Thursday, September 27, 2012

Why Wage earners would always lag behind under the current monetary setup - Story of Wages, Capital & Middlemen (Banks)

The growing wealth disparity has become a raging issue in the upcoming Presidential elections. Both sides are promising to tackle this issue from their own idiosyncratic viewpoints. While the democrats want to tax the rich in order to reduce this income gap; the republicans think that a slowing economy due to excessive regulations is a result of this widening disparity. The Federal Reserve has also time and again expressed its empathy and concern over this phenomenon. What is however unmistakably clear is the fact that this process that started to gain traction since 1970 i.e. since the onset of the monopolised fiat monetary system has been responsible for stealing the vitality from the millions of American households.
While it’s true that our current monetary setup has broken the shackles of the past wherein the supply of credit was restricted by the amount of gold and thus enabling various parts of the world including US to witness unforeseen growth and so it would be na├»ve to return back to the previous system, however a fatal flaw of this setup has meant that steadily fewer people would end up controlling large chunk of the economic resources and thus not just widening the income gap but also paving the way for a plunge in future growth rates.
Under the previous commodity based monetary system, the depositors used to deposit their savings in form of gold or gold backed dollar bills in their banks and this used to form the basis of the credit that the bank used to lend forward so in other words the savings would lead to credit. In the prevailing system the banks create credit out of thin air and lend it to the borrower which is simultaneously deposited in the bank account. Thus under the current monetary setup it is the credit that leads to savings and deposits.
The problem with the current setup is that unlike previously wherein the price for the malinvestments was paid by savers, today the bill for the malinvestments fall on the doorsteps of the workers themselves. Infact any loss from the malinvestments in a sector would impact that particular sector first followed by the banks which would then transmit the losses to various other sectors of the economy like a nerve centre of the brain. So the current fiat monopolised monetary setup converts the unwinding of malinvestments in a particular sector into a full blown downturn for the entire economy.
This phenomenon of wealth transfer taking place today can be explained more clearly by the following scenario.
An entrepreneur planning to setup a business hires some workers. These workers can be compensated in two ways; a share of the profits (equity) or a fixed compensation.
The entrepreneur would now approach the bank to get a loan which he would use to pay off his workers atleast till his business start to generate cashflows.  The workers would in turn deposit these wages into their bank accounts which would now constitute the liabilities of the bank.
In the first scenario the risk for the success of the project is shared between the entrepreneur and the workers and so the compensation of the workers is higher. In the second scenario the risk is shared between the entrepreneur and "the bank" and "not the Workers" and so they are given lesser compensation. However as we are going to see the workers still share the risk and are not even compensated for it anymore, all because of the monetary system.
Now let's say that the project has failed and hence has not generated any cashflows, the bank would have to right-off that loan (an asset on the books of the bank), following the rules of accounting it has to wipe-off an equal amount in liabilities which would mean that the salaries of the workers would now be obliterated. So as in scenario one because the project has failed the entrepreneur and the bank gets nothing but more importantly even the workers would have nothing; which is unfair as they took to the option of lesser compensation because they wanted to have their pay irrespective of the state of the project.
However if the project succeeds the entrepreneur makes millions, bank is going to have an interest income but the workers would have no upside but only the pay which was unfairly computed as it was assumed that the workers are taking no risk.

So the irony of the current monetary system is that the people working at fixed pay have no upside to the success of any business but downside to its failure, banks have no downside but upside (interest income if project succeeds & no real losses as they anyways printed money to lend which would be written off) and people working for equity have both upside and downside.  Under the earlier setup the risk of the failure of the project was passed on to the savers and not the workers.
Ofcourse in practical parlance to avoid such a possibility in which the banks would have to right-off the savings of the workers, the Central Banks constantly aim at boosting the credit growth in the economy and inflating the money supply which only creates an illusion wherein the people working on fixed pay appear not to lose money but this scenario changes nothing as they are still losing out in the same "real terms" to the banks and people working for equity.
As a result of these actions not just the wealth disparity in US and across the world has exploded but the malinvestments have been prevented from getting unwound. As a result the financial sector which is supposed to play a tertiary role has grabbed the bulk of economy (see graph) and the wealth is moving in the hands of a few people at an increasing rate.

Even though US has registered decent GDP growth over the last 3-4 decades but thanks to the grotesque monetary tools the living standards of a majority of the population has not changed by much and now with even the growth slowing down, the monetary authorities have to choose between the devil and the deep blue sea because pursuing the old policies would mean a slow bleed in the living standards of the people while  failing to do anything would end up with a catastrophic unwinding of the massive malinvestments which threatens to take down the savings of the masses. The only way out of this mess is to move away from the monetary setup that is akin to “cocktail socialism” and give way to a system wherein the quantity of credit and its price (interest rate) is determined by the forces of free market rather than a politburo of the Central Bankers.

1 comment:

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