To Consume or Not to Consume?

super_size_me

THAT is the question. In fact, it is the defining question for an exchange economy. Let’s dissect exactly what it means. “To consume” seems fairly obvious, like the question you ask your kid at the dinner table, “Are you gonna eat that?” But “Not to Consume” offers all kinds of confusing options. To not consume means to save. Save for what? To invest? Invest for what? More stuff? Yes, more stuff to consume in the future. There’s really no other option: “Not to consume now” merely means to defer consumption to some indefinite future time period. (If you die before then, your heirs will consume whatever you saved.)

The implications of this simple insight are broad and deep for understanding the economy. How do we know how to choose whether to consume or save? If we go by the simple human weakness of instant gratification, who would save at all? Why put off until tomorrow the pleasures we can enjoy today? Since in many cases we do exactly that, there must be a good reason. Saving has two payoffs: one, it helps us reduce the risk of not having enough consumption goods to survive in the future (that would be eating our seed corn); and two, saving and investing in future production gives us more tomorrow than we give up today (that would be interest on the savings or profits on the investment).

There are two factors that influence how we choose to save and invest. First is our life-cycle needs – when we are young we consume a lot because we are growing and haven’t yet learned how to produce; in middle age we’ve learned to produce in excess of our needs, leading to saving for old-age when we are no longer producing but still need to consume. This is why societies are most productive if they have a demographic bubble in their middle years, as the US has had with the baby boom generation in the 1980s, 90s and 2000s.

The second factor is technology and the opportunities it offers to make a greater return by saving and investing for the future. The recent computer chip/Internet/social media revolution is a good example of this. If one put aside $100 back in the 1980s to buy shares of Microsoft or Apple, one would be a millionaire several times over today. Not a bad return for putting off one nice dinner.

The key that unlocks the economics of this choice between saving and consuming is the interest rate that signals whether the future may give us more consumption than the present consumption we sacrifice. When interest rates are high, we should consume less to save and invest, and when they are low we should consume more, (given all other things equal). So, the interest rate is crucial to making correct economic choices.

The simple insight of choosing between consuming or saving also illuminates the problems we have in the global economy when countries try to consume or save too much. China’s growth rate is falling because the savings rate is too high and its economy depends on selling too much of its product through exports to other countries, like the US, which is discovering in turn that its consumption is too high and savings too low (reflected in our excessive private and public debt). In other words, to sustain economic growth, the Chinese will have to consume more of their own product and Americans will have to produce more of what they hope to consume. Export-driven economic policies have been very popular in helping developing countries like the Asian tigers to grow rapidly – but we can see by this simple insight that the policy is not sustainable over the long run.

This simple question – To consume or not to consume? – is helpful to understanding many of the complex economic issues we face today, especially sustainability. You see, THAT is the real question, because life is certainly not all about consuming more stuff. The most important consumption good we can enjoy is more free time and leisure to enjoy the short lives we have on this earth.

(Read about this topic in greater depth in the book Common Cent$: A Citizens’ Survival Guide. Available at Amazon in eBook or print.)

(The Illusion of) The Perpetual Money Machine

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This is an excerpt from an excellent paper by Didier Sornette and Peter Cauwels on the state of our world financial economy. Your can download a pdf of the entire paper here. It’s worth a read. The layman’s version can be found here.

There is no use trying,” said Alice. “One can’t believe impossible things.”

“I daresay you haven’t had much practice,” said the Queen. “When I was your age, I always did it for half an hour a day. Why, sometimes I’ve believed as many as six impossible things before breakfast.”
 – Lewis Carroll

Chasing fantasies is not the exclusive pastime of little girls in fairy tales. History is speckled with colorful stories of distinguished scientists and highly motivated inventors pursuing the holy grail of technology: the construction of a perpetual motion machine. These are stories of eccentric boys with flashy toys, dreaming of the fame and wealth that would reward the invention of the ultimate gizmo, a machine that can operate without depleting any power source, thereby solving forever our energy problems. In the mid-1800s, thermodynamics provided the formal basis on what common sense informs us: it is not possible to create energy out of nothing. It can be extracted from wood, gas, oil or even human work as was done for most of human history, but there are no inexhaustible sources.

