Social capital comprises the larger share of wealth in developed economies1. It encompasses the value created by law and order, mutual trust, and public institutions; all of them assets that have formed as a result of the emergence of a jurisdictional, legal and social order over centuries.
In parallel, modern societies have also amassed a large stock of public financial assets. In general, they have neither originated from tax contributions nor from selling the countries’ riches, but have instead been created out of thin air by arbitraging the mismatch between liabilities at perpetuity and finite human lives. The first of such inventions was the fractional reserve banking system; predicated on a central bank that can create and lend fiduciary money at its discretion. The second breakthrough was the development of the Social Security system under the “pay-as-you-go” principle, where those employed pay for the pensions of the retired.
Both schemes are relatively modern. Emperors and kings have long been adept to money debasement, but fiduciary money only started in earnest in the early seventies, when Nixon put an end to the ”Gold Standard”. Coincidentally, the welfare state, which had been confined to offering disability insurance and protection for the poor, broadened the range of entitlements to include “non-funded” public pensions.
Similar to other intangible assets, social capital is less prone to depreciation and depletion than physical capital, although it requires adaptations – revolution at times – to cope with societal change. However, the problem with pensions and fiat money is that they are “one-off” creations, and can therefore not be easily replenished. In fact, both are in need of expansionary dynamics in order to endure – hence their frequent comparison with Ponzi schemes. Fiat money requires price inflation, whilst population growth is paramount for public pensions.
As in the seventies and eighties the demographics in developed economies were favorable it was possible to increase entitlements without having to raise taxes; too big a temptation for politicians to resist. However, now that populations are ageing, these assets are being depleted at a worrying pace and reforming the system is a political bomb. As a result, pension deficits will likely translate into public debt – a social liability.
As for paper money, after some years of experimentation under the new regime, during which time inflation got out of control, central banks managed to keep a stable but positive rate of inflation. On the contrary, asset prices from real estate to stock markets tended to bubble periodically. After every market crash, the same medicine was administered – the famous Greenspan put – consisting in lowering interest rates to reactivate credit and reflate asset prices in order to preserve the “wealth effect”.
However, each time it happened, the dose had to be increased for the sick man to recover, and interest rates kept trending down with debt piling up. When the financial crisis arrived, central bankers quickly ran out of medicine, and deflation threatened to put the system into reverse. At this defining moment, Bernanke pulled a rabbit out of the hat, and QE helped to squeeze some more monetary juice.
Since then, the economy has stabilized and markets are booming once again. Central bankers now talk about policy “normalization” as they are in the need to replenish the monetary arsenal, knowing that it is inevitable that a new crisis will arrive sooner or later; but under the heavy load of the debt accumulated over decades – and the one forthcoming from pension holes – there is no easy way back without hurting the asset values they so badly want to preserve.
Hence, provided no growth or productivity miracle happens, extend and pretend is the only way forward for the authorities, and QE and pension deficits are here to stay, inextricably tied to each other like Siamese twins. However, the perpetuation of these schemes is not free of side effects as both fuel social inequality across wealth and age brackets, and deplete one of the most treasured assets, which is social cohesion.
1http://siteresources.worldbank.org/INTEEI/214578-1110886258964/20748034/All.pdf
Fernando de Frutos, MWM Chief Investment Officer
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