I was recently interviewed by Rear Vision for a retrospective on the crisis, entitled "Here we go again: A look at the US economy post the 2008 GFC crash” which debated why the crisis is still with us today.
Other speakers were Ed Harrison from Credit Writedowns, with whom I’m very much in agreement, economic historian Richard Sylla from New York University, and Steve Hanke from John Hopkins with whom I almost completely disagree. Hanke doesn’t even discuss the level of private debt, puts the standard neoclassical argument that government debt is the problem, that a stimulus is contractionary (the so-called “reverse Ricardian Equivalence” argument) and so on, ideas which I regard as total nonsense.
Follow the link above to hear the program via the ABC website, or click below to listen to it here. I’ve also reproduced the transcript below, and corrected a few errors in the ABC original.
Journalist [archival]: One of the top three credit rating agencies, Standard & Poor’s, has downgraded its rating of US debt from AAA to AA+. It’s the first time the US has been downgraded since it first received a Triple-A rating from Moody’s in 1917.
Journalist [archival]: John Chambers said S&P’s decision to reduce US creditworthiness was because for too long it’s been spending when it should have been saving.
John Chambers [archival]: Instead of storing our nuts for the winter, we ate out nuts and now we’re in a position where we have very little fiscal room to manoeuvre with an economy that’s taking a second leg down.
Annabelle Quince: Just over a week ago, Standard & Poor’s downgraded the United States credit rating from AAA to AA+. The downgrade sent shockwaves through stock markets across the world and raised the spectre of a double-dip recession.
Hello, I’m Annabelle Quince and this is Rear Vision on ABC Radio National, Radio Australia, and via the net. Today, we’re going to try to piece together how and why it is that the United States of America, the largest economy in the world, has ended up in such a mess.
While there’s a debate about how to fix America’s economic woes, most economists and commentators agree that the main cause of the crisis is debt-both private and government debt.
According to Steve Keen, associate professor in economics and finance at the University of Western Sydney, debt in the United States has been accumulating for decades.
Steven Keen: You need private debt to finance proper investment, but what the banks make money out of is financing Ponzi schemes. Right from the get-go in America and from about the mid-60s in Australia, private debt to income has been rising. And America’s gone from 45 per cent of GDP in 1945 to 300 per cent of GDP by 2009; that’s when it peaked out.
Now, all that’s been financing speculation, and when you finance speculation what you’re really doing is gambling on rising asset prices. The gamble itself drives the asset prices up and then at some point, of course, it has to fall over, because when you’re borrowing money to gamble on rising asset prices, you’re not actually increasing the number or the productivity of those assets. So you’re increasing the debt burden on society without actually increasing society’s capacity to pay.
As soon as people start to try to reduce their debt, you go from rising debt boosting the economy to it slashing demand. Go back to 2008: the GDP in America was roughly $14 trillion but the increase in debt that year was roughly $4 trillion. So that means total spending in the economy was about $18 trillion. Simply slowing down the rate of growth of debt; that means you went from having an $18 trillion economy to a $12.5 trillion economy in two years. That’s what caused the crisis.
Journalist [archival]: A year ago, those who predicted that giant investment banks would fail were dismissed as madmen. Today, in the early hours of the morning in New York, the venerable firm Lehman Brothers announced that it would file for bankruptcy.
Steve Hanke: Towards the end of 2002, one of governors of the Federal Reserve Bank gave an important speech in November-now Chairman Bernanke, he was a governor at the time, but he’s now the chairman of the Central Bank.
Annabelle Quince: Steve Hanke, professor of applied economics at John Hopkins University.
Steve Hanke: He said the main danger we faced in the United States is deflation and he convinced the then chairman of the Federal Reserve, Alan Greenspan, that he was right and Greenspan concluded that deflation was the number one problem facing the United States.
They started pressing on the money supply accelerator as fast as they could at the central bank and they reduced interest rates down to one per cent by June of 2003. Now, at the time that was a record low and this started and enabled all the bubbles to be created-the housing bubble and commodity price boom was associated with this. Loads of liquidity all over the world and a falling dollar, and the falling dollar was the cause for roughly, in my estimation, between about 55 and 65 per cent of all the commodity price increases. All these things were started with the Fed. So that’s how we got all these bubbles that started expanding and eventually popped.