What about wealth? Can it be created out of thin air? Surely, a central bank can print crispy banknotes and, by means of the modern electronic equivalent, easily add another zero to its balance sheet. But what is the deeper meaning of this money creation? Does it create real value? Common sense and Austrian economists in particular would argue that money creation outpacing real demand is a recipe for inflation. In this piece, we show that the question is much more subtle and interesting, especially for understanding the extraordinary developments since 2007. While it is true that, like energy, wealth cannot be created out of thin air, there is a fundamental difference: whereas the belief of some marginal scientists in a perpetual motion machine had essentially no impact, its financial equivalent has been the hidden cause behind the current economic impasse.

The Czech economist Tomáš Sedlácek argues that, while we can understand old economic thinking from ancient myths, we can also learn a lot about contemporary myths from modern economic thinking. A case in point is the myth, developed in the last thirty years, of an eternal economic growth, based in financial innovations, rather than on real productivity gains strongly rooted in better management, improved design, and fueled by innovation and creativity. This has created an illusion that value can be extracted out of nothing; the mythical story of the perpetual money machine, dreamed up before breakfast.

To put things in perspective, we have to go back to the post-WWII era. It was characterized by 25 years of reconstruction and a third industrial revolution, which introduced computers, robots and the Internet. New infrastructure, innovation and technology led to a continuous increase in productivity. In that period, the financial sphere grew in balance with the real economy. In the 1970s, when the Bretton Woods system was terminated and the oil and inflation shocks hit the markets, business productivity stalled and economic growth became essentially dependent on consumption. Since the 1980s, consumption became increasingly funded by smaller savings, booming financial profits, wealth extracted from house prices appreciation and explosive debt. This was further supported by a climate of deregulation and a massive growth in financial derivatives designed to spread and diversify the risks globally.

The result was a succession of bubbles and crashes: the worldwide stock market bubble and great crash of 19 October 1987, the savings and loans crisis of the 1980s, the burst in 1991 of the enormous Japanese real estate and stock market bubbles and its ensuing “lost decades”, the emerging markets bubbles and crashes in 1994 and 1997, the LTCM crisis of 1998, the dotcom bubble bursting in 2000, the recent house price bubble, the financialization bubble via special investment vehicles, speckled with acronyms like CDO, RMBS,  CDS, … the stock market bubble, the commodity and oil bubbles and the debt bubbles, all developing jointly and feeding on each other, until the climax of 2008, which brought our financial system close to collapse.

Each excess was felt to be “solved” by measures that in fact fueled following excesses; each crash was fought by an accommodative monetary policy, sowing the seeds for new bubbles and future crashes. Not only are crashes not any more mysterious, but the present crisis and stalling economy, also called the Great Recession, have clear origins, namely in the delusionary belief in the merits of policies based on a “perpetual money machine” type of thinking.

“The problems that we have created cannot be solved at the level of thinking we were at when we created them.” This quote attributed to Albert Einstein resonates with the universally accepted solution of paradoxes encountered in the field of mathematical logic, when the framework has to be enlarged to get out of undecidable statements or fallacies. But, the policies implemented since 2008, with ultra-low interest rates, quantitative easing and other financial alchemical gesticulations, are essentially following the pattern of the last thirty years, namely the financialization of real problems plaguing the real economy. Rather than still hoping that real wealth will come out of money creation, an illusion also found in the current management of the on-going European sovereign and banking crises, we need fundamentally new ways of thinking.

A graph of the Perpetual Money Machine can be viewed here. Some of those new ways of thinking can be found here.

Economic Policy in a Nutshell

In a previous post (Economics in a Nutshell) we established a conceptual framework for reducing economics to the simple decision of when to consume (now or in the future?). We expressed this through the following equation, calling it the Inter-temporal Consumption Ratio (ICR):

Cfuture < divided by > Cpresent   < or >  Cf / Cp

The changes in this ratio will help determine the level of savings, investment, production and economic growth. However, before we can apply policy to our analysis we need to address two important factors that will affect the ICR over time. Economists have documented recurrent patterns in the ebb and flow of consumption, savings, investment, and production. One is the “lifecycle hypothesis” that shows greater consumption and lower savings at the beginning and end of life, among the young and the old. Saving and producing is maximized during the middle “working” phase of our lives. So, the consumption pattern of the entire population will be influenced by the demographic distribution of that population. In the U.S., this has been most noticeable with the economic boom associated with the postwar baby boom generation during its most productive middle-aged years.

