The UK Government has taken the first tentative steps towards a solution to this crisis with its decision today to give stressed borrowers an interest repayment holiday of up to two years (New scheme to help people at risk of repossession).
The scheme is limited in scope to households that suffer ”a significant and temporary loss of income as a result of the economic downturn to defer a proportion of the interest payments on their mortgage for up to two years”. It also guarantees banks that the deferred payments will ultimately be made.
This is a step in the right direction–towards ultimately debt moratoria. It isn’t enough–because the interest will still be compounded–but it does make the important point that the accrual of interest on debt can be tampered with by legislative means as well as by economic ones.
I favour the legislative approach–which should ultimately include debt moratoria, or a revision of this scheme which involves no accrual of interest and repayments therefore reducing outstanding principal–because I don’t believe the accepted economic approaches to reducing the real debt burden will work.
The standard economic means to reduce the debt burden is to “print money to cause inflation”. Ben Bernanke himself is famous for the following remark:
If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation. (Bernanke, Deflation: Making Sure “It” Doesn’t Happen Here)
I have little confidence in this mechanism. It is predicated on a Monetarist theory of money, in which, to quote the Godfather, “Inflation is always and everywhere a monetary phenomenon” (Milton Friedman, A Monetary History of the United States 1867-1960). It is possible to substantially agree with this argument and still argue that government printing of money won’t cause inflation–because Milton Friedman’s “model” of money completely ignored the existence of credit money.
Here is Milton’s model of money creation and how that engenders inflation:
Let us suppose now that one day a helicopter flies over this community and drops an additional $1,000 in bills from the sky, which is, of course, hastily collected by members of the community. Let us suppose further that everyone is convinced that this is a unique event which will never be repeated…
… When the helicopter starts dropping money in a steady stream … it takes time for people to catch on to what is happening… As people catch on, prices must for a time rise even more rapidly, to undo an initial increase in real balances as well as to produce a long-run decline… (Friedman, “The Optimum Quantity of Money”, in THE OPTIMUM QUANTITY OF MONEY AND OTHER ESSAYS, pages 4-5 and 13)
IF a helicopter flying over the land dispensing largesse (otherwise known as the Central Bank creating M0) was the only manner in which money could be created, and IF there was no private debt, and IF the economy was in long run general equilibrium and prices prior to the helicopter drop were therefore equilibrium prices… then this approach would work.
Yeah, right…
Instead, in the real world in which we live, financial institutions control the creation of money, private debt is at unprecedented levels, and the global economy is rapidly transiting from a far-from-equilibrium debt-financed boom into a far-from-equilibrium debt-induced crash in which the price of everything is totally out of whack.
In this world, government creation of M0 will be sent straight to the banks to reduce debt levels. The impact on turnover of goods and therefore prices will be minimal. Deflation will continue, and could do so for years as the government effectively swaps base money for credit money–only to see the absolute money supply drop. This was the Japanese experience.
Ultimately, I expect that the failure of the economy to respond to this Friedmanite tonic will result in a profound shift in politics, in which the unthinkable today will become policy: that much of the debt that the financial sector issued especially in the last two decades should never have been created in the first place, and it should be abolished–in conjunction with substantial reforms to financial assets that prevent a similar debt-bubble in the future.
We are still a very long way from that change in consciousness, but this move by the UK government is a first step towards it.
al49er,
i’m a bit of a history enthusiast and used one of the more contemporary examples, although, this by far not the only example in history; it goes as far back as the time of Greco-Persian ware when the Greeks fought the Persians in 493BC.
For the reason for the debt moratoria look to the big picture. UK is expecting a fair number of unemployed and if they all are forced to sell their houses the property market may really crash. Result may be that prices are actually too low and banks will fail resulting in costs to the government as well as costs when the unemployed are evicted and require rental accommodation. Given the multipliers it wont be good. So allowing a moratorium may cause some government losses but will avoid others.
