Rudd’s essay is on the money
on July 27th, 2009 at 9:06 am
Australian Prime Minister Kevin Rudd has followed up his critique of neoliberalism with a new essay in the Sydney Morning Herald on the causes of the crisis, and the policies needed after recovery.
With one exception, his key explanations for the crisis are the same as those identified by myself and the handful of other economists who predicted this crisis before it happened:
The roots of the crisis lie in the preceding decade of excess. In it the world enjoyed an extraordinary boom… However, as we later learnt, the global boom was built in large part on a three-layered house of cards.
First, in many Western countries the boom was created on a pile of debt held by consumers, corporations and some governments. As the global financier George Soros put it: “For 25 years [the West] has been consuming more than we have been producing … living beyond our means.”
In the United States, in particular, consumers went on a long, debt-fuelled shopping spree. Household debt rose from about 65 per cent of income in 1983 to nearly 140 per cent of income by 2007. The commentator Bill Gross summarised the US consumption boom as: “For too long it’s been McHouses, McHummers and McFlatscreens, all financed with excessive amounts of McCredit .. What a colossal McStake.”
Australian consumers also spent up big. Between 1996 and 2007 there was a 460 per cent increase in credit card debt, a 340 per cent increase in household debt, a 450 per cent increase in corporate debt and a 200 per cent increase in net foreign debt.
Second, these debts were racked up on the back of skyrocketing asset prices. In several countries, stock prices and house values soared far above their true long-term worth, creating paper wealth that millions of households used as collateral for their growing debts. The value of global financial assets grew from less than 45 per cent of global GDP in 2003 to nearly 490 per cent in 2007…
The finance sector, rather than servicing the needs of the real economy, began to primarily service itself.
The final layer of the house of cards was the huge volume of money funnelled from China, Japan and the Middle East to Western banks and governments. Cheap savings from the East flooded into the West to finance ballooning deficits. From 1999 to 2006 the US current account deficit more than tripled, from $US63.3 billion to $US214.8 billion, balanced by huge surpluses in other countries, especially China. (the emphases in these and subsequent quotes is my own)
The only element of that with which I disagree is the third point–which I’ll get back to later on.
Rudd also provides some interesting “insider’s” statistics on the size of the collective efforts taken by OECD governments to try to limit the scale of the crisis:
On the fiscal front, governments from the world’s largest 20 economies are expected to collectively pump about $US5 trillion into their economies by the end of next year (or nearly 8 per cent of global GDP since the crisis began). Altogether, the measures are the equivalent of an extraordinary and unprecedented 18 per cent of global GDP.
That’s an extraordinary injection–against which the scale of this crisis should be apparent. Inject an additional 18 per cent of activity into a global economic system over about 3 years, and yet the system still falls by about 6 per cent over that period? Without that intervention, output could have fallen by 25 per cent over 3 years, which is a Depression in anyone’s language.
Where I differ again with the Prime Minister is over whether this government stimulus alone is sufficient to avoid a Depression. Though his case is far more nuanced than most, the “green shoots” phrase nonetheless gets an airing:
We have already begun to see the results. Early signs of “green shoots” have emerged in recent economic data. And this month the International Monetary Fund revised up its forecast for the global recovery, from 1.9 per cent to 2.5 per cent growth next year. An IMF report this month noted “the world economy is stabilising, helped by unprecedented macro-economic and financial policy support”. The truth, however, is the world is still a long way from recovery.
The extent to which Rudd is “levelling” with his audience is also quite welcome:
The average budget deficit for OECD economies increased more than sixfold, from 1.4 per cent of GDP before the crisis in 2007 to 8.8 per cent of GDP in 2010. Public borrowing is required to finance these deficits and is expected to increase from 73.5 per cent of GDP in 2007 to 100.2 per cent in 2010. Among the big advanced economies, net debt will increase from 52 per cent of GDP in 2007 to 79 per cent in 2010.
Australia’s deficit and debt position have inevitably been affected, albeit much less than in other advanced economies. The combined effects of collapses in revenue ($210 billion) and policy interventions to support our economy ($77 billion) are expected to result in a deficit that peaks at 4.9 per cent of GDP in 2009-10. Net public debt is expected to rise to 4.6 per cent of GDP this financial year and peak at 13.8 per cent of GDP in 2013-14. Both are the lowest by an order of magnitude of all major advanced economies.
Clearly, government global action has come at a cost. But as the IMF argued earlier this year: “While the fiscal cost for some countries will be large in the short run, the alternative of providing no fiscal stimulus or financial sector support would be extremely costly in terms of the lost output.”
Without government intervention, global growth, global unemployment and prospects of global financial recovery would be much, much worse.
We never got to see whether Howard or Costello would have provided a reasoned explanation of policies in the light of an economic catastrophe, because they never experienced one–instead, they were amongst the lucky incumbents who held office while the global financial excess that caused this crisis held aloft the illusion of prosperity, and lost office before The Piper called to collect on The Tune.
