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Bubbles Always Burst: the Education of an Economist


I did not set out to be an economist. In college at the University of Chicago I never took a course in economics or went anywhere near its business school. My interest lay in music and the history of culture. When I left for New York City in 1961, it was to work in publishing along these lines. I had worked served as an assistant to Jerry Kaplan at the Free Press in Chicago, and thought of setting out on my own when the Hungarian literary critic George Lukacs assigned me the English-language rights to his writings. Then, in 1962 when Leon Trotsky’s widow, Natalia Sedova died, Max Shachtman, executor of her estate, assigned me the rights to Trotsky’s writings and archive. But I was unable to interest any house in backing their publication. My future turned out not to lie in publishing other peoples’ work.

My life already had changed abruptly in a single evening. My best friend from Chicago had urged that I look up Terence McCarthy, the father of one of his schoolmates. Terence was a former economist for General Electric and also the author of the “Forgash Plan.” Named for Florida Senator Morris Forgash, it proposed a World Bank for Economic Acceleration with an alternative policy to the existing World Bank – lending in domestic currency for land reform and greater self-sufficiency in food instead of plantation export crops.

My first evening’s visit with him transfixed me with two ideas that have become my life’s work. First was his almost poetic description of the flow of funds through the economic system. He explained why most financial crises historically occurred in the autumn when the crops were moved. Shifts in the Midwestern water level or climatic disruptions in other countries caused periodic droughts, which led to crop failures and drains on the banking system, forcing banks to call in their loans. Finance, natural resources and industry were parts of an interconnected system much like astronomy – and to me, an aesthetic thing of beauty. But unlike astronomical cycles, the mathematics of compound interest leads economies inevitably into a debt crash, because the financial system expands faster than the underlying economy, overburdening it with debt so that crises grow increasingly severe. Economies are torn apart by breaks in the chain of payments.

That very evening I decided to become an economist. Soon I enrolled in graduate study and sought work on Wall Street, which was the only practical way to see how economies really functioned. For the next twenty years, Terence and I spoke about an hour a day on current economic events. He had translated A History of Economic Doctrines: From the Physiocrats to Adam Smith, the first English-language version of Marx’s Theories of Surplus Value – which itself was the first real history of economic thought. For starters, he told me to read all the books in its bibliography – the Physiocrats, John Locke, Adam Smith, David Ricardo, Thomas Malthus, John Stuart Mill and so forth.

The topics that most interested me – and the focus of this book – were not taught at New York University where I took my graduate economics degrees. In fact, they are not taught in any
2KillingTheHost_Cover_ruleuniversity departments: the dynamics of debt, and how the pattern of bank lending inflates land prices, or national income accounting and the rising share absorbed by rent extraction in the Finance, Insurance and Real Estate (FIRE) sector. There was only one way to learn how to analyze these topics: to work for banks. Back in the 1960s there was barely a hint that these trends would become a great financial bubble. But the dynamics were there, and I was fortunate enough to be hired to chart them.

My first job was as mundane as could be imagined: an economist for the Savings Banks Trust Company. No longer existing, it had been created by New York’s then-127 savings banks (now also extinct, having been grabbed, privatized and emptied out by commercial bankers). I was hired to write up how savings accrued interest and were recycled into new mortgage loans. My graphs of this savings upsweep looked like Hokusai’s “Wave,” but with a pulse spiking like a cardiogram every three months on the day quarterly dividends were credited.

The rise in savings was lent to homebuyers, helping fuel the post-World War II price rise for housing. This was viewed as a seemingly endless engine of prosperity endowing a middle class with rising net worth. The more banks lend, the higher prices rise for the real estate being bought on credit. And the more prices rise, the more banks are willing to lend – as long as more people keep joining what looks like a perpetual motion wealthcreating machine.

The process works only as long as incomes are rising. Few people notice that most of their rising income is being paid for housing. They feel that they are saving – and getting richer by paying for an investment that will grow. At least, that is what worked for sixty years after World War II ended in 1945.

