On borrowed time (How serious is the global financial crisis?)

Member Name: duncantorr

Product:	How serious is the global financial crisis?
Date:	28/10/08 (565 review reads)
Rating:

Advantages: "Those who don't learn from history . . . "

Disadvantages: ". . . are doomed to repeat it." (George Santayana)

A thought-provoking - and rather alarming - graph was published in The Economist not long ago. It charted the ratio of average debt to average income year by year over the past century. It showed a twin-peak pattern. Relative to income, debt rose to a high point in the 1920s, fell sharply in the 1930s and then stayed low until the mid-1990s, since when it has risen inexorably. It is now at its highest point for over a hundred years, higher even than in 1929. We really have been borrowing an awful lot of money.

One can explain the world's current financial crisis in many ways (rash mortgage lending to sub-prime prospects unable to keep up repayments, the spawning of shoals of sub-species of financial instruments that repackaged these and other dubious loans, or which purported to insure them, and so on), but perhaps these are just symptoms of an underlying disease: the unsustainable level of the western world's indebtedness. If so, it is much the same disease as in the late 1920s, and purging it from the system may involve as drastic a cure, however much we look for kinder medicines.


* Does this sound at all familiar? *

To anyone acquainted with the economic history of the period between the wars, the pertinence of the parallel will be as obvious as it is sinister. Weaning the world off its debt addiction then was not achieved in gentle, easy stages. Rather, it was akin to cold turkey, and quite as horrible to undergo. No one prescribed this shock treatment. It just happened, when the forces that had driven debt upwards stalled and had nowhere further to go except into reverse.

Beguiled by short-term experience, people had assumed that asset prices (particularly those of houses and shares) would only ever rise, and felt safe borrowing more and more to buy them, thereby driving prices higher still. But the time came when lenders, no matter how creatively they juggled their books, had no more money to lend, neither real nor imaginary, neither their own nor others people's. Prices stagnated. Those who couldn't keep up repayments had to sell. Prices declined, and the over-extended banks found themselves stuck with collateral worth less that what they had lent against it. The weakest collapsed, taking depositors' savings with them, impoverishing people in the process and sending asset prices lower still. Confidence in banks evaporated and more folded, with more people suffering as a result. So did businesses needing credit to keep going or holding inventories of goods to sell, which suddenly few customers could afford. Many went bust.

Call it an implosion or a vicious circle or simply a crash. It hardly matters. Whichever term you prefer, it ushered in what was known in Britain as the Slump, and in the States as the Great Depression. Employment plummeted, and stayed low for years. In the USA, one in four men of working age was jobless and many others on short time. Salaries and wages fell across the board. So did output, down by a third. So did profits. Peak to trough, shares on Wall Street lost over 80% of their value. Britain fared little better. These were the years of mass unemployment and hardship, as exemplified by the Jarrow marches. Recent recessions look like frothy bonanzas by comparison.

Growth did not resume until Roosevelt's New Deal policies eventually took hold in the mid-thirties, at which point the economy still had a lot of lost ground to make up. Or maybe it resumed because by then the excess debt had been painfully squeezed off the world's balance sheet.


* Can this sorry history repeat itself? *

Yes, of course it can. This is not to say that it must or necessarily will. There are initiatives that might prevent it and which are being tried, but no one yet knows whether they will work, so neither can we be certain that it won't.

The basic case for pessimism has already been touched on: we, the public, are over-extended as borrowers - not all of us individually, of course, but on average and in aggregate. Banks, as lenders, are over-extended, and their finances have been rocked to the foundations over the last year, with several household names having to be humiliatingly rescued from collapse on both sides of the Atlantic and in the middle (where Iceland is approximately located). The whole financial structure of western capitalism is clearly quite as shaky as it was in 1929, arguably even more so.

The case for optimism would start from the observation that those household name banking institutions are mostly being rescued by governments in a way in which their predecessors were not at the time of the great crash.

Optimists would go on to say that that financial crash was exacerbated into an economic depression by the wrong-headed responses of the authorities at the time. Specifically, those authorities increased interest rates (restricting credit when it was already becoming scarce), tried to maintain balanced budgets (denying any fiscal quenching to assuage the monetary drought) and raised tariff barriers in a misguided attempt to protect the home-grown industry (but in practice provoking beggar-my-neighbour retaliation from their customers and competitors). None of these, the optimist would assert, is going to happen this time. Governments and central banks, so we are assured, have learned their lessons and are already working together to take the necessary action: supporting cash-strapped lenders, lowering interest rates to stimulate liquidity, being ready to run larger-than-ever budget deficits and eschewing protectionism.