Had they held on to power, I have no doubt that they would have–by force of necessity–been undertaking very similar fiscal policies to those Rudd now is (though the additional expenditure may have gone on the military and border patrols rather than ports and schools). Whether they would have presented as reasoned an explanation for their actions I think would have been less likely.
Rudd also revisits the anti-neoliberalism theme of his previous essay:
As I have argued elsewhere, the boom-and-bust economic cycle of the past decade has been an unavoidable consequence of a decade of neo-liberal free market fundamentalism that reinforced a culture of corporate greed and excess in the financial sector. The central principles of this extreme form of capitalism are that markets are self-regulating; that government should get out of the road of the market altogether and that the state itself should retreat to its core historical function of security at home and abroad.
As someone who has long argued that the economic theory that underlies neoliberalism (Neoclassical Economics) is intellectual drivel, I of course support this critique.
Where I beg to differ is Rudd’s dating of this–merely the last decade? We’ve been following Neoclassical-Economics-inspired policies ever since 1975, including under the preceding Australian Labor Party government of Bob Hawke and Paul Keating (or since 1973 if we include Whitlam’s 25% overnight cut in tariffs). And of course, the last decade wasn’t one of boom and bust around the globe, which was partly the problem: the mild US downturn after the 2000 Stock Market Crash occurred because the huge runup of private debt-financed spending that was the Subprime Crisis overwhelmed the negatives of the DotCom swindle, and of course set us up for the far bigger crash we are now experiencing.
The absence of economic downturns since 1993–and the mildness of the mainly US recession after the DotCom Bubble burst–played a large role into deluding neoclasssical economists like Bernanke into believing that they had tamed the trade cycle in what they termed “The Great Moderation”:
… the low-inflation era of the past two decades has seen not only significant improvements in economic growth and productivity but also a marked reduction in economic volatility…, a phenomenon that has been dubbed “the Great Moderation.” Recessions have become less frequent and milder, and … volatility in output and employment has declined significantly… The sources of the Great Moderation remain somewhat controversial, but … there is evidence for the view that improved control of inflation has contributed in important measure to this welcome change in the economy … (Bernanke, 2004)
Bollocks to all that. The prediction I made in 1995 in my paper “Finance and Economic Breakdown: Modelling Minsky’s Financial Instability Hypothesis” has stood the test of time rather better:
From the perspective of economic theory and policy, this vision of a capitalist economy with finance requires us to go beyond that habit of mind which Keynes described so well, the excessive reliance on the (stable) recent past as a guide to the future. The chaotic dynamics explored in this paper should warn us against accepting a period of relative tranquility in a capitalist economy as anything other than a lull before the storm. (Keen, 1995)
A Nascent Recovery?
Like most global leaders, Rudd is now speaking as if recovery has already begun. But to give him his due, even here there is a word of caution:
The first phase of Australia’s response to the global crisis has legitimately focused on crisis management, emergency interventions and implementing a strategy for recovery. But we must now deal with two challenges that arise in the context of a possible recovery.
There is also welcome realism that a debt-financed recovery is barely possible and certainly undesirable, and an awareness that deleveraging and deflation are the major risks facing the global economy.
This crisis has shown we have reached the limits of a purely debt-fuelled global growth strategy. Not only will the neo-liberal model of the past not provide growth for the future, its after-effects will make recovery more difficult. Mountains of global public and private debt, global imbalances, and a weakened global financial system will drag on global growth for a long time. As the renowned financial columnist Martin Wolf has written: “Those who expect a swift return to the business-as-usual of 2006 are fantasists. A slow and difficult recovery, dominated by de-leveraging and deflationary risks, is the most likely prospect.”
Since Rudd has properly entertained the prospect that the next decade will be dominated by deleveraging rather than rising debt levels, let’s get a handle on what that might mean for aggregate demand over that decade.
Australia has experienced two previous bouts of deleveraging, in the Depressions of the 1890s and 1930s. In both those previous Depressions, deflation and falling real output drove the debt to GDP ratio higher after the onset of the crisis–something we have yet to experience–after which the painful process of deleveraging began.
In the 1890s, we began with a debt to GDP ratio of just over 100 per cent, which then fell to a low of roughly 40 per cent over a 15 year period. In the 1930s, we started with a lower level of 75 per cent, which fell over a similar period to a low of 25 per cent–but the Second World War clearly accelerated the deleveraging process, which prior to then was running more slowly than after the 1890s Depression.
In the Figure above, these historical episodes are fitted by an exponential decay process. The rate of decay in the 1890s was roughly 4% per year; it began at roughly 3% in the 1930s prior to the War, but over the entire period including the War it fell at an average rate of 8% a year.
There was no policy intervention to accelerate economic recovery in the 1890s, so 4% might be taken to be the endogenous capacity of a Depressed economy to de-lever, whereas 8% can be regarded as a policy-accelerated rate (where however that “policy” was an arms race during a global military conflict). Both these rates are considered as hypotheticals for reduction of our debt levels today.