But bubbles always burst, because they are financed with debt, which expands like a chain letter for the economy as a whole. Mortgage debt service absorbs more and more of the rental value of real estate, and of homeowners’ income as new buyers take on more debt to buy homes that are rising in price.

Tracking the upsweep of savings and the debt-financed rise in housing prices turned out to be the best way to understand how most “paper wealth” has been created (or at least inflated) over the past century. Yet despite the fact that the economy’s largest asset is real estate – and is both the main asset and largest debt for most families – the analysis of land rent and property valuation did not even appear in the courses that I was taught in the evenings working toward my economics PhD.

When I finished my studies in 1964, I joined Chase Manhattan’s economic research department as its balance-of-payments economist. It was proved another fortunate on-the-job training experience, because the only way to learn about the topic was to work for a bank or government statistical agency. My first task was to forecast the balance of payments of Argentina, Brazil and Chile. The starting point was their export earnings and other foreign exchange receipts, which served as were a measure of how much revenue might be paid as debt service on new borrowings from U.S. banks.

Just as mortgage lenders view rental income as a flow to be turned into payment of interest, international banks view the hard-currency earnings of foreign countries as potential revenue to be capitalized into loans and paid as interest. The implicit aim of bank marketing departments – and of creditors in general – is to attach the entire economic surplus for payment of debt service.

I soon found that the Latin American countries I analyzed were fully “loaned up.” There were no more hard-currency inflows available to extract as interest on new loans or bond issues. In fact, there was capital flight. These countries could only pay what they already owed if their banks (or the International Monetary Fund) lent them the money to pay the rising flow of interest charges. This is how loans to sovereign governments were rolled over through the 1970s.

Their foreign debts mounted up at compound interest, an exponential growth that laid the ground for the crash that occurred in 1982 when Mexico announced that it couldn’t pay. In this respect, lending to Third World governments anticipated the real estate bubble that would crash in 2008. Except that Third World debts were written down in the 1980s (via Brady bonds), unlike mortgage debts.

My most important learning experience at Chase was to develop an accounting format to analyze the balance of payments of the U.S. oil industry. Standard Oil executives walked me through the contrast between economic statistics and reality. They explained how using “flags of convenience” in Liberia and Panama enabled them to avoid paying income taxes either in the producing or consuming countries by giving the illusion that no profits were being made. The key was “transfer pricing.” Shipping affiliates in these tax-avoidance centers bought crude oil at low prices from Near Eastern or Venezuelan branches where oil was produced. These shipping and banking centers – which had no tax on profits – then sold this oil at marked-up prices to refineries in Europe or elsewhere. The transfer prices were set high enough so as not to leave any profit to be declared.

In balance-of-payments terms, every dollar spent by the oil industry abroad was returned to the U.S. economy in only 18 months. My report was placed on the desks of every U.S. senator and congressman, and got the oil industry exempted from President Lyndon Johnson’s balance-of-payments controls imposed during the Vietnam War.

My last task at Chase dovetailed into the dollar problem. I was asked to estimate the volume of criminal savings going to Switzerland and other hideouts. The State Department had asked Chase and other banks to establish Caribbean branches to attract money from drug dealers, smugglers and their kin into dollar assets to support the dollar as foreign military outflows escalated. Congress helped by not imposing the 15 percent withholding tax on Treasury bond interest. My calculations showed that the most important factors in determining exchange rates were neither trade nor direct investment, but “errors and omissions,” a euphemism for “hot money.” Nobody is more “liquid” or “hot” than drug dealers and public officials embezzling their country’s export earnings. The U.S. Treasury and State Department sought to provide a safe haven for their takings, as a desperate means of offsetting the balance-of-payments cost of U.S. military spending.

In 1968 I extended my payments-flow analysis to cover the U.S. economy as a whole, working on a year’s project for the (now defunct) accounting firm of Arthur Andersen. My charts revealed that the U.S. payments deficit was entirely military in character throughout the 1960s. The private sector – foreign trade and investment – was exactly in balance, year after year, and “foreign aid” actually produced a dollar surplus (and was required to do so under U.S. law).

