Coming Down from Cloud Cuckoo Land

Schlitz beer was always revolting.  But at the right price – and having the right effect – “the beer that made Milwaukee famous” had a nice run.

In between the birth and death of capital there’s a wide-ranging succession.  The lifecycle of capital generally follows that it is imagined, produced, consumed, and destroyed.  How exactly this all takes place involves varying and infinite undulations.

One generation may produce wealth.  While the next generation burns through it.  Many aspects of a person’s capabilities, understanding, industry, and character can determine if they’re producers or consumers.  The most determinant facet, however, is how one approaches their unique circumstances.

The July 21, 2014, edition of Forbes Magazine documented the Stroh family’s methodical rise and swift disappearance from the beer brewing business.  The print edition of the article titled, How to Blow $9 Billion, began with the following remark:

“It took the Stroh family over a century to build the largest private beer fortune in America.  And it took just a few bad decisions to lose the entire thing.”

What worked for the Stroh family was taking a long-term time horizon.  Wealth was built by incrementally acquiring and growing a loyal and devoted regional customer base.

What didn’t work for the Stroh family was ‘going big.’  The debt financed acquisitions of Schaefer and Schlitz in the early-1980s, and the costly bid to become a national brand, was its ultimate demise.

By the end of the century, after growing too big for its britches, the 150-year-old Stroh family beer business was sold off at fire sale prices.

We mention the capital lifecycle of Stroh, as an example.  Our real interest here is wealth.  Where does it come from?  How is it accumulated?  And why is it destroyed?

What follows, is an attempt to answer these questions…

Coffee Table Economics

As we understand it, when a depositor makes a deposit, he is, in essence, lending money to the bank.  But what does the deposit represent?

If the deposit is earned money, it represents something of equal value to that produced by the depositor’s labors.  The deposit also represents something the depositor would rather save for the future than consume today.

In a tangible sense, the deposit could represent anything.  It could even represent a coffee table.  In this example, there are only a few things to do with a surplus coffee table.  You could store it for your own future use.  You could trade it with a willing buyer for something of equal value.

In each of these instances, there’s no increase in capital.  The coffee table remains a coffee table.  Nothing more.  Nothing less.

Alternatively, you could sell the coffee table for cash.  If you then stuff the cash in your mattress, you have the equivalent of one coffee table.  Again, there’s been no increase in capital.

But suppose you deposit the money at your bank and leave it there at interest.  You would’ve loaned the bank your surplus labor, as represented by the value of a coffee table.  And the interest paid represents the beginning of an increase in capital.

Now consider that after your deposit, an enterprising carpenter, who’s without tools and materials, borrows your deposits from the bank to buy a table saw, doweling jigs, and red oak lumber.  These tools and materials represent your coffee table.

But with these tools and materials, the carpenter gets to work and makes three coffee tables.  One he keeps for himself.  The other two he sells.

Wealth Accumulation and Destruction

With the earnings from the second coffee table, he repays the bank the money he borrowed to buy the tools and materials.  After that, he still has the proceeds of the third coffee table, which is profit.  Then, instead of spending this profit, he saves it.  He deposits it in the bank at interest.

The bank now has the capital of two coffee tables.  In addition, the carpenter still owns the tools.  All from one surplus coffee table to begin with.

If he desires, he can repeat this process again and again.  He may even file articles with his state government and incorporate his coffee table business.

Through this activity wealth has been produced and accumulated.  And more wealth can be produced and accumulated in this manner, provided the labor is not lost.

Yet just as wealth has been produced and accumulated, it can also be consumed and destroyed.

Suppose a third man comes to the bank and borrows the money that the carpenter deposited.  But instead of investing it in his own labor and ingenuity, he uses it to make an ill-advised speculation on shares of WeWork Inc – just prior to its 95 percent share price swan dive.

The borrowed money, for both the lender and borrower, represents a loss.  Specifically, in this instance, the loss is equivalent to the amount of labor necessary to produce two coffee tables.

Still, in this example, the loss is limited.  The borrower learns a valuable lesson from the school of hard knocks.  The lender can likely write it off without much effect.

Of course, if this were to happen en masse it would be an entirely different story.

Alas, the story of borrowing, speculating, and going broke en masse is the primary story of our time.  In fact, we’re on the cusp of the sort of real wealth destruction that only occurs about once per century – or even once per millennium.

Inverted Debt Pyramids

Fractional reserve banking has always been a game of smoke and mirrors.  Bankers pretend they hold deposits.  Depositors pretend the banks have their cash stacked, and safely stored away in an interior vault where they can access it at any time.

Prudent bankers strive to lend credit to those who produce and accumulate wealth.  So, too, they try to limit their business dealings with riverboat gamblers.  Recognizing the difference in today’s hyper-modern economy takes real wisdom.

Modern banking, especially where Wall Street is involved, can misalign anticipated rewards with their underlying risks.  We’ve all seen how the proliferation of financial products, and the supposed assets they represent, can obscure risks that are real and consequential.

Wall Street banks make a fine art of confounding assets and liabilities.  Loans, for example, are securitized in the form of mortgage-backed securities and collateralized loan obligations and sold as investments.

All the paper shuffling works well, so long as the flow of credit remains one step ahead of debt servicing.  In this manner, credit can be piled in an inverted debt pyramid to unfathomable heights.

Still, that doesn’t mean there are no limits at all.

Remember, the value in money is in what it represents.  Every dollar of actual money should be derived from a dollar’s worth of wealth that has been produced.  Every dollar of credit multiplied upon that money should imply a dollar’s worth of wealth that’s in the process of being created, plus interest to compensate the lender’s risk.

This is how wealth creation should work in a world where money is sound, budgets are balanced, and bankers stand behind their loans.

Coming Down from Cloud Cuckoo Land

The present world, however, rarely works as expected.  Through policies of extreme credit market intervention by the Federal Reserve, an illusion of fake money wealth has been concentrated and pushed to the limit.

This is the current state, as we see it, which has manifested over the last 40 years.  This period is coming to an abrupt end.  The next part of the story is when the fake money wealth is set on fire with systematic efficiency.

Bill Bonner, of Bonner Private Research, recently elaborated where we’ve been and where we’re going:

“The basic building brick for the whole world’s financial edifice is the US 10-year T bond.  Yesterday [Tuesday], the real yield (adjusted for inflation) on the 10-year rose to 2.27%.  That was what it was in January 2009, just after Ben Bernanke began his disastrous ultra-low rate fantasy (as if you could actually make people better off by falsifying the cost of capital!)…the proximate cause of today’s financial distress.  

“Until Bernanke went off the rails, the US financial system retained at least the appearance of sanity.  It could walk and talk, more or less like a normal economy.  People remembered where they lived; they could still get home.

“It cost money (positive interest rates) to borrow back then…which limited debt to what people could afford.  But then, after the Fed dragged interest rates below zero, in real terms, the sky was the limit.  That is what made the US financial world what it became – 2009-2020 – cloud cuckoo land, where fake capitalists borrowed fake money at fake interest rates in order to make fake profits.

“Those profits disappear when the whole fake hullabaloo comes to an end.”

The best way to come down from cloud cuckoo land is to never travel there to begin with.  Of course, this is no longer an option.  Thanks to Fed policies of extreme credit market intervention the entire economy has been taken for a wild ride.

And the return flight – where consumers, businesses, and governments go broke en masse – is headed for a crash and burn landing.

[Editor’s note: Today, more than ever, unconventional investing ideas are needed.  Discover how to protect your wealth and financial privacy, using the Financial First Aid Kit.]

Sincerely,

MN Gordon
for Economic Prism

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