Monday, July 13, 2009

On the Destruction of Capital

The European Commission’s recently issued report on member states says that “the crisis is the equivalent of capital destruction, reducing – at least for a time –the productive potential of the economy.”

Capital is a social thing. It has no equivalent any more than art or religion has equivalents. Its destruction, likewise, is a very particular phenomenon. So it is nonsense to speak of the “equivalent of capital destruction”. What we have in this crisis is the destruction of capital, period.

Why did the authors of the report insert the word equivalent where it does not belong?

The answer is that it tones down what is being said. To the delicate ears (or eyes) of bureaucrats in Brussels, “destruction” would be too strong, so their minions diluted the word the best they could.

But surely these authors must know what capital destruction is, otherwise it would be impossible to speak of something “equivalent” to it.

The truth is that they do not. They merely have an inkling about it, the way Bernanke has an inkling about systemic risk. If pushed to explain exactly how capital is destroyed or what the “system” is in systemic risk, they would have nothing to add except reguritating what they have already said.

The pussyfooting and hesitant writing is the by-product of unclarity of thought. At the same time, it works to maintain the unclarity and, in doing so, creates a going concern of ignorance.

I have written about the destruction that is going on around us. See, for example, here and here and here.

When capital is destroyed, its various forms shrink. Speculative capital is hit particularly hard because of its reliance on leverage. Arbitrage opportunities turn exoskeletal and cannot be exploited quickly – or at all. That is the story behind the closing of Meriwether’s “relative value” fund. The man is no doubt a good trader but like all traders understands nothing about the real theory of finance.

How exactly is capital destroyed? What are the mechanics and dynamics of the destruction – and its consequences?

These are the main questions tackled in Vol. 4 of Speculative Capital. If you are interested in the subject, stay tuned.