do quite well for yourself.

But Wang sees a darker side to the equation. "Fictitious capital is no more than a piece of paper, or an electric signal in a computer disk. Theoretically, such capital cannot feed anyone no matter how much its value increases in the marketplace. So why is it so enthusiastically pursued by the major capitalist countries?"

The reason, at least until recently, is that the "major capitalist countries" have been using their fictitious capital to finance consumption of "other countries’" material goods. Thus far, the most major of the capitalist countries, the United States, has been able to profit from the system because since the establishment of the Bretton Woods system, and increasingly since its demise, the world has balanced its accounts in dollars.

Wang Jian: The Fictitious Economy

"Until now," writes Wang, "U.S. dollars [have counted] for 60-70% in settlement transactions and currency reserves. However, before the ‘fictitious capital’ era, more exactly, before the fictitious economy began inflating insanely in the 1990s, America could not possibly capture surplus products from other countries on such a large scale simply by taking advantage of the dollar’s special status in the world…Lured by the concept of the ‘new economy’, international capital flew into the American securities market and purchased American capital, thus resulting in the great performance of U.S. dollar and abnormal exuberance in the American security market."

And here we arrive at the crux of Wang’s argument that a war is brewing. "While [fictitious capital] has been bringing to America economic prosperity and hegemonic power over money," he suggests, "it has its own inborn weakness. In order to sustain such prosperity and hegemonic power, America has to keep unilateral inflow of international capital to the American market…If America loses its hegemonic power over money, its domestic consumption level will plunge 30-40%. Such an outcome would be devastating for the US economy. It could be more harmful to the economy than the Great Depression of 1929 to 1933."

Japan’s example suggests, as your editors have oft reminded you, that a collapse in asset values in a fictitious economy can adversely affect the real economy for a long time.

In the era of fictitious capital, Wang surmises, America must keep its hegemonic power over money in order to keep feeding the enormous yaw in its consumerist belly. Hegemonic power over money requires that international capital keep flowing into the market from all participating economies. Should the financial market collapse, the economy would sink into depression.

America’s reigning financial monopolies, he believes, (whoever they may be), would not stand for it.

Addison Wiggin
The Daily Reckoning
November 4, 2004

America’s consumers outdid themselves last quarter. With the saucy confidence of a fat girl in love, they spent a record $342 billion (annualized) more than they received in disposable income.

Our oldest baby boomers have lived through this before, Paul Kasriel points out, but under entirely different circumstances.

World War II was a real war. America did not launch a peremptory strike against Japan; they waited for Japan to do something wrong. Then, with the gods of war on its side, America kicked Japan’s butt.

The war years were lean for consumers. Output was redirected towards supplying tanks and planes, not automobiles and refrigerators. Consumers had no choice; they saved their money.

Then, when the war was won, our parents married…and began families. We were just tots in 1950 – the last year in which consumers overspent as much as they do now. In the 3rd quarter of 1950, consumers spent $1.05 for every dollar of after-tax income. Then, incomes rose…and for the next 50 years…never again did consumers spend significantly more than they earned.

But Alan Greenspan’s EZ credit-terms turned a good thing into something that was too wonderful. The Fed’s key lending rate was set well below the inflation rate. Even after two rate hikes, the Fed still lends money at 1.75% – about a full percentage point below the rate of consumer price inflation. The Fed has been giving money away; can you blame consumers for taking it?

In the 3rd quarter of 2004, the baby boomers – half a century older, but none the wiser – almost matched the record set 54 years ago. For every dollar in after tax income, they spent $1.04.

But instead of satisfying the demands pent up in the war years…and instead of spending savings built up when the going wasn’t so good…today’s consumers spend money they haven’t got on things they don’t really need. Who needs a new SUV? Who needs a new mortgage? Who needs a new TV for the new family room in the new house in the new development?

Who needs a TV at all? "Television is very educational," said Groucho Marx. "Whenever it is on, I go in another room and read a book."

Spending savings is one thing. Spending debt is something altogether different. Savings represent real demand. Real demand can bring about a real and sustainable boom. In the early ’50s…America began a boom that lasted for most of the baby boomers’ lives.

Now, the oldest of the boomers are in their mid- to late-50s. The real boom has turned into a phony one. The great fortune the boomers have enjoyed seems to be turning over in a great, rolling top…

The cheap oil of the ’50s is all used up. The factories and machinery that gave us such an edge after the war is not worn out; but manufacturing buildings are converted into loft apartments and shopping malls. Our parents used to sweat. Now, the sweating is done on the other side of the planet – where the new factories are built. A man from China or India will work all day for $10. We want 10 times as much for our labor. After World War II, we could get it. Because we had the most savings, most modern machinery, the most efficient roads, the best trains, the most energy…and most highly skilled workforce in the world. Now, those things have spread all over the world, and there is no stopping them.

The cheap credit must soon be coming to an end, too. After the war, we had the world’s only solid economy…and the only solid money, backed by real gold. Now, the whole world stands knee-deep in dollars and dollar credits. And we boomers stand up to our necks in dollar debts. Our parents had few debts and much savings. We are so much smarter; we have few savings and much debt.

Time marches on. The world turns. We boomers were just learning to walk 54 years ago. Now, we are getting soft and weak. Our boom is phony. Our dollar is a phony. Our war is phony. Our consumer demand is phony. Our president is a phony. Our wealth (in housing prices) is largely phony.

Not that we are complaining. We’ve enjoyed 50 very good years. Would it be so bad if the Baby Boomers finally had to face some real trouble near the end of their careers? Would it be so startling, or so unkind, or so unjust, if the going were not so good…and the world not quite so wonderful?

More news, from our team at The Rude Awakening:


Eric Fry, reporting from Wall Street…

"’A gold mine,’ Mark Twain once observed, ‘is a hole in the ground with a liar on top.’ The trouble is, even when an honest geologist stands atop a hole in the ground, the precious metal is very difficult to find."


Bill Bonner, back in London:

*** " [America] bled Russia for 10 years, until it went bankrupt and was forced to withdraw in defeat," says Osama bin Laden.

"So we are continuing this policy in bleeding America to the point of bankruptcy."

Nice of him to tell us. Nice of the Fed, the Bush administration and consumers to cooperate so fully.

*** Pssst…wanna make some real money? Invest in emerging markets! While Wall Street may be yesterday’s news, and America itself is on its way to Banana Republic status, tomorrow’s news is coming in from the Banana Republics themselves.

The Colombian stock market rose 75% so far this year – in dollars. Mexican stocks went up 27%. In Eastern Europe and the Middle East the story is similar, with the Czech Republic up 49%…and Egyptian stocks soaring an incredible 81%.

The emerging economies are doing well. They had two big advantages…three really. First, they have lower cost labor. Second, no one would lend them any money, so budget deficits are much smaller than in the developed world. And third, Alan Greenspan’s low rates have helped accelerate the process of globalization. Developing countries’ ratio of debt service to exports has been almost cut in half since 1998. And stocks are still cheap – with the average PE at just about 8.

The Daily Reckoning