* But will it work? *

Necessary action this may by common consent all be, but necessary doesn't necessarily mean sufficient. Governments don't have unlimited power, or infinite funds. However much they juggle, or borrow, ultimately the real value of the resources they can deploy is limited by their ability to tax the economies over which they preside, in other words by the amount they can extract from their countries' GDPs.

Will this be enough in current circumstances? No one knows the answer to this question for the simple reason that no one knows how much of the debt owed to the banks will turn out to be bad and therefore need to be nationalised. It is worth noting, however, that the proportion wouldn't need to be that high for governments' resources to be very thinly stretched, perhaps to breaking point. The outstanding nominal value of all loans and derivative obligations held by banks around the world is estimated at $600trillion, or about 11 times global annual GDP. Put another way, it's nearly $100,000 for every man, woman and child on the planet. Of course, not all of this is dodgy but not all of it, or even much of it, would need to be dodgy for it to be for the burden to become an intolerable strain on the world economy. How much of 11 times global GDP can be realistically underwritten by governments only able to tax a proportion of their own countries' GDPs on a year-by-year basis, especially when that GDP is likely to decline under the pressure of the demands made on it?

So far governments worldwide have committed $2.5 trillion to "rescue packages" of one kind or another. By most standards this is a staggering amount of money, but it is only 0.4% of the total amount of debt outstanding, and for all anyone knows the percentage that is unrecoverable may be much more than that. One can reasonably imagine that governments might simply not have enough money, or even be able to borrow enough money to neutralise all the bad debt already In the system. What then?

They could, of course, "print money", by spending beyond what they could raise by tax or borrowing. This would inevitably generate inflation, eroding the real value of the outstanding debt, but also eroding the real value of the monetary assets that people still possess. In effect, this would just be different way of spreading the unbearable burden, and a mighty unfair one: letting those who had lent or borrowed recklessly off the hook of their own creation, at the same time as penalising those who had behaved more prudently. Something similarly unfair is already being done, it could be argued, by bailing out the foolhardy banks that engaged in stupid lending, or that simply gambled, using as chips esoteric financial instruments that no one else understood and which it is now apparent they didn't understand either.

Beyond considerations of fairness, both bailing out and printing money also incur what is known as "moral hazard" - removing the incentive for anyone to behave prudently in the future, when it pays such poor dividends compared with behaving foolishly. This in turn would make future crises both more likely and less soluble. These are policies of last resort, but we already seem to be resorting to one of them, and the other may in due course prove to be the only resort available.


* How successful can success be really? *

Let's imagine for the sake of argument that governments do have enough money and central banks enough supporting weapons in their armouries. At enormous cost to all us long-suffering tax-payers, the least sound debts are written off and the more marginal given time and a chance to be repaid eventually. Meanwhile, let's assume that the lenders, now under state control, don't take advantage of low interest rates to start issuing new lines of risky credit. Cleansing the system of the toxin by these means will take many years, and it will be an unpleasant course of medicine. It is likely that, whilst mitigating the depth of the recession, it will extend its length. Or it could just be delaying a depression that might be inevitable in any case.

You could argue that some of the prescription now being proposed has already been being administered for some years, without effecting a cure. Not state control of lenders, of course, which may or may not prove to be a good thing, but low interest rates and governments ready to run budget deficits. It is, when you think about it, rather odd that cutting interest rates now is seen as part of the solution to a problem that was at least partly brought about by interest rates being kept too low throughout the mid-2000s.

Maybe a deep recession was already overdue at the time of the bursting of the dotcom bubble six years ago, or even back in the early 1990s at the time of the last housing boom/bust. In each case, sharp reductions in interest rates and deficit financing by governments mitigated the effects and stimulated a resumption of growth, though only by extra liquidity flowing through into higher credit levels and inflated asset prices. It is that credit bubble that now seems to be bursting. Patching it up and re-inflating it may look like the best bet now, but might only render it readier to burst even more explosively another time. We might be only delaying the inevitable.


* Last laugh to Kondratieff? *

One doesn't hear much these days about Elliot Wave Theory, which used to be quite a fashionable sideline in economics when I studied the subject back in the sixties. A man called Elliot, who lost all his money in the Great Depression, spent the rest of his life trying to figure out why, or at least how, this had happened. In doing so, he pulled together the work of other economists in identifying a series of "waves" that seem to influence the ebb and flow of global economic activity.

