Wednesday, March 11, 2009

What is the Crisis About? Fictitious Capital or the Destruction of Wealth?

This short essay briefly describes the financial side of my interpretation that the crash reflected a disconnect between the underlying investment in the economy and its financial representation -- what Marx called fictitious capital. The stock market people call this realignment, "destruction of wealth," even though what is destroyed is the illusion of wealth. The illusion may have been capable of purchasing valuable things so long as other people accept that illusion.

Long ago people accepted the illusion as an illusion and went on with their business. Here is what a former governor of Illinois wrote:

Ford, Thomas. 1854. History of Illinois (Chicago: S. C. Griggs and Co.).

227: "Our Whig friends contended that the continual and violent opposition of the democrats to the banks destroyed confidence; which, by-the-bye, could only exist when the bulk of the people were under a delusion. According to their views, if the banks owed five times as much as they were able to pay and yet if the whole people could be persuaded to believe this incredible falsehood that all were able to pay, this was 'confidence'."

Ordinary people understood what was happening. Here is an incident from Chicago about the same time:

Peyton, John L. 1869. Over the Alleghenies; extracted in Warren S. Tryon, ed. A Mirror for Americans, 3 vols. (Chicago: University of Chicago Press, 1952): III, pp. 589-607.

605: Visiting Chicago in 1848, Peyton objects to taking wildcat notes from an obscure Atlanta bank [meaning that the unregulated bank probably had little or nothing backing up its money]. The hotelkeeper responds, is discussing notes:

"Why, sir, ... this hotel was built with that kind of stuff .... I will take "wild cats" for your bill, my butcher takes them of me, and the farmer from him, and so we go, making it pleasant all around. I only take care ... to invest what I may have at the end of a given time in corner lots .... On this kind of worthless currency, based on Mr. Smith's [the issuer's] supposed wealth and our wants, we are creating a great city, building up all kind of industrial establishments, and covering the lake with vessels -- so that suffer who may when the inevitable hour of reckoning arrives, the country will be the gainer, Jack Rossiter [the speaker] will try, when this day of reckoning comes, to have "clean hands" and a fair record .... A man who meddles, my dear sir, with wild-cat banks is on a slippery spot, and that spot the edge of a precipice."

A few years earlier, a Philadelphia banker wrote about this arrangement to the famous economist, David Ricardo:

Raguet, Condy. 1821. "Letter to David Ricardo, 19 April." In David Ricardo. Minor Papers on the Currency Question, 1809-1823, Jacob Harry Hollander, ed. (Baltimore: The Johns Hopkins Press, 1932): pp. 201-3.

202: "The circulating medium is there [in interior of the country] principally depreciated and inconvertible paper, and so far is the delusion still kept up, that in Kentucky and Tennessee new banks without a specie capital or [any] obligation to pay their notes and gold or silver, have lately been established."

202: "You state in your letter that you find it difficult to comprehend why persons who have a right to demand coin from the Banks in payment of their notes, so long forbore to exercise it. This no doubt appears paradoxical to one who resides in the country were an act of Parliament was necessary to protect a bank, but the difficulty is easily solved. The whole of our populations are either stockholders of banks, or in debt to them. It was not in the interest of the first to press the banks and the rest were afraid. This is the whole secret. Any independent man who is neither a stockholder nor a debtor, who would have ventured to compel the banks to justice, would have been persecuted as an enemy of society, and during the whole period of suspension of specie payments, not an instance occurred in this City of a suit being brought before a court of Justice. A friend of mine in New York was however bold enough to attempt it toward the close of the scene ... The Banks became alarmed, and began to call in their loans -- the local currency of New York became 5 percent better than it was -- millions of dollars worth of goods ordered from Europe were countermanded."

Here is the way a modern capitalist sees the same situation. Steve Palmer posted this on Lou Proyect's Marxism list:

Davies, Megan and Walden Siew. 2009. "45 Percent of World's Wealth Destroyed: Blackstone CEO." Reuters (10 March).
Private equity company Blackstone Group LP (BX.N) CEO Stephen Schwarzman said on Tuesday that up to 45 percent of the world's wealth has been destroyed by the global credit crisis. "Between 40 and 45 percent of the world's wealth has been destroyed in little less than a year and a half," Schwarzman told an audience at the Japan Society. "This is absolutely unprecedented in our lifetime"."


TheTrucker said...

There should be no use of the word "capital" unless you are talking about trucks and trains and aireoplanes and other _PRODUCED_ "goods" employed in the production of other "goods". Therefore, the words "fictitious capital" are probably quite appropriate. The houses (durable goods as opposed to "capital goods") still exist regardless of the accounting system and are true wealth.

Even if you define "wealth" as the capacity to command the labor of others no wealth has been lost in the aggregate. And as this power of command moves from one group or individual to another then "financial wealth" is being transferred. In my own little world of understanding political economy financial "wealth" is zero sum; it is this power of command. said...

It is often forgotten that during the antebellum era of US "free banking," dollars issued by banks in different states did not trade at equal values. We were a multi-money country without fixed exchange rates (and it has long been averred that "Dixie" as a name for the South came from the widespread use of ten dollar bills issued by Louisiana banks, with "dix" meaning "ten" in French, and these notes often worth less in the New York banks than their ten dollar bills).