Another natural pattern is associated with innovation waves in technology. Consider the impacts of the industrial revolution, the development of such technologies as the railroads, steel production, electricity, the automobile, telegraph and telephone, airplane transportation and, more recently, the development of the microchip, the personal computer, and the Internet. During periods of technological advancement, consumption is deferred as investment is poured into new productive opportunities. This is facilitated by rising interest rates, increased saving, increased productivity and economic growth.

These two cyclical patterns of demographics—or population growth—and technological progress are the true determinants of economic growth rates. If the population is growing and new technologies are being developed, economic growth takes care of itself. The problems arise when either population growth or technology or both fall into periods of retrenchment or stagnation. For example, the productive baby-boomers are entering their retirement years, so we can expect their consumption levels will increase, depressing savings and investment and economic growth. At other times technological innovation will stall. But neither innovation nor population demographics are really responsive to short-term government policies, and there lies the rub for the politicians and policy professionals. What to do when economic growth stagnates?

The economy stagnates when present consumption demand is inadequate or investment collapses, (both of these economic variables actually depend on each other in a feedback cycle over time – remember, everything economic derives from the ICR). The policy response has been to pull consumption toward the present and jumpstart productive investment. By our simple ICR, we can see how lower interest rates and government spending stimulus would promote these results. One problem is that increasing present consumption will reduce savings needed for investment, so the policies would seem to be contradictory. We overcome the problem of financing both consumption and investment at the same time by borrowing. This explains the explosion of debt over the past twenty years, and especially the explosion of public debt since 2008.

Now we can see the source of the true problem we face today. For thirty years we’ve been “stealing” consumption from the future by borrowing against the present. (What do you think all those re-fis are?) The borrowing initially went into the information technology revolution, but when that slowed the excess demand went into asset speculation—in commodities, in financial assets and in housing. When the bubbles in these markets popped, credit for investment dried up completely. Consumption collapsed as people feel the need to pay down their debts as their assets lose value. The economic downturn then threatens incomes, which fail to support the service of the debt. In other words, houses and financial assets lose value, people lose jobs and the economy falls into a downward spiral. There is no easy solution to this problem, short of a magical new technology wave. Unfortunately, they can’t conjure this up in Washington D.C.

In addition, our vain attempts to reflate a bubble are distorting all the price signals in the economy that would tell us how we should be allocating our consumption, saving and investment in order to grow again, at whatever pace. The added uncertainty and misallocation hampers the economy as we struggle, but fail to get up off the mat. (Remember, the economy is really us. No people, no economy.)

The foregoing is meant to help us understand what is happening and how to make sense of the gobbledygook coming out of Washington. There is no painless elixir that can set everything straight again, and if we think policymakers in Washington have some magic solution then we’re merely smoking fairy dust. But the important lesson to take away is that we can understand what the ultimate economic effect of policy will be if we understand how it will affect our desire or propensity to consume now or later. Economic disequilibria (a fancy word meaning imbalances) occur when the balance between the present and the future gets skewed too much either way.

For a more thorough exposition refer to Common Cent$: A Citizen’s Survival Guide.

Economics in a Nutshell

In this post we will examine a simple formula that reduces complex economic concepts and analysis into easy-to-understand terms. [The following is excerpted from the book, Common Cent$: A Citizen’s Survival Guide.]

Consume now or later?

These four words can help make sense of the macro-economy. First off, all economics is merely derived from simple decisions we make everyday over whether to consume something today, or save and wait to fulfill our consumption needs and desires tomorrow (or a day, a month, a year, or decade later). Think about some of these decisions you make all the time: eat at home this week so you can splurge on a 5-star restaurant meal next month; put off buying a new car or house for a few years so you can afford to get an MBA; put 15% of your income in the bank to save for a down payment on a house; or borrow to buy a car today instead of next year because the interest rates are low and the discount rebates high.