Taking 50% of GDP as a level at which normal economic activity might resume (higher than the 40% level that applied in the 1920s and 25% level of the 40s-60s), this implies that deleveraging could take anywhere between 15 years (at the accelerated 8% rate) and 30 years (at the “natural maximum” 4% rate).
We can get a preliminary handle on what this might mean for economic growth by calculating the percentage of GDP represented by each year’s deleveraging–effectively by converting the percentage reduction in debt each year into a fraction of GDP for that same year (this ignores feedbacks between the rate of change of debt and GDP itself, but it will do as a first pass). In the first year (2009) when debt started at 165% of GDP, a 4% reduction in debt levels is equivalent to a 6% reduction in GDP; the size of this hit then falls as the debt to GDP ratio itself falls.
The following chart shows each year’s deleveraging as a percentage of GDP, at the rates of 4% and 8% per year:
We are currently deleveraging at the 4% rate, and debt has fallen from 165% of GDP in March 2008 to 159% today–a 6% fall as a percentage of GDP, as noted above. At this rate, debt will not fall below 50% of GDP until 2038, and the annual reduction in debt will be equivalent to 3% of GDP until 2028.
To compare this to what happened during the 30s and 40s, the next Figure shows the impact of deleveraging in the 1930s: the actual 3% rate that applied from 1932 till 1939, what a “natural maximum” rate of a 4% fall per year would have meant as a percentage of GDP, and how bad things might have been without a World War if the achieved rate for 1932-45 of an 8% reduction had come via reducing debt rather than increasing GDP via a huge militarisation effort.
Even the worst rate of 1930s deleveraging (including WWII) only just compares to the impact of deleveraging today at the 4% rate–because the debt ratio in 2008 peaked at 2.2 times the peak level in the 1930s. And throughout the 1930s, deleveraging never subtracted more than 3% from GDP–again because debt was so much lower then than it is now.
While Rudd is therefore aware that deleveraging will probably be the defining economic experience of the next decade, I doubt that he is aware of the scale of its potential impact. Though Treasury–if it has had any input into Rudd’s paper–seems more aware of the dangers of deleveraging than the RBA, deleveraging is surely not factored into Treasury’s economic modelling of the post-crisis recovery scenarios on which some of Rudd’s budget predictions are based. These presume a return to real economic growth of 3%+ by 2010, which imply a capacity for the economy to grow at upwards of 7% per annum in real terms, to counteract deleveraging subtracting more than 5% from GDP every year till 2015.
If we rely upon the “natural maximum” process of deleveraging, we face a 30 year period in which changes in debt will cut at least 3% from the growth potential of the economy
This is why I propose a far more radical policy to deal with the crisis than the government stimulus package that Australia and other OECD nations have followed to date. These policies are attempting to address a crisis caused by irresponsible private lending, yet they involve continuing to respect this debt. They attempt to counteract private deleveraging by running up public debt instead. And they drastically underestimate the impact of deleveraging: rather than achieving a return to growth by 2010, these policies alone are likely to result in zero or sub-zero growth for most of the next decade.
That private debt does not deserve respect. It was irresponsibly lent in the first place, and the financial institutions that lent it should pay the price–not the public nor the public purse–via deliberate debt reduction. This of course would bankrupt those financial institutions, but as should be obvious from the US experience, these institutions are effectively bankrupt already.
A Copernican Switch on Savings
I noted above that the one aspect of Rudd’s analysis of the crisis that I disagreed with was the proposition that:
The final layer of the house of cards was the huge volume of money funnelled from China, Japan and the Middle East to Western banks and governments. Cheap savings from the East flooded into the West to finance ballooning deficits.
This is the “Savings cause Loans” perspective of the conventional model of money. As I explained in The Roving Cavaliers of Credit, this model is rather like the pre-Copernican view that the Sun orbits the Earth: it’s easy to understand (we still speak of “sunrise” and “sunset” after all) and also completely wrong. Just as the Earth orbits the Sun, “Loans cause Savings”.
The “excess savings” of the East were thus caused by the excess borrowing of the West. Chinese, Japanese and Middle Eastern accounts accumulated money because Western consumers and firms borrowed up big, and spent that borrowed money buying goods produced in China, Japan and the Middle East. Now that the borrowing binge in the West has come to an end, those “excess savings” in the East should start to diminish.
Conclusion
Rudd’s essay shows a stronger appreciation of the causes of this crisis, and the fragility of the economy in its wake, than I’ve yet seen from any other official source (with the sole exception of the Bank of International Settlements, where Bill White‘s influence appears to remain, even though he is no longer its Economic Adviser–check this story on Bill and his forlorn attempts to raise the alarm during the Bubble).
Its one weakness is continued reliance upon neoclassical economic models to predict the future course of the economy after this crisis–when those same models ignore the role of private debt (which caused the bubble in the first place) and deleveraging (which will in fact drive the future course of the economy).
We can expect Rudd and Swann to continue with a large scale fiscal stimulus, in the hope that this will end the crisis. The next stage will come when this stimulus fails to achieve the level of growth predicted by neoclassical economic models, and as a result unemployment exceeds forecasts, public debt continues to run up, and deficit reduction strategies get pushed back in time.
