Quick fixes for Capitalism: Part 1

Is capitalism broken?

It certainly seems like it. Global trade and economic growth is slowing in real terms and standards of living for many are either stagnant or declining. Despite aggressive tax cuts and imposed austerity, it just doesn't seem possible to reverse the current trend. Even if we consider that wages in the developing world are slightly higher today than they were 30 years ago, it has come at the cost of terrible ecological damage.

Our future?

In fact, if we want any kind of future at all, we may have to consider cutting our levels of consumption in half. Earth Overshoot day now falls in August. This is the day when we can consider our economies to have used 100% of the non-renewable resources of the Earth, or to have degraded the renewable sources such as clean water and fish stocks to the point where they can't recover. We are using 200% of the Earth's capacity already...

50-20/50-80

But as many people might already know, much of that consumption, and the waste that is a bi-product is concentrated in a small part of the economy, and a small number of hyper consumers.
Also, exploitation and degradation of our resources is not uniform.

Wasted resources

While we produce much too much CO2, and throw away too much food uneaten, there is a lot of potential farmland which is underutilized, because the produce can't be profitably distributed, or local people can't afford to eat. And our human resources are terribly underutilized. Billions of people are under-educated and under-employed. They could be doing the work which is currently being done by dirty machines or is not being done at all.

So what's the solution?

Wait a minute! Please don't jump to the obvious conclusion.

Capitalism is bad, so if we get rid of capitalism, whatever we get instead must be better.

Maybe not.
The other options sound great in theory, but have always had their own problems when executed in reality. For example, the Aral Sea is often used to illustrate how Capitalism is destroying our environment, but the sea was already greatly reduced by bad farming practices during the Soviet era.

Bad vs Bad.

The centrally managed Soviet economy often didn't attach any more value to environmental assets than the Capitalists do. I suggest that it isn't a matter of who owns the resources, and is responsible for managing them, but how the owners define their value.

Creating balance.

Could Capitalism be reworked to provide a better valuation of our resources, so that we use less of what is really scarce and use more of what is underutilized?

(I hope to address the issue of non-ownership, a commons or trustee economy  separately in future).

Quick fixes.

For now, I will try to suggest some little fixes that could be made to our current system so that it could be better directed towards sustainable development. These are not things that require us to roll out the guillotines, or establish world socialism, but modest changes to how capitalism already works. Today I address asset risk weighting.

Where does new money come from? 

That's a question I don't want to delve too deeply in to here, but suffice to say, new money is created when private banks loan money to the public. This money didn't exist before it was loaned, and when is paid off, it will go back to not existing. The economy grows by debt inflation.

What stops banks from lending infinite money?

Commercial banks have to balance their loans and other assets against the capital that they hold. They can only lend our more money if they have something on the other side of the balance sheet to support it. These loans are risk weighted, which means that some are more risky than others, so the banks can't lend as much of one kind of loan as another. As an example, commercial real estate has 100% risk. So a bank needs $1 of capital to balance every $1 of loans in that sector. Housing loans (mortgages) have $50 risk weighting, so they need $0.50 for every $1 of household mortgages. Credit cards have up to %120 risk weighting, so they are only profitable if they come with very high interest rates to offset their risk.

This has had a predictable effect on our economies. Lending for mortgages far outstrips all other kinds of loans. This is because the amount you can borrow to buy an asset, ends up defining the cost of that asset. If you can sustain the debt burden on a $200,000 house, that's the house you are going to go out and buy. As average mortgage limits increase, property prices rise too.

How can we use this to our advantage?

Many people think that the economy is essentially "free" and unregulated, and that the rise of house prices is a result of the "natural" property market. But there's nothing natural about it. Someone decided the levels of risk weighting to apply to different classes of assets. It happened as part of an international government regulation effort. Mortgages are low risk because they are perceived to be low risk, since they are secured with the house as collateral.
Business loans are high risk because they are not secured with expensive assets.
But the value of those assets ends up being set by the very measure that is supposed to reflect it.

We can set the value of assets by setting the risk weighting of those assets. 

We should take in to account not just the individual risk of the loan, but the systemic risk of an overheated housing market, high cost of living and stagnant business growth. These are the problems which led to the 2008 financial crisis. We should also factor in environmental risk which promises an even bigger danger in the long term.

Things which are bad for the environment should have a very high risk factor to discourage lending in those sectors. Fossil fuel companies should have a hard time getting credit to carry out their business, because their business represents a clear systemic risk. Banks which lend to fossil fuel companies are accelerating the point at which ecological degradation can cause inevitable economic collapse. When climate change causes massive flooding, it often destroys property, making mortgages worthless overnight.

Rewarding future security.

We could go further than this and suggest zero risk factors. A bank which lends money on an energy efficient home is reducing the risk of systemic failure. They are taking steps to make their bank more secure in the long run. The house price will increase faster over time than a house which is not energy efficient because lower interest rates will be offered, allowing borrowers to service a bigger debt.

When we are not looking at assets but cash flows from business revenues, then high risk factors discourage lending and reduce availability of credit. We get the opposite effect. High risk weighting leads to slow business growth.

By giving green businesses access to cheap capital from low risk loans, we can encourage the growth of those companies which are ecologically friendly.

Regulations are bad?

Remember, these are not new regulations. We already have asset risk weighting. Without it, banks would be able to write infinite IOUs or simply cook their books to make it look like they were addressing risk. For any libertarians out there, they should be happy that this kind of guiding hand could be used to avoid more direct interference in the economy by government, such as big bank bailouts after a systemic crash.

Leaving Capitalism unguided and unregulated leads to the situation we are currently in. We need to get our hands on the steering wheel and drive to the future that we want. I hope to address other problems with Capitalism in future, and try to suggest small changes that could help to steer us in a better direction.

If Capitalism doesn't fix itself, there are plenty of people ready to polish up the guillotine and provide their own solutions. So it's now or never for saving Capitalism from itself.