There is also the social aspect that forcing sales when the market is lowest and unemployment is worst for owners who have some equity seems unreasonable. Governments must take some responsibility for what has happened and if that means helping out people who have simply bought a house for their own use then that is fine.
Michael,
sorry but your comment is non-sense, you understand nothing of the issue. In particular this sentence:
The reason a shortage of script occurred was not due to a lack of script but a lack of productivity due to a lack of demand. The productivity produced was in exact keeping with the demand required.
shows that you don’t understand the economic concepts of productivity or (effective) demand. What are you saying the problem was – that people didn’t want to work? Then you didn’t read the story very carefully.
Basically they needed more liquidity because of hoarding of script. The other problem due to issuing too much script is the equivalent of hyper-inflation – people will lose trust in the value of the script and the fairness of the system. But in this case it wasn’t outlined just because it distracted from the primary theme.
Steve Keen…
Based on this,
Added to this is the neoclassical economics obsession opposing government deficits, which has in Japan led to them insisting that all fiat money creation is financed by issuing government bonds rather than simply “printing money”.
I guess we agree at least on this. I’m just suspicious about the morality and politics of debt forgiveness. It involves a massive redistribution with no obvious fairness principle. I would rather a massive redistribution that is clearly fair.
But I guess we both think, the real answer is to avoid this problem in the first place. And that I think needs a redesign on the (international) financial system.
A couple of links I like on this:
http://www.guardian.co.uk/commentisfree/2008/nov/18/lord-keynes-international-monetary-fund
http://www.interfluidity.com/posts/1225607671
Michael to put it more obviously, the babysitting story has some couples wanting to increase their credit balances (and so cutting their demand to save), and other couples with zero balances unable to afford the services the savers wanted to offer. The system needed more credit (or base money) in circulation. You don’t seem to understand the script in order to be accepted by strangers wasn’t just scribbles on pieces of paper but issued vouchers. There just weren’t enough of them issued according to the demand for positive balances.
As a side-issue, why is it that people are so ready to be certain that they have a clearer understanding about economics than a nobel prise winning economist? I would rather wonder “what have I misunderstood here” before shooting off my mouth.
Steve,
Thanks for your post.
Next question
.
What’s the fundamental difference between a debt moritoria and the government printing some bills and ‘paying’ it off for you?
Surely both have exactly the same effect – you get something for nothing?
Doesn’t this automatically devalue any savings about?
For instance, what use is my savings (saving for a house) if all of the houses in the market are suddenly made nill debt? Surely a huge part of my bargaining power is removed (ie the seller HAS to sell because either he can’t finance 2 places and is moving for work, or he can’t finance his own place). Sellers can just squat at no expence tightening supply further inviting a new bubble (and doesn’t this apply to everything else?). Inflationary (in real terms), no?
Dicko,
i would think the difference is that with debt moratoria house prices are reset back to a fair value, whilst the excess debt is written off.
The writeoff would be worn by the banks, where this writeoff would effectively reduce the banks equity and consequently the shareholders equity in the financial institution. That is, the bank shareholders take the hit. Depending on how big the hit is, the bank may be sufficiently weakened and not have the capital requirements to facilitate robust lending & continue business. Which will then either be taken over by another bank, allowed to collapse and the banks depositor funds transferred to another bank, or equity is injected into it by the government.
Whilst, if the government attempts to pay this, they will either increase taxes, raise debt, via directing the treasury to issue government securities (bonds) to the market. If the government attempts to pay this via raising debt, through bonds, then it will depend on whether the bonds offered into the market are well supported. If not, the central bank may need to purchase the balance of these bonds from the treasury. This is akin to printing money and is inflationary.
So in short:
1. Debt moratoria -> bank and bank shareholders take the majority of the hit, and depending on whether there is a short fall in bank equity, the government will provide the short fall. Refer to point 2., below, for how the short fall will be payed.
2. Government pays for it -> you the tax payer will pay for it via higher taxes or via inflation.
I would be interested to hear Steve’s take on it.