Of course earlier, in such places as Tennessee, such things as coonskins functioned as money legally, just as tobacco certificates did in colonial Virginia.

Anonymous said...

I get a portion of my retirement each month by cashing in a fixed percentage of the shares in my stock-based fund (CREF, if you are interested).

As the value of the fund has declined so has the size of my monthly check. There is nothing "fictitious" about this capital.

The real problem is that since the world went off the gold standard we have no peg on which to hang value. Even the Fed and Treasury are confused as they still talk about the inherent value of discounted assets.

It is hard to imagine a society based only upon trust, but that is what we have. As recent events have shown gold, real estate, oil and currency can all lose value in unpredictable ways.

I don't know if there is a way to fix this, but those trying to reinflate the financial system certainly aren't looking for one.

Shag from Brookline said...

I'm not an economist and I don't play one on TV or the Internet, but I have a "what if." What if the world had not gone off the gold standard? What differences would have developed in the world's economy?

Michael Perelman said...

Anonymous, your stock and even money has value only because others are willing to trust in it. Shag says gold might work, but gold is valuable mostly because people agree to treat it as a source of value. It would still have value in dentistry, jewelry, .... but not nearly so much.

Trucker, because in normal times, people trust in the value of stocks and even financial derivatives, they appear as capital.

Barkeley is correct about the wildcat banking period. But counterfeiters also supplied much of the monetary stock.

Mihm, Stephen. 2007. A Nation of Counterfeiters: Capitalists, Con Men and the Making of the United States (Cambridge: MA: Harvard University Press).

BruceMcF said...

I do love the story about the circle of "frontier banks" ... in Michigan, I believe ... which had a capital of two barrels of gold, which passed in the same circuit as the state bank examiner for the region, one barrel being in motion past the town the bank examiner was in while the bank examiner was verifying the adequacy of the capital of the bank in that town, and then the first barrel was sitting waiting for the examiner while the second picked up to go to the next bank in the cycle.

There was a regular ... but not perfectly regular ... ebb and flow of liquidity between the developing fringe and the eastern seaboard cities, and given the much smaller relative "financial" size of any west of the Appalachia region to any large Eastern city, a "western" region that insisted on a "pure money supply" would have put itself at the mercy of Boston and New York and Philadelphia.

And, of course, there's nothing wrong with that, for money ... money ought not to be confused for something intrinsically valuable in itself. What creates the "fictitious capital" effect is when the permission of financial capital reigns supreme over the actual ability to produce (and even worse today, reigns supreme over the willingness to recognize destruction of the ability to produce).

TheTrucker said...

Michael Perelman said...

"Trucker, because in normal times, people trust in the value of stocks and even financial derivatives, they appear as capital."

These things serve as a "store of value" but that is a totally different creature from the classical definition of "capital". A jar of peaches is a "store of value", But you don't use it to make more peaches as you would a tractor. In classical terms, tractors are capital and money and peaches are not. The return to lending out money (money being created on a keyboard at the central bank) is much more like classical "rent" due to the totally unearned nature of the return.

Anonymous said...

It would appear that the US Govt. is still trying to address the issues that Andrew Jackson was addressing before the Civil War. Cheap and easy credit? Or a hard currency? The argument for cheap and easy credit made by Peyton's interlocutor sounds a lot more valid in a frontier economy, but the US frontier has been closed for a long time now.

Shag from Brookline said...

Michael, perhaps you misunderstood my query re: gold when you commented:

" Shag says gold might work, .... "

Let me clarify: All I was asking was would staying on the gold standard have resulted in a different economy than developed after getting off the gold standard and if so what the economy would have looked like today if we hadn't gone off the gold standard. I may have been making a rhetorical inquiry as I cannot imagine, even with my not being an economist, that the economy would have been better remaining on the gold standard. But every once in a while someone out there suggests bringing back the gold standard. It's like someone wishing for the "good old days" that in retrospect might not have been quite that good. Maybe there's a screenplay sort of like "Back to the Future - Gold Standard" in this. said...


Part of the problem with answering your question is to anwer "when did we go off the gold standard?" Some would say it happened in 1931 when the UK repegged its gold value, and some would say 1933 when the US did so, and some would say 1944 when Bretton Woods was adopted, which effectively made the US dollar the international standard of value, although it continued to have a nominal tie to gold at a fixed rate, very rarely exercised, and finally some would say only ni 1971 when that final last nominal tie was severed. So, which is it?

If it was one of the early ones, we would have had a much deeper and longer Great Depression. If it was 1945, then we would not have had as vigorous a recovery after WW II, and if it was 1971, then the US (and probably the world) economy would have fallen into a much deeper and longer recession than we did in 1973-74.

Any further questions?

Shag from Brookline said...

Let's hear it for the Yankee Dollar!

One follow up, Rosser, JB:

If we went back to the gold standard, would the economy make a comeback, at least in alchemy? (This is of course tongue in cheek - my own, with no gold fillings.)