JEDDAH, 20 September 2004 — In the last century, American people were pioneers of system and technology innovation. In order to understand the current state of the financial markets, one needs to figure out what the fundamental economic interests of America are.
By the mid-1970s, the US, the UK, France, Germany, Italy, Japan and other major capitalist countries had completed the industrialization process now under way 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. Add few financial innovations, like derivatives, and the “fictitious” economy assumed the central role in the global monetary system.
Money transactions related to material goods production, counted 80% of the total (global) transactions until 1970. However, only 5 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 .5% in 2002.
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 US has increased only 50%, while the money supply has grown by a factor of 3. Money has been growing more than six times as fast as the rate of goods production. The results? In 1997, before the blow-off in the US stock market, 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. 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 this 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, 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 (down) market can bankrupt millions of people. 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.
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, nonexistent — values. In the era of paper money, 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 interest rates and increased their borrowings backed by the value of these financial assets. They then turn around and trade the new capital on the markets. During this process, the demand of money no longer comes from the expansion of material goods production, instead it comes from the inflation of capital price. The process repeats itself.
Derivatives 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. 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 US, 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. Until now, US 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 US dollar and abnormal exuberance in the American security market.
While (fictitious capital) has been bringing to America economic prosperity and hegemonic power over money, 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, 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, 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.