My monograph prompted an invitation to speak to the graduate economics faculty of the New School in 1969, where it turned out they needed someone to teach international trade and finance. I was offered the job immediately after my lecture. Having never taken a course in this subject at NYU, I thought teaching would be the best way to learn what academic theory had to say about it.

I quickly discovered that of all the subdisciplines of economics, international trade theory was the silliest. Gunboats and military spending make no appearance in this theorizing, nor do the all-important “errors and omissions,” capital flight, smuggling, or fictitious transfer pricing for tax avoidance. These elisions are needed to steer trade theory toward the perverse and destructive conclusion that any country can pay any amount of debt, simply by lowering wages enough to pay creditors. All that seems to be needed is sufficient devaluation (what mainly is devalued is the cost of local labor), or lowering wages by labor market “reforms” and austerity programs. This theory has been proved false everywhere it has been applied, but it remains the essence of IMF orthodoxy.

Academic monetary theory is even worse. Milton Friedman’s “Chicago School” relates the money supply only to commodity prices and wages, not to asset prices for real estate, stocks and bonds. It pretends that money and credit are lent to business for investment in capital goods and new hiring, not to buy real estate, stocks and bonds. There is little attempt to take into account the debt service that must be paid on this credit, diverting spending away from consumer goods and tangible capital goods. So I found academic theory to be the reverse of how the world actually works. None of my professors had enough real-world experience in banking or Wall Street to notice.

I spent three years at the New School developing an analysis of why the global economy is polarizing rather than converging. I found that “mercantilist” economic theories already in the 18th century were ahead of today’s mainstream in many ways. I also saw how much more clearly early economists recognized the problems of governments (or others) relying on creditors for policy advice. As Adam Smith explained, a creditor of the public, considered merely as such, has no interest in the good condition of any particular portion of land, or in the good management of any particular portion of capital stock. … He has no inspection of it. He can have no care about it. Its ruin may in some cases be unknown to him, and cannot directly affect him.

The bondholders’ interest is solely to extricate as much as they can as quickly as possible with little concern for the social devastation they cause. Yet they have managed to sell the idea that sovereign nations as well as individuals have a moral obligation to pay debts, even to act on behalf of creditors instead of their domestic populations.

My warning that Third World countries would not to be able to pay their debts disturbed the department’s chairman, Robert Heilbroner. Finding the idea unthinkable, he complained that my emphasis on financial overhead was distracting students from the key form of exploitation: that of wage labor by its employers. Not even the Marxist teachers he hired paid much attention to interest, debt or rent extraction.

I found a similar left-wing aversion to dealing with debt problems when I was invited to meetings at the Institute for Policy Studies in Washington. When I expressed my interest in preparing the ground for cancellation of Third World debts, IPS co-director Marcus Raskin said that he thought this was too far off the wall for them to back. (It took another decade, until 1982, for Mexico to trigger the Latin American “debt bomb” by announcing its above-noted inability to pay.)

In 1972 I published my first major book, Super Imperialism: The Economic Strategy of American Empire, explaining how taking the U.S. dollar off gold in 1971 left only U.S. Treasury debt as the basis for global reserves. The balance-of-payments deficit stemming from foreign military spending pumped dollars abroad. These ended up in the hands of central banks that recycled them to the United States by buying Treasury securities – which in turn financed the domestic budget deficit. This gives the U.S. economy a unique free financial ride. It is able to self-finance its deficits seemingly ad infinitum. The balance-of-payments deficit actually ended up financing the domestic budget deficit for many years. The post-gold international financial system obliged foreign countries to finance U.S. military spending, whether or not they supported it.

Some of my Wall Street friends helped rescue me from academia to join the think tank world with Herman Kahn at the Hudson Institute. The Defense Department gave the Institute a large contract for me to explain just how the United States was getting this free ride. I also began writing a market newsletter for a Montreal brokerage house, as Wall Street seemed more interested in my flow-of-funds analysis than the Left. In 1979 I wrote Global Fracture: The New International Economic Order, forecasting how U.S. unilateral dominance was leading to a geopolitical split along financial lines, much as the present book’s international chapters describe the strains fracturing today’s world economy.

