When banks do crazy things

Gerald Holtham offers a layperson’s guide to the global economic crisis

One of the problems the public has in contemplating the current turmoil in financial markets is the cacophony of different opinions from experts about what should be done. Here is a sample of some conflicting views:

  • We have too much debt so how can more debt be the answer?
  • Stagnation or sluggish growth makes the debt burden worse. We are running out of fossil fuels and overheating the planet so the quest for growth is a chimera.
  • Without growth we cannot solve the debt problem or ease distributional disputes in our society and ensure communal peace.
  • We must retrench. Retrenchment is self-defeating and we must stimulate the economy by increasing the government deficit and printing money.
  • The problem is fiscal irresponsibility in America. The problem is political paralysis in America.
  • The real problem is the mistaken one-currency policy in Europe – the Euro was a mistake  for many countries
  • The true problem is the imbalances in the world economy and the huge Chinese surplus which drains demand from the system. The Chinese earn more than they spend, selling to us but not buying enough back with the proceeds.

No wonder everyone is confused. Every one of those assertions has some truth, more or less.  They point to different facets of a complicated situation. None of them on its own is a sufficient summary of the problem or its solution. The situation has a number of key elements:

  1. The pattern of the world economy as it has evolved since the 1980s.
  2. The half-conscious policy response to problems caused by that pattern.
  3. Certain intrinsic characteristics of capitalist investment and financial markets that cannot be eliminated.
  4. The existence of certain political idée fixe leading to… (i) a lack of consensus  about what to do now; and (ii) a lack of political leadership.
  5. And, as ever, luck plays some role.

Let’s take them one at a time. The pattern of the world economy is characterised by the term globalisation. It is a consequence of: (i) the abolition of capital and exchange controls in most countries and all Western countries, starting in 1979, freeing capital; (ii) advances in information and communication technology that made it easier to distribute production and trade in many services internationally; and (iii) the collapse of communism and other autarkic systems, opening up countries to trade and releasing millions of new workers into the world economy.

One consequence was capital could chase and find cheap labour, so profits rose. Incomes rose fast in hitherto poor countries while in the West the share of profits in GDP rose and the earnings of unskilled, semi-skilled and some skilled workers began to fall behind GDP. Those workers could not therefore afford to buy the output while workers in the third world, though getting better off, remained at a relatively low income level. This threatened a shortfall of effective demand in the world economy – more goods being produced than could be bought.

In the 1990s there was no problem because the rising profits led to an investment boom which soaked up production. That was the dot.com boom which saw a soaring stock-market. However, businesses can’t keep investing without selling final output to consumers. The boom led to excess capital investment, much in no-hope schemes, and then collapsed. The world had a mild recession in 2000-2001.

Policy responded in the US and elsewhere by slashing interest rates to stop the recession deepening. It worked because the workers used the cheap loans to buy houses. As house prices rose many people felt richer. Their pay wasn’t keeping up but why worry if your house made more in a year than you did? Why not take out a second mortgage against rising house prices and buy those goodies? That happened. The economies of the West ‘recovered’ and grew on a rising tide of household debt. In turn that helped China and other developing countries to keep expanding industrial production and churning out exports.

Why did not policy-makers turn off the money tap and raise interest rates? Because orthodox opinion was monetary policy was just there to control inflation.  And there was no inflation in most goods, thanks to cheap imports from China.  Evidently, it was thought, when house prices got too high the market would ‘correct’ of its own accord. Such touching faith in the magic of the market place ignored certain facts about…

Financial markets, which seized on the property boom and drove it to crazy levels. A neglected economist of the 1970s, Hyman Minsky saw it coming. In financial markets success always breeds excess. It can’t be helped; it is an inevitable feature of capitalism, the price you must pay for the dynamism of the system. The longer something makes money, the surer people are it will go on doing so.  If I make money by borrowing 50 per cent of the price to buy a house, I’ll make more if I borrow 60 per cent, 80 per cent and eventually … 100 per cent, and in some cases even more. So the degree of borrowing, in the jargon the ‘leverage’, rises inexorably.

Asset prices get swept up to the moon on a rising tide of debt. But there is no air on the moon. The market becomes very fragile; the smallest random thing which causes prices to hiccup means some people can’t meet their debts. Forced selling follows, prices begin to fall. The whole debt bubble bursts and millions of people left holding the chain letter go bust.