Interesting article (well it interested me anyway lol) about ethical investing and I think it makes a very good point – economics can ot and never will tell the while story we must look and account for human behaviour as well and humans tendancy towards being prepared to make “easy” money.
http://business.theage.com.au/business/earning-the-economy-we-deserve-20081204-6rot.html
I think some people are being confused bour the difference between short emergency measures and long term solutions.
The danger in this situation is a a rolling total collapse, with real economic affects being amplified by peoples’ panic. Putting in some short term ‘buffers’ hopefully slows things down a bit and buys some time for more considered and permanent measures.
Example: even in a depression the majority of people have money and jobs. They will still spend (albeit at a lower level). But in a panic those who can still spend will close their wallet, amplifying the demand drop more than is fundementally justified.
Short term measures aimed at keeping people in their houses is a really good thing in economic, social and of course political terms.
Of course the danger is always that ‘short term’ emergency mesures to reduce panic then become, inappropriately, longer term solutions, which is why there has to be quick folllow ups of more considered solutions.
The anology is a heart attack, get the clot bursters in quickly, put them on oxygen and get them to hospital quickly, longer term solutions such as diet, weight control exercise, etc, come later, after the patient survives the initial crisis.
Longer term most western societies are going to have to move to a ‘savings/capital investment’ (inc social end environmental capital) oriented model of capitalism, from the ‘debt/consume’ model we have followed for the last 20 years or so. This is if the democracy/capitalism model survives at all.
Trouble is we are so fixated about GDP that we don’t look at the balance sheet side. Bit like looking at just a P&L for a company. Reports great profits, but if its assets and capital investment keep declining and its debt keeps going up, then you know there is going to be trouble.
Which is pretty much what has happened at a financial, corporate and country level in most of the world. Not rocket science, if your consumption and debt is going up but your transport infrastructure is crumbling, education declining, rivers running dry, etc …. you are defintely not getting richer as a society no matter what you feel, you are just drawing down on past savings.
OldSkeptic,
you are correct there will not be complete economic collapse, although the world was at the precipice in mid October, when the entire world credit market completely seized, and governments around the world resuscitated them, and they are still dysfunctional and only being supported by governments around the world.
The issue is the necessary readjustment that must take place due to the trade imbalances that exist. This adjustment for some will be more painful than for others.
The question is whether the major debtor nations and major creditor nations stop ignoring this problem. The status quo can not be maintained and there must be structural adjustments in these economies.
How this transition plays out is where it becomes uncertain.
History is a very good teacher, and it is imprudent to neglect it’s lessons.
Furthermore, when the plutocracy that controls society, whether we like it or not, dictate the outcomes.
When society is dumbed down with government, media and corporates are complicit in this then we will continue down the slippery slope of decline.
Citizens of a nation must not allow others to think for them and believe everything that is presented to them. They must think for themselves.
I still can’t see deflation going on for long.
Here is a great interview with a rather crazy UK hedge fund manager that made 50 % in October betting on government bonds : http://www.bloomberg.com/avp/avp.asxx?clip=mms://media2.bloomberg.com/cache/vRa_Dah8BqSM.asf&vCat=/adviser&RND=731428275&A=0
He is comparing what is happening now in the bond market as the Nasdaq going from 4000 to 5000 if bond yields were to drop even lower.
If the Bond market is a bubble, then the market will sell off, and the inflationary trend will go on.
I think the deflation theory don’t work, because the balance sheets of the countries themselves is in to bad condition, and the CDS spread of the countries are getting worse and worse, both the UK and the US have higher CDS spreads than Iceland had at the start of the year. Iceland, they to should have been having deflation now, if these theories were right. But they have had extremely high inflation, and interest rates at 18 %. I think this crisis is like the Asian Crisis, only this time around, even countries like UK, and the US seems to be on the hook.