Journalist [archival]: And so what is the feeling? Is the feeling that bankruptcy is inevitable now, is that the concern?
Interviewee [archival]: Yeah, I think so and there’ll be more, there’ll be more.
Journalist [archival]: Hours ago Merrill Lynch also confirmed it has fallen victim to the bear market.
Steve Hanke: They saw nothing coming. The Fed and all the establishments all over the world, the establishment politicians, they saw none of this coming. The International Monetary Fund, they had not a clue that anything was amiss. It did of course really hit the fan in September of 2008 when Lehman Brothers collapsed and then the US officials in particular went into kind of a panic mode, indicating that if there wasn’t an enormous bailout provided that the whole financial system would collapse.
Journalist [archival]: The US government has launched a takeover of the nation’s two biggest mortgage companies.
Henry Paulson [archival]: Fannie Mae and Freddie Mac are so large and so interwoven in our financial system that a failure of either of them would cause great turmoil in the financial markets here at home and around the globe.
Steve Hanke: And the secretary of treasury, Paulson at the time, had sent a three-page letter up to the congress requesting hundreds of millions of dollars in bailout money-$700 million in bailout money-you know, close to a trillion dollars. And just in a three-page letter with no background or anything. And of course they turned him down and no one paid any attention to it. And he said, ‘Well, if you don’t give me the money everything’s going to collapse.’
Henry Paulson [archival]: This turmoil would directly and negatively impact household wealth from family budgets to home values to savings for college and retirement.
And Paulson, the secretary of treasury, panicked. He was a former head of Goldman Sachs and had a fine record as an investment banker but no qualifications whatsoever for operating in the public sphere and as a secretary of treasury.
And he panicked, he totally panicked. That’s the general problem. You had personalities in there that were amateurs who had no idea of what they were doing and no idea that they were creating public panic. It wasn’t the recession or depression of 2009; it was the panic of 2009 that we’re talking about here.
Steve Keen: The reason we’re in this crisis-many, many reasons, but one essential reason is extremely bad thinking. Bernanke was publishing papers with titles such as ‘The Great Moderation’, talking about how wonderfully the economy was going and congratulating himself for his good monetary management, right up until 2006–2007. So they just basically saw stability. They were completely ignoring the level of debt.
So the crisis took them completely by surprise, they had no idea it was coming, and because it was so devastating they went into total panic mode. Now if you read Hank Paulson’s account, On the Brink, at one point he’s explaining that $700 billion injection he got the congress to give, which he actually gave to the banks. And explaining what was going on he said, ‘I didn’t dare mention a trillion dollars, that would cause sheer panic, but I had to mention a large number and I said $700 billion,’ and then he said, ‘I was then asked, “What would happen if you didn’t sign it all over?“‘ His answer was, ‘May God help us all.’
Journalist [archival]: ‘Desperate’ is a word being used a lot in the United States at the moment, and ‘crisis’. Both are apt descriptions of what’s going on. The American Congress failed to pass the bailout bill and the collapse of the financial rescue plan has sparked a huge sell-off on Wall Street.
Journalist [archival]: Well, there’s disbelief at this death blow for the bailout bid. After all, let’s not forget President George W. Bush was predicting a deep and painful recession for the US if it’s not passed.
George W. Bush [archival]: I was disappointed in the vote with the United States Congress on the economic rescue plan. We put forth a plan that was big because we’ve got a big problem.
Annabelle Quince: The Emergency Economic Stabilization Act, or Bank Bailout Bill, did eventually pass, in October 2008. The aim of the bill was to shore up the failing banks by pumping $700 billion into the system.
Edward Harrison is an economic analyst and the founder of economic website Credit Writedowns.