So though Rudd is aware of the problem of deleveraging, he hasn’t yet taken developed policies that directly tackle it. But awareness of the problem is a necessary first step in addressing it, and Rudd has taken that first step.
PS Gittins on the Boil
Ros Gittins wrote a far less flattering review of Rudd’s essay in this morning’s SMH (Rudd’s new bogy: fearing the pain of recovery, SMH July 27 2009).
There were a few elements of his argument I agreed with, but most of it I reject. The points he made that I agree with include:
- That Rudd’s definition of neoliberalism is bogus–or at least incomplete. As Gittins puts it:
“The notion that the Libs could be fairly described as “neo-liberal free-market fundamentalists” is laughable.
And yet Rudd boasts about the success of the Hawke-Keating government’s micro-economic reforms and promises more reforms of his own.
Micro-economic reform and neo-liberal mean the same thing. As an ideological warrior, this guy’s a phoney.”
True–as I noted above:
We’ve been following Neoclassical-Economics-inspired policies ever since 1975, including under the preceding Australian Labor Party government of Bob Hawke and Paul Keating (or since 1973 if we include Whitlam’s 25% overnight cut in tariffs).
- The false claim that our national balance sheet is healthy:
“He boasts his intention is to maintain Australia’s position as having “the best national balance sheet of the major advanced economies” (I didn’t know we were a major economy). Really? With a net foreign debt equivalent to 56 per cent of gross domestic product?”
True again. But Gittins himself has rarely (once from memory–see below) acknowledged the parlous state of private debt in general in this economy. Rudd’s essay did discuss that, and he drew the implication of the danger of deleveraging as well, which applies to all debt, whether owed domestically or overseas.
- And finally, the fact that most of Rudd’s reform agenda is no different to anything else proposed at any time in the last two decades–in other words that it’s still reading from the neoliberal script, which of course is written by neoclassical economists:
“First is regulation and competition reform… Next is infrastructure (nothing new here), innovation (the national broadband network “will arguably be the single greatest multiplier of productivity growth”; I certainly hope it isn’t the best we can do), skills (nothing new) and tax reform (waiting for the Henry report). Then comes the “broader reform agenda”: retirement income policy (waiting for Henry), health and ageing (may do something in response to the imminent report) and climate change and water (nothing new).”
But that’s about it. Otherwise
- Rudd had an accurate analysis of what caused the crisis, on which Gittins had no comment; and
- Based on this analysis, Rudd warned of the dangers ahead in deleveraging and deflation, while Gittins seems to have bought the “it’ll all be over by Christmas” sentiment. For instance:
“Rudd fails to explain just why it will be so tough to get the budget back to surplus. It shouldn’t be, when you remember that all the official stimulus spending is once-off and the budget’s “automatic stabilisers” will eventually bring back the revenue they took away.”
and…
“I’m starting to see the motive for all this talk about tough times ahead: you make it sound terrible so that when it turns out it isn’t so bad, voters are more relieved than angry. It’s spin, in other words.”
Yes there was certainly some spin there. But there was also a better appreciation of what caused this crisis than I’d previously seen from an international leader. In practice, Rudd may well have set the grounds for what is needed politically if, as I expect, things turn out to be a lot worse than most neoclassical economists and commentators like Gittins expect.
Anyone who read Gittins’s diatribe before reading Rudd’s essay would probably conclude that it wasn’t worth the effort to do so anyway. That would be a mistake. It’s rare that a major essay in a newspaper actually (a) identifies the cause of this crisis and (b) notes the dangers that lie ahead. The former has happened only once, so far as I can recollect in any of Gittins’s own columns (“It’s not inflation that did us in, it’s the borrowing“, SMH 08/12/2008–see my blog entry on this “Ross Gittins finally comes aboard“), the latter, never.
On that point alone, reading Rudd’s essay is a far more rewarding activity than reading Gittins’s critique.
Congratulations Dr Keen on the prime minister’s agreement!! finally the mass media will have ‘egg on their faces’!!In light of this ‘revelation’ from the p.m.it will be interesting to see the ‘floggers’ views ‘going forward! and of the ‘green shoots’scenario!
I am also sceptical of the p.m’s timing (yes political one up manship on opposition) in view of increasing unemployment when ALL the govt. stimulus has now finished(and finishing FHOG)and we fly solo as it were with reduced foreign income as explained on this site!
Another question, does anyone here believe that possibly the p.m. has had a ‘briefing’ on what may be coming?? silly me! congrats again Dr Keen!!
Steve,
Lots of interesting material there! A few observations:
1. Savings may not cause loans but surely you agree they affect the interest rates available? Would the cheap credit have even been possible otherwise? If so, then it seems to me asian deferral of consumption did have a role to play in this mess.
2. You advocate jubilee, but presumably that is just for Oz? If the banks responsible go BK, what then of protection for savings deposits in those banks, and their foreign liabilities – won’t the public purse have to cover these? Is this a realistic possibility, and what effect would it have on future interest rates and credit availability? What if all affected nations everywhere did it?