The real economy is generated by millions of these aggregated individual decisions on whether to consume now or later and the exchanges based on those decisions. The real economy can thus be represented by a simple relationship representing the trade-off between present consumption and future, or deferred, consumption. Symbolically we can represent the trade-off as:

Cpresent versus Cfuture or Cp : Cf

We might prosaically call this trade-off our inter-temporal consumption ratio (ICR), which represents all our aggregate economic decisions over whether to consume now or later.

Now, if you’re wondering where savings, investment, interest rates, government spending, taxes, etc., come in, please be patient. Just remember this simple truth: all resources and the production of goods and services are ultimately allocated toward one end: consumption. What we don’t consume today we may save and/or invest for future consumption, perhaps by our descendants, but ultimately everything is consumed. After all, “You can’t take it with you.”

We can demonstrate the relationship to interest rates and economic growth if we take the formulation and express it as a divisor:

Cf / Cp

Think about how an interest rate affects our preferences for future vs. present consumption. A high interest rate will decrease present consumption as we save more and borrow less in order to reap the high returns of the interest received. In other words, we put our money in the bank (or the money, bond, or stock markets) in order to have our wealth grow to allow us to consume more in the future. Conversely, when the interest rate is low, we prefer to consume now because there is less reward for waiting. The ratio as expressed above is positively correlated with the interest rate: if the ratio is high or rising we would expect interest rates to be high or rising and vice-versa.

This ratio is also positively correlated with the growth rate of the economy. If we defer consumption and save and invest in new production, then the economy grows and we have more to consume in the future. China has been growing at double-digit rates for the past generation because the savings rate is estimated to be near 50% of income and the population’s consumption has been deferred. Of course, China has also relied on selling their goods and services to the rest of the world, since they aren’t consuming much themselves. (Obviously, there is a limit to this “export” growth strategy since the whole world cannot simply produce and sell when nobody buys and consumes.)

Let’s try another thought problem: imagine if interest rates go to zero. Would you be a lender? A zero rate means there is no compensation for risk, zero time value of money, and little to be gained from deferring the immediate gratification of present consumption. In the extreme, a zero interest rate implies a willful disregard, or disbelief, in the future. Naturally, when interest rates go to zero, or even negative numbers in real terms,* we expect the anomaly to be short-lived. We should question the Federal Reserve’s Zero Interest Rate Policy, aka ZIRP. Their policy intent is to stimulate present consumption, but at what cost? How concerned about tomorrow are today’s policymakers?

This brings us to the point where we can discuss how different policy options might affect the ICR (Intertemporal Consumption Ratio), which will be the subject addressed in the next post, Economic Policy in a Nutshell.


* Interest rates are expressly in nominal terms, but if inflation is present, the effective real rate may be negative. For example, if the interest rate is 3% and the inflation rate is 5%, then the real rate is -2%. In this case one should borrow to the max and use the funds to buy appreciating real assets, like real estate, collectibles, or precious metals.

Gambling on the Welfare State

State-sponsored gambling is the one acceptable way of raising taxes on lower-income folks to help fund the welfare state. …Dancing in [politicians’] heads are visions of new state-sponsored gambling empires built on online poker, online slot machines and online lottery-ticket sales, with politicians collecting most of the vig.  …With or without federal regulation, legalized online poker is likely coming your way in 2013.

LOL. These are some great quotes from the article cited below. I’ve been waiting for someone to expose this dark secret about one way our politicians seek to fulfill their promises to take care of the poor. A remarkable trend that is probably inevitable, like sin taxes.

In my 2002 article titled CasinoWorld (downloadable pdf), I identified four behavioral types in terms of gaming strategies that explain risk behavior under uncertainty. These four types are explained in the following excerpt from the study:

The two dimensions of risk-taking (odds and stakes) yield four separate categories of agents (see Table 4.1):

  1. High odds/variance + high stakes = gambler
  2. Low odds/variance + high stakes = investor
  3. High odds/variance + low stakes = lottery player
  4. Low odds/variance + low stakes = subsistence/saver

————————

If we run a game of chance with these four strategies employed, eventually we end up with only two types: investors who own all the wealth and lottery players who live a subsistence life. Is this the world our leaders have planned for us? The 1% and 99%? Think about it, carefully. Happy Holidays!