Why did the bankers lend so foolishly on overpriced real estate to people who could not repay if prices fell? And why did other bankers take those mortgages when they were bundled into securities and sold on? All one can say is every few decades they always do. History is littered with episodes of crazy bank lending.    So financial folly and the policy response to an incipient problem of deficient global demand created a financial crisis.

At first the global policy response to that was Keynesian: don’t let the system fail but bail-out or nationalise the banks. Then as the economy swooned, governments stepped up spending, despite falling tax revenues. Of course, that led to large government deficits. Normal recessions in a developed capitalist economy don’t last long – six months usually, 18 months in a really bad case.  Then growth in the recovery is swift. The government deficit usually falls quickly with fast growth as tax revenues rise with incomes.

But not this time. After a financial bust on the scale of 2008, recovery is typically slow – as in the West after 1929-31 and in Japan after 1989. People, companies and banks have to pay down their debt to ‘deleverage’. The banks go from lending like drunken sailors on a spree to being super careful and Scrooge-like. The economy grows very slowly, tax receipts don’t pick up much, the government deficit doesn’t shrink and the public debt grows rapidly. Japanese government debt is now over 180 per cent of GDP, twenty years after their bust in 1990.

So we come to the parting of the ways. In most countries, the economy is sluggish, unemployment is high and not falling, government debt is rising alarmingly. What do you do – spend more to try and jump-start the economy or spend less to stop public debt spiralling up and exceeding GDP?

In some countries – the US and UK – the central bank tried to solve the problem by ‘quantitative easing’, a fancy term for creating more money. Meanwhile, however, the developing countries of Asia and South America were still growing and their immature economies were still soaking up raw materials. Usually in a recession commodity prices fall as industrial production slackens. Thanks to China and others that has not yet happened. Oil prices and other commodities rose. Easy money pushed down the exchange rate in the UK, making commodities even more expensive. So, despite the sluggish economy, inflation picked up, squeezing incomes more. Can a central bank whose policy objective is low inflation keep printing money when that happens? And how can it fight inflation when policy tightening is bound to hit already sluggish growth causing a double-dip recession? Answers: no and it can’t. Result: paralysis.

In the Euro area, a number of countries would like to have that dilemma. With monetary policy ceded to the European Central Bank they had no instrument to try and stimulate growth. As their public deficits widened and debt soared it became obvious they could not hope to raise enough tax to service their debts.  Other European countries provided some money for a temporary bail-out to save the Euro – and save their own banks which had bought a lot of the debt of the distressed governments. But they were unhappy about an open-ended commitment to bail out their weaker brethren. The more the market fled the debt of the weak countries, the greater the crisis.

In the US the dilemma defeated the political system, which descended into angry bickering with no sign of a policy consensus. Faced with that paralysis, one of the rating agencies downgraded US government debt. Everywhere there was dispute and dissension about what to do next so the markets took fright, launching the latest phase of a crisis that has been brewing since the 1980s and which first came to the boil in late 2007.

Can we muddle through?

It is not obvious. If we cannot, what will happen? If we look at the 1930s, we note that despite some recovery in the second half of that decade, unemployment remained high in the US and UK. Governments devalued their currencies, printing money, but equally lost their nerve about spending and tried to restrain their deficits. What finally resolved the situation was the second world war.  Faced with a greater threat, governments lost all inhibitions about spending.  They imposed capital controls and spent money massively.

At the end of World War II British government debt was 250 per cent of GDP (now we are, reasonably, concerned that it is rising from 40 to perhaps 90 per cent of GDP). Full employment was achieved and maintained even after demobilisation and for the following 25 years – as it was in the United States.  The cost was creeping inflation that swindled the bond-holders.

It is to be fervently hoped that we do not get another global war and one does not seem likely. But if things continue to deteriorate some limited roll-back of globalisation becomes more likely. Liberalisation has transferred power from the state to markets with the promise of greater prosperity.

However, if greater insecurity is more obvious than greater prosperity, the political winds may shift. And if the private sector will not invest, public enterprise may come to fill the gap in some countries. That is not spending on free things like education and health, but the provision of services for which the state can charge – for example, green energy or tolled motorways. The spending would boost the economy but since the services would yield revenues there need not be an increased debt burden on future tax-payers. And procurement would deliberately favour domestic suppliers in contravention of current rules and doctrine.

Free marketeers will hope such heresy does not gain ground. But unless the economic system begins to display more powers of spontaneous recovery, they had better brace themselves.

Gerald Holtham chaired the Welsh Government's Commission on Funding and Finance and is an IWA Trustee. His recommendation for the Welsh economy can be read here.

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