3. Looking deeper, why the need for debt fuelled consumption in the first place anyway? Why couldn’t the asians consume their own output? Fear of goods?
Isn’t it the old marxian trope of capital accumulation and the tendency for the rate of profit to fall combined with deteriorating demographics that’s driving the ongoing economic deterioration since the late 60s?
If not then I think we need some other explaination for why for example, we left the gold standard in the first place, and then for why sufficient western consumer demand could only exist when funded by debt.
Unless we’re armed with some theories here, even your conservative estimate for how long deleveraging could take may be completely wrong if all the while the deleveraging is taking place, demand is being further destroyed by the issues that caused it in the first place, still neither being addressed nor understood. This latter point is what worries me most – if we’re ever to recover from this mess, we’d better have a damn good idea what sort of world we’re recovering towards.
Steve, you know I love your work, I really do… but really, agreeing with the Prime Minister when he says:
“As I have argued elsewhere, the boom-and-bust economic cycle of the past decade has been an unavoidable consequence of a decade of neo-liberal free market fundamentalism that reinforced a culture of corporate greed and excess in the financial sector. The central principles of this extreme form of capitalism are that markets are self-regulating; that government should get out of the road of the market altogether and that the state itself should retreat to its core historical function of security at home and abroad.”
Now if you want to keep a central bank which permits the unlimited creation of credit, and fractional reserve banking which is the engine of loaning money into existence… then maybe I can see why the PM would make such a fallacious and caveman conclusion.
Just a quick follow up to qualify my ‘caveman’ critique of the PM’s conclusion… to criticize free market capitalism and spin massive government intervention while ignoring that you have an institution that is not born of the free market and a banking system that loans money into existence (i.e. FRB) is a massive intellectual omission.
One more thing related to my questions above.
The link below shows how simple CD accounts in the US have outperformed equities between 1994 and 2008.
http://www.fivecentnickel.com/2009/07/20/investment-performance-cds-vs-stocks/
The thing I’m struggling with is that if there is any sense in our economy at all, then a long term equity index investment should outpeform a CD due to the higher risk involved, otherwise what’s the point of equities?
Surely from this we either have to conclude that the cost of capital has been too high, or that equities are undervalued (both of which amount to the same thing really). You might suggest in return that the money was badly invested, but the bad outcome could just as easily have been due to a cost of capital sufficiently high vis-a-vis real earning potential to guarantee a bad outcome.
drwasho, I don’t know why people keep asking these questions. I’m sure steve has answered them in the past. Without fractional reserve banking there would be no lending, because:
1. typical capital assets (in normal financial times) will yield about 1% after costs (i.e. general operating costs and the paying of depositors their interest, plus defaults). Don’t forget that a proper bank (i.e not goldman) makes money on the spread of deposit and loan rates).
2. because of the low yield an intermediary needs to lend out each $ of deposit several times over to have a viable business.
3. without financial intermediaries there is not going to be any lending. We don’t and never will have a barter economy unless and until we’re all living in mud huts again.
4. intermediaries have to be trusted to be effective and given the scale of the global economy they therefore need access to guarantees provided by a bank-of-last resort, preferably one that can print money or tax people, otherwise no-one would deposit a dime. Free banking in early 19th century USA did not have a good reputation.
Main problem with Rudd’s essay is that the rhetoric doesn’t match the policies. Rudd is a disciple of Tony Blair and will turn this sort of rubbish out until everyone realises the hypocrisy. Seems to have broken both the UK economy and the British labour party.
First, while we are told that debt is wrong what is the solution: more debt. Government intervention to encourage debt, especially for housing is still happening. In a addition to first home owners there are various schemes to encourage investment in affordable housing. Not to mention the government debt.
Secondly, there seems to be no recognition that the increased debt flows through to increased affluence, allowing us to purchase lots of foreign made goods. Apparently nation building doesn’t include building factories of our own. We’re going to do it all based on more school halls. At least they are not made in China.
Thirdly, I can’t remember how many times that we were told by Beasley etc that Labor would have turned the economy around with public spending. Stick that on top of what was already there and the result is massive public debt, as well as private. Think UK. When does our public deficit end ? When teh private sector starts borrowing ridiculuous amounts of money again.
There are probably other things.
“drwasho, I don’t know why people keep asking these questions. I’m sure steve has answered them in the past. Without fractional reserve banking there would be no lending…”
Yes… there was no lending prior to the early 19th century, ever.
I have some recommended reading material:
http://mises.org/story/1829
http://mises.org/mysteryofbanking/mysteryofbanking.pdf
DrWasho, I hope you’ve read my Roving Cavaliers of Credit post where I explain that fractional reserve banking is not merely not the problem, but not the system in which we live. Credit creation is largely independent of government creation of fiat money, and the former follows the latter, rather than preceding it.
The point on which I am now in agreement with Austrian economists is that the Central Bank has done more harm than good–not through the credit creation process itself, which proceeds independently of their actions, but in their rescues of this system from its own innate instabilities. This has led to the system accumulating twice as much debt as it would have done so without Greenspan’s “rescues”. With that large an increase in debt, we go through one of Marx’s “quantitative change becomes qualitative change” points so that what might have worked as a rescue in the past–government deficit spending–won’t work this time.