From the WSJ:

D.C. Plays Fizzbin With Online Poker

How to make the poor pay for the welfare state: online gambling.

By HOLMAN W. JENKINS, JR.

Sometimes only a Star Trek metaphor will do. Remember the episode about a primitive people who developed a planet-girdling civilization based on the principles of the Chicago gangs? Many modern economic anthropologists would tell you that the state begins as organized crime, dividing up rackets and controlling turf.

Case in point: anything having to do with Internet poker.

It starts with the enterprising activities of the Justice Department. Seizing on a 2006 law making it illegal to process U.S. payments for online gambling, federal prosecutors last year brought charges against three offshore poker websites. While admitting no wrongdoing, the sites quickly settled and agreed to hand over substantial sums of money to the department.

Some of these funds were supposed to reimburse the “victims,” U.S. poker players who had money in their accounts when the sites were shut down. But so cumbersome and legalistic is the process created by Justice that many lawyers say they don’t expect their clients to find it worth the trouble or legal fees. Justice may end up keeping much of the loot itself under asset-forfeiture rules.

Don’t expect a hue and cry from gambling interests, however. Bigger stakes are up for grabs, not unlike the turf war Captain Kirk found when he beamed down to the gangster planet Sigma Iotia II.

Having cleared the online poker marketplace of its incumbents, Justice decided that under the 1961 Wire Act most Internet gambling isn’t illegal after all. This new “interpretation,” which came at the behest of Illinois and New York, has inspired a new light in the eyes of state officials looking for ways to fund the welfare state. Dancing in their heads are visions of new state-sponsored gambling empires built on online poker, online slot machines and online lottery-ticket sales, with politicians collecting most of the vig.

Not everyone is pleased by the prospect. Sen. Jon Kyl, an Arizona Republican who is retiring this year, doesn’t like gambling; Sen. Harry Reid, a Nevada Democrat, doesn’t like gambling when it’s not controlled by Nevada casinos.

During the lame-duck session, these improbable bedfellows promoted a bill to halt the online gambling stampede, except for online poker. Why the exception? Poker is a great American tradition, say supporters, including former Sen. Al D’Amato, representing something called the Poker Players Alliance.

More to the point, stopping Americans from playing Internet poker is probably impossible. Under the Kyl-Reid proposal, at least players would be pitted against each other, not the house, which is deemed less iniquitous and corrupting.

The bill satisfies Mr. Reid, meanwhile, because Nevada is already pushing ahead with in-state online poker. Nevada’s casinos and Nevada’s gaming regulators see a federal law as a way to give themselves a headstart in marketing a government-endorsed version of the game to the masses nationally and internationally.

The Kyl-Reid bill, as Captain Kirk would quickly suss out (aided by the deductive powers of Mr. Spock), was destined instantly to become a bone of contention among the various gangs jostling for a piece of the online poker action.

The state lottery commissioners and governors opposed the bill because it would prevent them offering an array of tantalizing new online games to suckers, er, citizens of their states.

Convenience-store owners opposed the bill, fearing it would clear the way for online lottery ticket sales, which would cut into their lucrative piece of the over-the-counter lottery racket.

The Nevada casinos naturally favored any law that would give them a leg up in the emerging marketplace for legal online poker.

In hearings before Congress last year, a Native American spokesman argued that tribes must be allowed to offer online poker on grounds that his 101-year-old grandmother had been a reservation schoolteacher fighting to preserve native culture. Therefore, “if anybody deserves to be at the front line in this industry it’s Native American people.”

Captain Kirk, it will be remembered, invented the deliberately convoluted card game “Fizzbin” as a ruse to distract the gambling-mad, gangster inhabitants of Sigma Iotia II. The Reid-Kyl gambit may have run out of time, but the feds aren’t likely to desist from trying to control so profitable a new racket. State-sponsored gambling is the one acceptable way of raising taxes on lower-income folks to help fund the welfare state. With or without federal regulation, legalized online poker is likely coming your way in 2013. Don’t be surprised if one of the games is called Fizzbin.

So Long Price-Earnings, Hello Price-Expectations

Casino anyone? These are the consequences of boundless credit and QE 1234ever. This juicing of the asset markets with easy money has been going on for a couple of decades. Sooner or later we must pay the piper… I’m guessing the present culprits will be long gone by then and the citizens stuck with the bill.