Later in the decade I became an advisor to the United Nations Institute for Training and Development (UNITAR). My focus here too was to warn that Third World economies could not pay their foreign debts. Most of these loans were taken on to subsidize trade dependency, not restructure economies to enable them to pay. IMF “structural adjustment” austerity programs – of the type now being imposed across the Eurozone – make the debt situation worse, by raising interest rates and taxes on labor, cutting pensions and social welfare spending, and selling off the public infrastructure (especially banking, water and mineral rights, communications and transportation) to rent-seeking monopolists. This kind of “adjustment” puts the class war back in business, on an international scale.

The capstone of the UNITAR project was a 1980 meeting in Mexico hosted by its former president Luis Echeverria. A fight broke out over my insistence that Third World debtors soon would have to default. Although Wall Street bankers usually see the handwriting on the wall, their lobbyists insist that all debts can be paid, so that they can blame countries for not “tightening their belts.” Banks have a self-interest in denying the obvious problems of paying “capital transfers” in hard currency. My experience with this kind of bank-sponsored junk economics infecting public agencies inspired me to start compiling a history of how societies through the ages have handled their debt problems. It took me about a year to sketch the history of debt crises as far back as classical Greece and Rome, as well as the Biblical background of the Jubilee Year. But then I began to unearth a prehistory of debt practices going back to Sumer in the third millennium BC. The material was widely scattered through the literature, as no history of this formative Near Eastern genesis of Western economic civilization had been written.

It took me until 1984 to reconstruct how interest-bearing debt first came into being – in the temples and palaces, not among individuals bartering. Most debts were owed to these large public institutions or their collectors, which is why rulers were able to cancel debts so frequently: They were cancelling debts owed to themselves, to prevent disruption of their economies. I showed my findings to some of my academic colleagues, and the upshot was that I was invited to become a research fellow in Babylonian economic history at Harvard’s Peabody Museum (its anthropology and archaeology department).

Meanwhile, I continued consulting for financial clients. In 1999, Scudder, Stevens & Clark hired me to help establish the world’s first sovereign bond fund. I was told that inasmuch as I was known as “Dr. Doom” when it came to Third World debts, if its managing directors could convince me that these countries would continue to pay their debts for at least five years, the firm would set up a self-terminating fund of that length. This became the first sovereign wealth fund – an offshore fund registered in the Dutch West Indies and traded on the London Stock Exchange.

New lending to Latin America had stopped, leaving debtor countries so desperate for funds that Argentine and Brazilian dollar bonds were yielding 45 percent annual interest, and Mexican medium-term tessobonos over 22 percent. Yet attempts to sell the fund’s shares to U.S. and European investors failed. The shares were sold in Buenos Aires and San Paolo, mainly to the elites who held the high-yielding dollar bonds of their countries in offshore accounts. This showed us that the financial managers would indeed keep paying their governments’ foreign debts, as long as they were paying themselves as “Yankee bondholders” offshore. The Scudder fund achieved the world’s second highest-ranking rate of return in 1990.

During these years I made proposals to mainstream publishers to write a book warning about how the bubble was going to crash. They told me that this was like telling people that good sex would stop at an early age. Couldn’t I put a good-news spin [on the dark forecast] and tell readers how they could get rich from the coming crash? I concluded that most of the public is interested in understanding a great crash only after it occurs, not during the run-up when good returns are to be made. Being Dr. Doom regarding debt was like being a premature anti-fascist.

So I decided to focus on my historical research instead, and in March 1990 presented my first paper summarizing three findings that were as radical anthropologically as anything I had written in economics. Mainstream economics was still in the thrall of an individualistic “Austrian” ideology speculating that charging interest was a universal phenomena dating from Paleolithic individuals advancing cattle, seeds or money to other individuals. But I found that the first, and by far the major creditors were the temples and palaces of Bronze Age Mesopotamia, not private individuals acting on their own. Charging a set rate of interest seems to have diffused from Mesopotamia to classical Greece and Rome around the 8th century BC. The rate of interest in each region was not based on productivity, but was set purely by simplicity for calculation in the local system of fractional arithmetic: 1/60th per month in Mesopotamia, and later 1/10th per year for Greece and 1/12th for Rome.