However I was willing to let many issues “pass through to the keeper” (to use a cricket analogy) because the main thing I favoured in Rudd’s essay was acknowledgement of the main cause (a private debt financed Ponzi bubble) and the main symptoms of its unwinding (deleverage and deflation).
Steve, nice to see there has been some changes from the PM about the cause, A little recognition for yourself and others who have been saying this all along. (don’t hold your breath though)would be good to. I think you said months ago that things will have to get much worse before any of them think of adapting your more radical approach but I think you’re right it’s the only solution.
The green shoots seem to be disappearing in the UK as this article outlines.
Business leaders fear new recession
Independent poll reveals fresh pessimism at prospects for economy
The number of business leaders detecting the green shoots of an economic recovery has fallen for the first time since April, raising fears that the country is heading for a “double-dip” recession, research carried out for The Independent has found.
The renewed gloom in industry – revealed in a survey of senior business people – comes after months of cautious optimism that Britain could soon be past the worst of the downturn.
http://www.independent.co.uk/news/uk/home-news/business-leaders-fear-new-recession-1762047.html
Thanks once again for a great analysis Steve.
I don’t think that, politically, Rudd can avoid more and higher levels of deficit spending. As you graphically point out, the GFC and it’s deleveraging will be with us for some time and I don’t see Rudd allowing our economy to wither any where near the point of it being politically damaging. After a good dose of luck, his only tool to prevent that will be MORE debt. Folks, get used to it- along with below average to negative economic growth ahead of us will be much more national debt and with it much higher taxes. That will be the formula until something breaks, which will then usher in our next crisis- a bond and currency crisis.
Hey Steve,
Yes I’ve read your article and I acknowledge that many Austrian schoolers like myself neglect to emphasize that the private sector is responsible for the bulk of the credit/money creation via the fractional reserve banking system (M2 preceding M0 etc)… which is why I refer to FRB as the engine of inflation as opposed to the central bank that permits it’s continuance via the discount window. Though the central bank does indirectly expand the money supply through the Soviet style decrees of interest rates and market money operations.
In two books: 1) ‘Mystery of Banking’ by Rothbard & 2) Money, Bank Credit and Economic Cycles by Jesus Huerta de Soto, there are very good cases to demonstrate that fractional reserve banking is fraudulent in the way it is presently conducted, unsustainable and obviously inflationary… yet at the same time, it offers alternative banking and credit models that don’t involve fiat credit creation. I recommend them to anyone who wants to hear the ‘so what’s your idea’ argument.
“However I was willing to let many issues “pass through to the keeper” (to use a cricket analogy) because the main thing I favoured in Rudd’s essay was acknowledgement of the main cause (a private debt financed Ponzi bubble) and the main symptoms of its unwinding (deleverage and deflation).”
Yes, admittedly its a big step for our beloved Prime Minister… I shouldn’t expect him to publish a second edition of The Wealth of Nations anytime soon though.
‘That private debt does not deserve respect’
Steve – if we forgive all the private debt then won’t that reward all the people who got into ridiculous levels of debt and punish the savers who have opted to rent until they can afford their residence?
The people in debt will keep their palatial homes and the savers will keep their rented units?!
Wouldn’t Chine get *really* annoyed if we decided to default on our debt?
DrBob127,
From the previous thread;
I think Clive and Lyonwiss covered well the responses that I would offer. Steve above also outlines the macro environment for economic growth or lack thereof that limit’s the scope of an earnings recovery.
However, in the scenario your Dad indicated, I would say that most corporations are now learning to deal with massive overcapacity to service their rapidly shrinking demand/sales base. Witness the shedding of labour and bankruptcies still strongly underway in the US. In that paradigm, ANY servicing of debt is a parlous state simply because the real bottom in demand (revenues) is falling away as jobs perish. In your Dad’s example, some assumptions I don’t buy into as they apply to the S&P500 , the subject of the chart;
- How many corporations would you believe are still in a “strong position” having seen their sales decimated?
- In a declining revenue environment, the cost of debt servicing (at undoubtedly higher than previous rates) rises thus imposing both other operational cuts (jobs) or discounting just to maintain sufficient cash flow. With most other Corps doing just the same, profits decline along with the customer demand base.
- If the original loan was to boost production, then that (and your competitors)added capacity is now partially/significantly idle.Ability to raise prices in future in an overcapacity world don’t exist. So a return to anything approaching normal revenues will also not materialize impairing all future bottom line results. Possibly worse, you will be priced out of business now in a mad scramble for market share. Mass casualties are and will continue to occur in this environment.
The chart in itself can be interpreted in many ways, I grant you. But , when comparing stock prices today, with any interpretation of the earnings chart and likely forward expectations , indicates to me that there is a gulf of disparity present.