From the WSJ:

Who cares about growth rates or profits as long as governments and central banks goose the markets?

By ROMAIN HATCHUEL

At the end of last week, major equity indexes including the S&P 500, the Stoxx Europe 600 and the MSCI Emerging Markets were up by about 15% from their early June lows, while the Dow Jones Industrial Average was up around 12.5%. Certain European bourses did even better, such as Spain’s IBEX 35, which surged more than 30%.

Market participants had been eagerly expecting and pricing in some positive developments, and they ended up getting everything they had hoped for. Between Aug. 31 and Sept. 12, the Federal Reserve announced it would engage in yet another round of quantitative easing; the European Central Bank said it would implement a new bond-buying program to support troubled EU countries; and the final legal hurdle to Germany’s ratification of the European Stability Mechanism, the euro zone’s permanent bailout fund, was cleared.

But this avalanche of good news was all about monetary action or political developments. It had nothing to do with the actual state of the global economy, which, according to a variety of indicators, remains worrisome.

The United States continues to grow at an abnormally slow pace, as shown by the latest estimate of second-quarter GDP, which was revised from a meager 1.7% on an annual basis to an even weaker 1.3%. The euro zone is stuck in no-growth territory as it struggles with its debt crisis. As for China, the world’s main growth engine, no one knows exactly how hard a landing it is currently experiencing—but its most recent manufacturing data signal a greater slowdown than previously anticipated.

None of this seemed to have had any effect, though, on global markets in recent months. It was as if traders world-wide had decided to ignore hard economic facts and focus exclusively on actions taken by governments and central banks to prevent the current crisis from getting even uglier than it already is.

In mid-September, soon after this chain of market-friendly events came to an end, the rally began to lose momentum and eventually stalled. Fortunately, Spain’s expected decision to request a full-fledged bailout (on top of the billions it already received to shore up its wobbly banking sector) quickly emerged as a new reason for hope.

Yes, as bizarre as it may seem, the thing that every bull is looking forward to—the announcement that could revive the rally and take equity markets up by another 3%, 5% or even 10%—is the official acknowledgment by the euro zone’s fourth-largest economy that it can no longer cope with its massive debt. As a result, every single move in the continuing poker game between Spanish Prime Minister Mariano Rajoy and European Central Bank President Mario Draghi is being meticulously analyzed.

Investors have always been in the business of anticipating, if not predicting, the future, and there is nothing wrong with this. However, in doing so, they would normally look at “real” economic indicators, such as GDP growth, corporate revenues, earnings outlooks and price-to-earnings ratios. They also knew that trying to figure out what was coming next did not give them a license to totally ignore current realities.

The 2008 global financial crisis and continuing debt crisis in Europe have changed that: The main thing that now seems to move markets—on the upside and on the downside—is monetary and political intervention (or lack of intervention, for that matter).

With traders constantly expecting the next summit, election result, central-bank decision or court ruling, the traditional price-to-earnings ratio has given way to a new indicator, which one could call the price-to-expectations ratio.

No need to worry about sluggish (or negative) growth, high unemployment, deteriorating corporate prospects and ever-rising public debts—as long as the price-to-expectations ratio remains under control, markets have room for appreciation.

The beauty of this new P-E number is that it never gets too high, because as asset prices rise, markets can always raise their expectations accordingly. Any sensible observer would have a hard time doing the same.

The Soviet Banking System—and Ours

The symbiosis between the Fed and the Treasury is unsustainable. (View graphic here.) Neither creates value, but they sure can destroy it. The financial sector is skimming its 3% or gambling house money on bigger payoffs, but eventually they will end up on the menu. Our policymakers are short-timers.

From the WSJ:

Capitalism depends on access to capital. It’s a sad development that banks have turned away from the noble task of directing financial seed corn and instead make bets on interest rates.

By JUDY SHELTON

Many in America today fear that our nation is going the way of Europe—becoming more socialist and redistributionist as government grows ever larger. But the most disturbing trend may not be the fiscal enlargement of government through excessive spending, but rather the elevated role of monetary policy.