Gittins admits that he was wrong http://business.smh.com.au/business/its-not-inflation-that-did-us-in-its-the-borrowing-20081207-6t9j.html
Doesn’t admit that anyone else was right, but these things take time.
ken,
I didn’t see your reply to Michael, sorry. And your point about supply disappearing if too much script was issue, was something I hadn’t thought about, but seems correct to me. Thanks.
I would think that debt moratoria would spell disaster. As usual, it’s looking at things on a macro level and not factoring in the change in decision-making of relevant players. Here’s my argument:
Governments are trying to make lending continue, and are terrified of the economy grinding to a halt as all lending seizes. The problem is one of confidence – now that people have been reminded that loans may not get returned, they don’t want to have loans they have to write off. If the government starts intervening in the payment of loans, lenders will become *even more* nervous about issuing loans.
In this case, the government is to “guarantee” the payment of the interest at a later date. Would you lend money if your financial position were precarious and you knew that you might get cut off from your revenue by government edict? If it’s tied to a property in a falling housing market, and you know that the “owner” will never make good on the loan, you want to foreclose and sell ASAP – but you can’t, you have to wait 2 years and all you’ll get for that capital loss is 2 years worth of interest payments – and only at the end.
This is in the case of a government guaranteed moratorium, as proposed. If something else canceled or reduced the debts, that would make lenders even more nervous – and less likely to lend – causing more deflation and failure. Personally, were I a billionaire, I wouldn’t lend now simply because I know the government is messing around with it and I really have no way of telling what the final risks will be.
Also, this just out:
http://market-ticker.denninger.net/archives/712-The-Price-of-Capitalism.html
Dear Lamarth,
A debt moratoria would indeed spell disaster, and would therefore only be possible to institute after disaster had already occurred. My interpretation of the US data in particular is that we entered disaster territory–defining disaster as the economy getting into debt commitments that it had no prospect of ever being able to finance–about eight years ago.
I am not a critic of debt in general. I’ve read “the price of capitalism” piece you link to, and of course the innovative aspects of capitalism would shut down if lending at interest were prohibited. But the majority of the debt that we’ve accumulated in the last four decades has had nothing to do with financing innovation and everything to do with financing Ponzi speculation on asset prices.
It is possible with such lending to accumulate a debt charge on the economy that exceeds its capacity to service that debt. This is what caused the Great Depression, and we now have at least twice as much debt (relative to GDP) as we did back then. This is why all five major US merchant bankers have already failed, as have effectively its major banks–where would they be now without the government bailouts to date? But this is far from the end of the crisis–the wave of bankruptcies still in the system will swamp the bailouts, as indeed they must when the USA’s debt is at least 3 times its GDP–and the bailouts have been of the order of $1 trillion compared to this $50+ trillion debt.
The problem then is not one solely of confidence, but of debt so excessive that there is no chance of ever properly honouring it and reviving economic activity. I expect a few years of failed attempts to revive the economy via government bailouts etc., at which time what should be obvious now will finally become so: that the banking system is already bankrupt. Then the futility of trying to revive it might finally be recognised, and the need to “wipe the slate clean” with respect to Ponzi lending might finally be accepted.
We desperately need a finance sector that finances innovation and of course provides working capital for firms, and makes a healthy profit from doing so. Debts issued by such a system should be enforced, and in the ordinary course of capitalism can be without any danger of systemic collapse. But a finance sector that finances Ponzi speculation, which is what financial deregulation has given us, is a parasite that will ultimately kill its capitalist host. Trying to keep the parasite alive while trying to revive the patient is likely to result in two sick organisms. One of them, ultimately, will have to go.
If a bailout or moratorium was offered to individuals that were struggling. Then many borrowers that were paying but marginal would consider not paying anymore. So that they could qualify for assistance. This would further distort the system and cause lenders to be even more cautious of lending. I think I read something like this on Mish’s site.
Steve,
Thanks for the reply. I agree completely with the problem, my disagreement is regarding a legislative solution – one way or another it creates incentive to do wrong, as Bullturnedbear argued. Any form of moratorium on debt is struggling to keep the parasite, as you put it, alive – we should wish for it to have a quick death.