These waves are of varying durations, and their effect is amplified when they coincide. Specifically, they tend to coincide to their most dramatic effect in a cycle of about sixty years from peak to peak or trough to trough, a cycle first observed by Russian named Kondratieff, and consequently known as the Kondratieff Wave.

Interest in Elliot Wave Theory seems to have waned when the recession of the early 1990s, though arriving bang on time by Kondratieff's schedule, proved relatively tolerable and certainly no match for the depressions of the past. Perhaps, it was assumed, either the notion of the cycle was misconceived in the first place, or we really have learned something from experience and now know how to manage our economies well enough to avert cyclical disasters.

On the other hand, perhaps we haven't learned to avert them at all, merely to postpone them. And maybe by postponing the inevitable we make it all the worse when the time finally arrives when it can be postponed no longer.

Kondratieff may yet have the last laugh, and the longest.


* Some other thoughts *

Well, that wouldn't be a very cheerful note to end on, would it, so here are some other, more or less related, thoughts to go with it:

1. Being clever doesn't stop you being stupid.

Investment banks and similar financial institutions pride themselves on recruiting the brightest graduates and paying them megabucks to do mental arithmetic at lightning speed as markets move, or to programme computers to do it even more quickly still. These are the geniuses who have lost their employers billions of dollars because being able to juggle the yield differentials on a range of collateralised mortgage obligations proved to be no substitute for only buying those that were likely to be repaid at some point. Did they assume that there'd always be some bigger fool further down the chain onto whom they could offload at a profit before the bubble burst? Or, perhaps more gullible still, some bigger genius?

2. When the shit hits the fan, it's not only the careless crappers who get besmirched by it.

Some people, I know, have been rather gratified at the humbling of the clever-stupid city slickers who are losing their jobs, or at least their inflated bonuses. Others have little sympathy for feckless folk who took on more debt that they could manage and may lose their homes in consequence. Such schadenfreude may be a very human reaction, but it's essentially misplaced, since not only the rash or the irresponsible lose out when a crisis of this kind comes to pass. Ordinary, sensible, frugal people who pay their taxes and save towards their retirement, people unconnected with the world of finance, will find their taxes diverted from more productive use to shoring up its shaky structure, while their pension funds contract in step with financial markets. Many will also lose their jobs as the economy stalls. There is very little silver lining to the clouds of an economic hurricane.

3. He who pays the piper is entitled to call the tune, but should exercise restraint in doing so.

Because financial conflagrations of the kind we are now experiencing can burn us all, and because the cost of extinguishing them falls on all of us who pay taxes, it is absolutely right that governments exercise control on our behalf over the institutions that have got us into trouble. Whatever free market fundamentalists assert, markets cannot always be trusted to deliver the best possible outcome. Sometimes they overshoot, overheat or simply go haywire. In no sane world, for example, would the market for credit-default-swaps have mushroomed to around $60 trillion - more than one year's worth of the world's economic output and many times the value of the bonds these instruments were originally intended to insure. These excesses have to be restrained by regulation.

Nevertheless, regulators don't always know best either; indeed, in most circumstances they're even less reliable than free markets. The Great Depression may have stemmed from the flawed workings of capitalism, but capitalist economies recovered from it to outgrow socialised ones many times over in the decades that followed. Hard times tempt people to put excessive faith in governmental leadership and guidance. Sometimes it's needed, but in the long run it tends to encourage poor economics, as well as being uncomfortable politics for those who value freedom.

4. The unsustainable can be sustained longer than you might imagine, but it's still unsustainable and better tackled early, not in a belated panic.

This financial crash did not come out of the blue. Its essential elements - the expansion of credit, the asset price bubble and the explosive burgeoning of esoteric derivative markets - have been evident, indeed obvious, for some time. Quite a few economists and commenters have drawn attention to them and their disquieting implications, but were largely ignored, as prophets of doom always tend to be until their forebodings are vindicated by events. People assume that because we seem to have muddled through before we can continue to do so. Perhaps we're programmed to think that way by our past evolutionary success as survivors. So far.

The analogy of the man falling from a high building and assuming there's nothing to worry about because he's already plummeted past several floors without apparent ill effect has never been more apposite. It may, though, prove in the future to be even more apposite in the case of our equally oblivious attitude towards the destruction we're inflicting on our environment.


© Also published under the name torr on Ciao, 2008

Summary: Our current troubles viewed in historical perspective