Our central bank, the Federal Reserve, uses its enormous influence over banking and financial institutions to channel funds back to government instead of directing them toward productive economic activity. For evaluating the damaging effects of this unhealthy symbiosis between banking and government, the more instructive model is the Soviet Union in its final years before economic collapse.

We can draw lessons from the fact that the Soviet Union went bankrupt even as its fiscal budget statements affirmed that government revenues and expenditures were perfectly balanced. Under Soviet accounting practices, the true gap between concurrent revenues generated by the economy and the expenditures needed to sustain the nation was obscured by a phantom “plug” figure that ostensibly reflected the working capital furnished by the Soviet central bank, Gosbank.

The problem for the Soviet government was that financing provided by the state-controlled bank was supporting an increasingly unproductive economy—bailing out unprofitable enterprises that had long since quit producing real economic gains that might have raised living standards. The extension of credit to these entities had little to do with merit or potential usefulness.

The Soviet central bank was making up for the difference between government revenues and government expenditures by creating empty credits to be disbursed by central-planning bureaucrats. By the time Mikhail Gorbachev came to power in 1985, vowing to address the disastrous financial situation of the Soviet Union through “perestroika,” or restructuring, the budget deficit being financed through the nation’s central bank amounted to more than 30% of total government expenditures.

Lenin had been wise about the uses of banks. Shortly before the October Revolution, he wrote: “Without big banks, socialism would be impossible. The big banks are the ‘state apparatus’ which we need to bring about socialism, and which we take ready-made from capitalism.”

Those big banks can be easily seen today in America: They’re the ones deemed too big to fail because their demise would threaten U.S. financial stability. As mandatory members of the Federal Reserve System, they are vital partners for conducting monetary policy through the purchase and sale of Treasury bonds orchestrated by our central bank, a process known as “federal open market operations.” Besides serving as conduits of Fed policy for expanding or contracting the money supply through Treasury debt transactions, commercial banks can also access short-term funding directly from the Fed through its “discount window.”

As our own nation’s budget deficit has grown substantially larger in recent years—with the shortfall between government receipts and government outlays widening to 34.9% in the enacted budget for fiscal year 2012—our central bank has aggressively stepped up its involvement in financing government spending in excess of revenues.

In 2011, the Fed purchased a stunning 61% of the total net Treasury issuance, thus absorbing a huge portion of the fiscal overhang. Meanwhile, the Fed has been making funds available to member banks at record-low interest rates, targeting zero to 0.25% in the federal funds market and charging less than 1% on primary loans through the discount window.

It’s a bad combination: The Fed, a government agency, not only conducts monetary policy through commercial banks using Treasury debt and by extending virtually cost-free lines of credit; it also regulates those same entities. Our nation’s depository institutions are at risk of becoming complicit instruments of the federal government rather than private credit-granting companies serving free enterprise.

Washington’s dire financial condition is distorting the very nature of banking and defeating the fundamental purpose of financial intermediation. Instead of taking on the risk of making loans to small-business owners, or to individuals wanting to purchase underpriced real estate with future potential, bank portfolio managers have every incentive to play it safe. Why do anything that might raise the eyebrow of the visiting banking examiner?

Even as community bankers feel the subtle pressure to avoid local lending, the distorted incentive structure resulting from the Fed’s behemoth presence in banking and finance has its greatest impact among the larger institutions. They can earn more profits by trading sophisticated financial derivative instruments and speculating in currency markets rather than engaging in the hard grind of evaluating individual proposals from entrepreneurs seeking investment capital.

According to the Bank for International Settlements, more than 75% of the $647 trillion in notional value of outstanding derivatives arises from such contracts linked to interest rates—an indication of the extent to which monetary policy dominates the world of big finance.

Capitalism depends on access to capital. It’s a sad development that banks have turned away from the noble task of directing financial seed corn to the most promising harvesters of productive endeavor. And that they are drawn instead to playing the Fed’s nuanced game of betting on government debt and arbitraging interest-related plays.

Recent suggestions that perhaps the solution is to involve our central bank even more in the lending decisions of banks—by having the Fed grant special funds to American banks for the express purpose of re-lending them to government-approved nonfinancial borrowers—highlight how alarmingly dirigiste the entire system has become. Can central planning be far away?