And a quick death is what it would be having if the governments were not intervening. Any form of government action should actually make the problem worse in the short term, by creating incentives for fiscal responsibility, or disincentives for irresponsibility/scheming, and by enforcing transparency, capital adequacy and accuracy of announcement rules.
I recall that Babcock and Brown announced around January ’08 that it would have 10% increased profit “even if global financial conditions did not improve materially.” – I really wish I still had access to the source of that forecast. Not quite as bad as the statements from Bear and Lehmans in the week before they went – but if they’re allowed to get away with that, how can anyone invest with confidence?
I’ll leave you with what I call “The Government Inequality”:
Total Wealth before Government Intervention > Total Wealth after Government Intervention
Hi Lamarth,
I don’t disagree, but my point really is that the incentives to do wrong have already well and truly been followed. Debt levels are already past the end-game, and government intervention–in the form of the many rescues led by the Federal Reserve and its counterparts–played a major role in driving these levels far beyond what they would have reached without government intervention.
Financial capital has an innate tendency to expand debt, and lead to crises–I am no Hayekian in my analysis of how a private monetary system would work–but this government-backed system we’ve designed led to even more debt being accumulated before a crisis.
Hi Steve,
In your response to Lamarth on Jan 7th, you said:
“I expect a few years of failed attempts to revive the economy via government bailouts etc., at which time what should be obvious now will finally become so: that the banking system is already bankrupt. Then the futility of trying to revive it might finally be recognised, and the need to “wipe the slate clean” with respect to Ponzi lending might finally be accepted.”
I knew things were pretty grim, but this is a view of a disaster of astronomical proportions.
I am not disputing that this is a possible outcome. There is already a sense of desperation creeping into Martin Wolf’s articles in FT – http://www.ft.com/cms/s/0/4f5c5ba2-dc22-11dd-b07e-000077b07658.html
But do we really know what it means in practical terms? Clearly, we do not, because the outcomes “on the ground” will depend a great deal on the extent to which people unanimously accept such a huge change, and how it is implemented.
I would expect that many, many people will resist such a change tooth and nail, to their dying breath – particularly those who have gotten filthy rich and super-powerful by using the “old” system – people who would be financially wiped out by such a change. So I would expect that change would not happen until unemployment hit something like 40% .
This has the potential to produce major social disruption. Imagine the Supermarkets closing, Service Stations running out of petrol, and so on.
During the Depression of the ‘30’s, the world was far simpler – people were a lot closer to food sources and essential services. Today we are much less self-reliant, much more dependent. I worry about the ability of our current social structure to survive it.
By the way, if you pick up the article Wolf cites from the Levy Institute, the appendix gives one of their “models”. It is heartbreaking to see the world economy being directed by a simple least-squares curve-fit.
Hi plp15,
I don’t think 40% unemployment would be needed to engender such public reactions–even 15% should do nicely on that front, and I expect that is well within the range of probable outcomes.
On every metric I’ve looked at, this crisis at the stage we have reached dwarfs the Great Depression at the same point: scale of debt/GDP (USA 290% vs 175%); rate of initial deflation (1.9% vs 0.6%); degree of asset market overvaluation (harder to quantify but houses were more than three times the GD level [they were actually in a slump] and shares reached probably twice the overvaluation level); number of merchant bank failures (all versus none)…
As for Godley’s work, it’s actually more sophsticated than a simple least squares–that would be an extract from one of his “Social Accounting Matrix” models. Wynne has been insistent that economists must develop “stock-flow” consistent models of economic processes, which I applaud.
However like most economists his knowledge of the mathematical technicalities of dynamics is limited, so his models are all difference equations (and they employ none of the analytic paraphernalia that exists in that mathematical field). I’m trying to introduce his group to nonlinear differential equation analysis, but it’s not easy to convert them!