Either earnings expectations are quite right (I must be missing something VERY BIG on the revenue side), or, they are dead / hopelessly wrong. Steve’s analysis , others and my own take on them leads me to believe earnings expectations (P/E’s) are ludicrous.
What would happen to all my savings in the banks that are going to be allowed to fail?
ie: – Steve – do you keep the money from your unit sale in a bank?
If the answer is ‘bullion under the mattress’ perhaps you better say ‘no comment’ lest people find out where you live
Why can’t people who have taken on too much debt be punished?
Whats wrong with that?
My Godfather was a multi millionaire -he had a mansion next to L. Fox in Toorak….olympic size pool etc….all the trappings….
He bought alot of real estate in sth melbourne – via debt.
interest rates went to 20% and he went broke.
he now rents a house….big deal…people go broke all the time …..its a life lesson that needs to be taught….
i say punish them and reward savers.
I’m in favour of bank deposits being 100% guaranteed Metadebt, as they are now after the crisis. You can abolish (a large percentage of) the debt without affecting deposits at all, which in a notional sense is a large shift to a fiat money system from a credit one gone bad.
Steve
Why not devalue the AUD and let the entire population tackle the problem NOW rather than continually defering it and letting the problem get bigger. The present solution only benefits the bankster class and likely it will end up being the consultants at the IMF at the expense of the real economy.
Why not enmass lower our standard of living via a currency decline to a level supported by our real incomes and not our illusory debt financed asset wealth.
We should devalue the AUD and generate trade surpluses to pay our way…
Australia should be quickly aiming to earn more than we spend for once in several decades.
My greatest disagreement – and annoyance – with Rudd’s essays is this posturing that the conservatives were the bastion of “free markets” and that has caused the GFC. Get me a bucket! The greatest bubbles that we have experienced have been in our housing markets, and they have been anything but free for a long time – under Labor or the conservatives. What we really have is markets that have been managed to produce an outcome that is politically palatable – increasing prices – and Mr Rudd is lining up to be the most active house price “manager” of all time!
Mr Rudd conveniently discussed housing prices only in relation to the “several countries” in which “… house values soared far above their true long-term worth”.
But I think the article is actually very suggestive that Mr Rudd does categorise us in those “several countries”. He talks about our massive run-up in personal debt in Australia (yes, like it only occurred under the Howard Government) – but conveniently neglects to point out that a very large proportion of that debt funded our own housing ponzi (or to fund wasteful consumption from that “paper wealth” delivered by the housing ponzi.)
Makes you wonder why he has encouraged so many young Aussies into our very mature ponzi? Did he really think it was the right course of action – to add to the “mountains” of private debt (that he went some length in underlining that we also have) – even though he foresees a very long and painful rebalancing ahead? That certainly is going to represent a significant impediment to his chances of re-election for a third term. Perhaps he had little choice but to repay some political favours?
Then again, perhaps he does read Debtdeflation???
Either way, there is no doubt that these essays show a good deal of his own “ideological hypocrisy” and it will be interesting to see whether he has the leadership qualities to get our society and economy heading in the right direction.
Steve, I am going to read this a few times. Money is clearly loaned into existance and the Asian boom was clearly created out of US home equity along with some other international housing bubbles. It appears the governments and finance ministers of the world continually attempt to hide how banking works and that banking created this mess. The Chinese are poor on a relative sense and I doubt could never save that much money, but a system of confiscation of international currency and a replacement of domestic currency could very well allow a society to spend all it made domestically and internationally be big savers.
What is clear to those of us that have a clue as to how to solve this problem is that institutions and depositors are going to have to take a haircut. The current attempt is to replace the shrinking money with public debt and that won’t solve the debt problem. Neither will wasting precious resources in what they call stimulus.
I believe the old time liquidation worked well. Short term chaos was replaced by a clearing out of the debt in the market. Sure people went broke, but the money remained while the debt was wiped out. There is a delusion in modern finance that the only way to expand is to spend money you don’t have. In this matter, it is clear that for there to be any long term solution, there would have to be a new method of having money, lending money and creating money other than at interest. Of course, this would tie the hands of government and remove the money creation mechanism from those that rule government behind the scenes.
Depression is one of the hardest things to understand, other than the fact that banking economies are married to expanding levels of debt to the point that debt can no longer expand and be rational or real. This is really a bag passing enterprise and those at the end of the line are now holding the bag.
The biggest danger is how do we give the needed haircut and not wipe out the savings of pensioners around the world? Social Security here in the states is busted and was the last response to this problem. I don’t believe it is a good idea to saddle the world with another passed bag. I think the world may need to learn to see beyond dollar signs and see product sold and bought in other terms.
Steve, good piece and, as you say, in the circumstances it seems reasonable to let quite a few things go through to the keeper.
Like some others here, I’m a bit uncomfortable with two things:
1. It’s not clear to me how, in practical terms, you’d recommend getting rid of the “irresponsible” private debt. Given that in your second comment you talk about “abolish[ing] (a large percentage of) the debt”, I imagine you have something fairly radical in mind.