Today these ideas are accepted within the assyriological and archaeological disciplines. In 2012, David Graeber’s Debt: The First Five Thousand Years tied together the various strands of my reconstruction of the early evolution of debt and its frequent cancellation. In the early 1990s I had tried to write my own summary, but was unable to convince publishers that the Near Eastern tradition of Biblical debt cancellations was firmly grounded. Two decades ago economic historians and even many Biblical scholars thought that the Jubilee Year was merely a literary creation, a utopian escape from practical reality. I encountered a wall of cognitive dissonance at the thought that the practice was attested to in increasingly detailed Clean Slate proclamations.

Each region had its own word for such proclamations: Sumerian amargi, meaning a return to the “mother” (ama) condition, a world in balance; Babylonian misharum, as well as andurarum, from which Judea borrowed as deror, and Hurrian shudutu. Egypt’s Rosetta Stone refers to this tradition of amnesty for debts and for liberating exiles and prisoners. Instead of a sanctity of debt, what was sacred was the regular cancellation of agrarian debts and freeing of bondservants in order to preserve social balance. Such amnesties were not destabilizing, but were essential to preserving social and economic stability.

To gain the support of the assyriological and archaeological professions, Harvard and some donor foundations helped me establish the Institute for the Study of Long-term Economic Trends (ISLET). Our plan was to hold a series of meetings every two or three years to trace the origins of economic enterprise and its privatization, land tenure, debt and money. Our first meeting was held in New York in 1984 on privatization in the ancient Near East and classical antiquity. Today, two decades later, we have published five volumes rewriting the early economic history of Western civilization. Because of their contrast with today’s pro-creditor rules – and the success of a mixed private/public economy – I make frequent references in this book to how earlier societies resolved their debt problems in contrast with how today’s world is letting debt polarize and enervate economies.

By the mid-1990s a more realistic modern financial theory was being developed by Hyman Minsky and his associates, first at the Levy Institute at Bard College and later at the University of Missouri at Kansas City (UMKC). I became a research associate at Levy writing on real estate and finance, and soon joined Randy Wray, Stephanie Kelton and others who were invited to set up an economics curriculum in Modern Monetary Theory (MMT) at UMKC. For the past twenty years our aim has been to show the steps needed to avoid the unemployment and vast transfer of property from debtors to creditors that is tearing economies apart today.

I presented my basic financial model in Kansas City in 2004, with a chart that I repeated in my May 2006 cover story for Harper’s. The Financial Times reproduced the chart in crediting me with [as] being one of the eight economists to forecast the 2008 crash. But my aim was not merely to predict it. Everyone except economists saw it coming. My chart explained the exponential financial dynamics that make crashes inevitable. I subsequently wrote a series of op-eds for the Financial Times dealing with Latvia and Iceland as dress rehearsals for the rest of Europe and the United States.

The disabling force of debt was recognized more clearly in the 18th and 19th centuries (not to mention four thousand years ago in the Bronze Age). This has led pro-creditor economists to exclude the history of economic thought from the curriculum. Mainstream economics has become blindly pro-creditor, pro-austerity (that is, anti-labor) and anti-government (except for insisting on the need for taxpayer bailouts of the largest banks and savers). Yet it has captured Congressional policy, universities and the mass media to broadcast a false map of how economies work. So most people see reality as written by the One Percent, and it is a travesty of reality.

Spouting ostensible free market ideology, the pro-creditor mainstream rejects what the classical economic reformers actually wrote. One is left to choose between central planning by a public bureaucracy, or even more centralized planning by Wall Street’s financial bureaucracy. The middle ground of a mixed public/private economy has been all but forgotten, denounced as “socialism.” Yet every successful economy in history has been a mixed economy.

Listen to Michael Hudson on the CounterPunch Podcast

This essay is excerpted from the introduction to Killing the Host.

Michael Hudson’s new book, Killing the Host is published in e-format by CounterPunch Books and in print by Islet. He can be reached via his website,

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