Germany's President Horst Koehler has denounced the world financial market as a
"monster" using "highly complex financial instruments" to make "massive
leveraged investments with minimal capital". Koehler, formerly head of the
International Monetary Fund, seems perplexed about the causes of the present
crisis, but I can explain them in a way any German can understand. Derivatives
are like sausages. You take the low-quality parts of the pig that you don't
want to look at while you are eating them, and grind them up into a package
that seems more appetizing.
The German financial system wanted to consume low-quality American assets, but
did not want to look on what it was eating. German banks have written down
about US$25 billion in securities derived from low-quality ("subprime")
American mortgages, and
doubtless will lose a great deal more. But it is silly to blame the
sausage-grinder. Why didn't the Germans and all the other overseas investors
buy mortgages in their own countries, instead of scraping the bottom of the
credit barrel in the United States? It is because there aren't enough Germans,
or Italians, or Frenchmen or Japanese starting families and buying homes. There
weren't enough Americans, either, and therein lies a tale.
The aging pensioners of Europe and Asia must find young people to pay interest
into their pensions, and they do not have enough young people at home. Germans
aged 15 to 24, on the threshold of family formation, comprise only 12% of the
country's population today and will fall to only 8% by 2030. But one-fifth of
are on the threshold of retirement and half will be there by mid-century.
It is fashionable these days to blame the Americans for borrowing instead of
saving. In effect, Americans borrowed a trillion dollars a year against
the expectation that the 10% annual rate of increase in home prices would
continue, producing a bubble that now has collapsed. It is no different from
the real estate bubble that contributed to the Thai baht's devaluation in 1997,
except in size and global impact.
The monster is not the financial system, crooked and stupid as it may have
been. The monster is the burgeoning horde of pensioners in Germany and other
industrial countries. It is easy to change the financial system. The central
banks can assemble on any Tuesday morning and announce tougher lending
standards. But it is impossible to fix the financial problems that arise from
Europe's senescence. Thanks to the one-child policy, moreover, China has a
relatively young population that is aging faster than any other, and China's
appetite for savings vastly exceeds what its own financial market can offer.
There is nothing complicated about finance. It is based on old people lending
to young people. Young people invest in homes and businesses; aging people save
to acquire assets on which to retire. The new generation supports the old one,
and retirement systems simply apportion rights to income between the
generations. Never before in human history, though, has a new generation simply
failed to appear.
As the above chart makes clear, America's population profile is far more benign
than Germany's, but it is aging nonetheless. There simply aren't enough young
people in America to borrow money from Europe's and Japan's aging savers.
The world kept shipping capital to the United States over the past 10 years,
however, because it had nowhere else to go. The financial markets, in turn,
found ways to persuade Americans to borrow more and more money. If there
weren't enough young Americans to borrow money on a sound basis, the banks
arranged for a smaller number of Americans to borrow more money on an unsound
basis. That is why subprime, interest-only, no-money-down and other mortgages
waxed great in bank portfolios.
America's financial market could not produce enough pork chops, so the
Europeans bought Spam and scrapple. America's rating agencies assured them that
derivatives created from subprime mortgages, second-lien mortgages and other
dubious parts of the pig were the equivalent of pork chops, and foreign
investors wolfed them down. Humbug and duplicity as I argued in
The devil and Alan Greenspan (Asia Times Online, October 2, 2007),
regulators, bankers and investors all looked the other way, and now all point
the finger at each other.
Coddled by an undeserved claim on the world's savings, Americans have done a
very poor job of creating wealth. America had the right idea about how to
create wealth, but the wrong kind of people. The Ronald Reagan administration
took office in 1981 after the worst period of value-destruction in postwar
American history. A dollar invested in the S&P 500 index of large American
stocks would have bought 50 cents' worth of consumption goods a decade later,
as the chart below indicates:
Between 1981 and 2001, however, $1 invested in the stock market would have
grown to $6 inflation-adjusted dollars. That was the greatest period of wealth
creation in the past century of American finance.
In Reagan's way of looking at things, ingenuity was more important than
savings. Removing tax and other barriers to innovation and investment allowed
Americans to create new products - computers, microwave ovens, cell phones and
a dozen other items unknown in 1981. The wealth generated by innovation would
more than make up for big budget deficits and rising indebtedness.
What went wrong? There is no one to blame but the Americans themselves. If free
elections give people the sort of government they deserve, free markets give
them the sort of economy they deserve. The stock market bubble of the late
1990s presumed that the Internet would transform American life according to a
pop-culture template. In my maiden essay for Asia Times Online on January 27,
2000 (What if Internet stocks
aren't a bubble?) I wrote:
What if it isn't a bubble? What if
consumers want to double or quadruple their spending on whatever it is the
Internet has to offer every year for the next 20 years? What if they will pay a
premium to watch their favorite episode of Pee-Wee Herman or the Lone Ranger
rather than the latest sit-com? What if they will spend heavily to explore the
cutting edge of anatomical possibility on the porn sites?
Recall the dying, drug-addicted Howard Hughes, a recluse in the penthouse suite
of a Las Vegas hotel, hair and fingernails untrimmed for months. That was in
the 1960s, and Hughes passed the time watching film after film in his private
screening room, a plutocrat's privilege. With the wonder of the Internet, cable
hookups, and the Time Warner-AOL film library, every Internet user can turn
into a dissipated freak like Hughes. That's American democracy at work.
After inflation, an investor who bought $1 worth of the S&P 500 in early
1998, just as the bubble was getting underway, would be able to sell this
position and buy $1 worth of consumption goods today. America's feckless plunge
into capitalized pop culture did not pan out.
America is in the midst of another wave of wealth-destruction. The Federal
Reserve has sought to devalue its way out of a financial crisis, giving foreign
investors all the less reason to buy American risk-assets, although foreign
central banks continue to buy American government bonds for lack of an
alternative. The result, as I argued recently in
Rice, death and the dollar (Asia Times Online, April 22, 2008), is an
epidemic of commodity bubbles raging from rice to petroleum. A few countries
have won the lottery, for example Brazil, while energy importers are suffering.
Koehler's indignation is understandable, but it is pointless to blame the
sausage-maker. Economics simply does not offer a solution to a lapse of the
will to live among some of the world's richest economies. The Europeans are
paying for their own nihilism. Having invented the perfect post-Christian
society with cradle-to-grave services, they have not found anyone willing to
live in it, except for the immigrants who well may inherit it from the