While I agree that deleveraging is essential (and indeed unavoidable), the manner in which it’s done is surely critically important. Wherever possible, I’d have thought standard legal and market processes should be allowed to do the job. Thus, for example, most if not all financial system insolvency problems (together with a decent chunk of overindebtedness) could be dealt with through the conversion of unsecured (and in exceptional cases some secured) debt to equity. This needn’t involve much in the way of coercion but could instead flow from a quasi (or literal) bankruptcy process.
In any case, I’d be interested in some elaboration from you on this point.
2. Like you, I never bought the “excess savings” hypothesis as the primary cause. Still, as scepticus noted, the Chinese in particular were hardly passive bystanders. They drove an aggressively mercantilist policy hard (and still do) and America’s debt fuelled consumer binge would have ended long before had they not done so.
Come to think of it, there’s one other thing (this one emerges from your first comment).
You say that fractional reserve banking “is not merely not the problem, but not the system in which we live”. Given that I don’t see how it can be claimed that our banking system doesn’t operate on a fractional reserve basis, I assume this must be a semantic, definitional issue (perhaps you’re thinking of earlier periods when central banks actively used reserve requirements as a tool).
On your larger point about credit creation, I agree that the financial system itself tends to lead the central banks, but (in addition to those innumerable rescues you mention) CBs do contribute to the process simply by “validating” credit growth via progressive additions to the monetary base.
Hi InGolf,
On the fractional reserve system, the normal model of this–the “money multiplier”–implies that credit can’t be created unless “seeded” by an initial drop of fiat money. In the Roving Cavaliers post (please read it if you haven’t already done so), I explain that this model doesn’t fit the empirical data, and that it is possible to have a pure credit economy without government money at all. So while there will be a statistical relationship between credit money and base money, it works in reverse to the standard theory.
If we rely on the usual market mechanisms to reduce debt, I honestly fear that we won’t have an economy by the end of it. Also, converting debt to equity would effectively allow the financial system to practice theft by debt–give people debt they can’t afford to service, and take over the assets afterward. Even if you did that, most of them would be bankrupt on their current asset holdings anyway, because the income stream from those assets wouldn’t maintain their current capital adequacy ratios. I’d rather send a message too that this level of financial irresponsibility will never be tolerated again.
Practically I expect that the debt to equity idea will be the one that is generally run with, combined with a politically appealing debt forgiveness for the poorest debtholders, when economic circumstances finally drive policy makers to unconventional actions.
hi peter w,
re the currency, i can see your point about this,
it would be a way to inflate our way out of a deflationary spiral, allthough i’m not sure what the employment consequences for retail and importing industries would be in the short to medium term under such a scenario.
i think you are going to get your wish anyway,
let me engage in a little wild speculation,
according to my reading of the tea leaves
the current weakness in the greenback i think is due to the relative strength in equities. this will soon change once the macro situation in the US changes, when everyone realises that the so called green shoots arent going to be self sustaining and are being propped up by alot of government and federal reserve fertilizer, or should that be manure.
adding fuel to the fire may be a scandel or two about the mismanagement of various bailouts.we can always rely on governments for a scandel or two when large sums of taxpayer money are given to people , some of whome quite frankly dont deserve it.
that should be enough to have everyone rushing for the door at the same time,
if the equities markets follow history then we are in for a large correction heading south, which by my reckoning will mean a significant devaluation in the oz dollar relative the greenback and probably the yen, probably below 50cents US in the medium term.
i could be wrong offcourse, and on this dung heap of debt beautiful roses will bloom
steve if you are in favour of bank deposits being 100% gauranteed by the government,
then why not go the extra step and change the laws which allow banks to committ regalised fraud by lending money which they do not have.
why not have 100% reserve banking!
i mean lets face it, regardless of their prudent lending policies , the very nature of a loan bank, is that it is always theoretically broke.
Steve, thanks for the quick reply. It looks like I didn’t explain myself well enough.
I have no problem with the idea of endogenous credit creation, and (as noted in my last paragraph) agree that the financial system itself tends to lead rather than follow. Absent central bank cooperation, (through relaxed reserve requirements, eventual monetary base additions etc), however, the process would quickly become much more difficult. And yes, I certainly agree that a pure free banking system (without government money or a central bank) can create plenty of credit. Still, without the various forms of systemic support, its capacity to expand is likely to be a good deal more limited than our Frankenstein version. By the way, I have read the Roving Cavaliers and thoroughly enjoyed it.
As for debt to equity conversions, I meant something very different to what you seem to have taken from my comments. What I was suggesting is that when a financial institution is no longer capable of surviving (as is) on its own, then some form of “bankruptcy” process should be used to convert some or all of its outstanding debt to equity. Like you, I think deposits should be excluded from this process and the conversion should proceed in accordance with the seniority of the debt.
This would “punish” more or less exactly the parties that you also think need to learn a hard lesson in the realities of risk v reward. It would also quickly (and potentially quite dramatically) reduce outstanding debt. An example of the sort of thing I have in mind is briefly laid out in this article by Prof Luigi Zingales:
http://www.voxeu.org/index.php?q=node/1670