Edward Harrison: Basically what they were trying to do was put a floor underneath the system, because all hell had broken loose and there was utter panic. And all of the other institutions were imperilled at that time: Goldman Sachs, Morgan Stanley, those were the two remaining institutions that were investment banks and they were both in jeopardy of going bankrupt. AIG had to be rescued. We also saw a very large bank, Washington Mutual, which went out of business and was bought out by JPMorgan.
So really what they wanted to do, they wanted to put a floor under all of that. And what they had originally planned to do was to buy up a lot of these assets-these dodgy assets-which had been causing these banks to fail and had been causing the panic. But as time went along they realised it would be better for them to inject capital into these institutions to shore up their balance sheets, as opposed to buying the capital, and so that’s what they ended up doing. And that’s what the bailouts were all about in the United States. So all of the largest institutions received capital from the US government.
George W. Bush [archival]: I believe in the long run this economy is going to be just fine.
Journalist [archival]: US President George Bush-‘Everything’s just fine.’ It’s been a few days since the congress passed that massive bailout package for the American financial system. How soon is it going to be up and running?
Interviewee [archival]: Well, the Bush administration has selected a former Goldman Sachs executive, 35-year-old Neel Kashkari, to be the interim head of this massive rescue effort.
Annabelle Quince: What was the kind of political thinking? Because clearly there was a lot of support, especially from the US public, to actually let some of these banks go under, and yet the political will didn’t seem to be there.
Steven Keen: Who are you trying to get to say “let the banks fail”? The people who actually run the American political system are the financiers. The same thing happened back in the 1930s, when you had this incredible growth in the power of the financial sector over the 1920s in particular, the JPMorgan firms of the world and so on, and then Roosevelt came along and his inauguration speech–which I recommend you reading-said that we’ve handed over control to the money lenders, problem caused by debt, their only solution is to say yet more debt. And he then led to the shutting down the banks, the bank holiday, reorganising them all and then destroying the political power of the banks.
So when the Second World War ended, the size of the financial sector, or called the ‘non-bank financial sector’, their debt level was about two per cent of American GDP. It since rose to 120 per cent. Now, ironically, when you borrow that much money you have that much political power. So you’re trying to tell people that they should commit harakiri for the better of the system-well they’re not going to do it.
Annabelle Quince: Not everyone agree that the bank bailouts were wrong. Richard Sylla, professor of the history of economics at New York University, argues that without the bank bailouts the United States might have fallen into another depression.
Richard Sylla: Ben Bernanke, who’s the chairman of the federal reserve system, was a great scholar. He was a Princeton University professor, studied the Great Depression a lot in his academic work, and he had written articles and books on that the Great Depression got to be as bad as it was because they allowed the many banks to fail, which caused a deflationary spiral, which caused even more bank failures in a weaker economy. So his stance was he wasn’t going to allow that to happen again, and so he would create a mass amount of liquidity, which was not done in the Great Depression of the 1930s.
Ben Bernanke [archival]: Credit is the lifeblood of the economy. If the credit system isn’t working, then firms cannot finance themselves, people cannot borrow to buy a car, to send a student to college, to buy a house. That’s not just an inconvenience, because if that is true generally, it’s going to cause the economy to slow markedly.
Richard Sylla: Of course I think that staved off another Great Depression, but it produced what’s called a ‘great recession’ now and a lot of people are not used to that and so they’re very critical of both Federal Reserve policy in bailing out banks, which I think was probably a good thing, and they’re not quite understanding what Bernanke did. But I think when this is all over and things get to be more normal again, we’ll look back on it and say, ‘Well, Bernanke didn’t turn things around right away, but he prevented something much worse from happening.’
Steve Hanke: The money ultimately comes from the taxpayers-I mean, it was financed by debt, of course, because the deficit went up and the amount of debt issued by the US Government went up, so the immediate source of the money was debt.
We went into the crisis by being over-indebted with no cushion and then we decided to ramp up the debt and even go into further debt to bail some of these institutions out. The ultimate result has been a very bad result in terms of the structure of the financial institutions.
Annabelle Quince: So you think without the bailouts that actually the financial institutions that were able to survive would have come through stronger and fitter?
Steve Hanke: Yes, because they would have themselves gone on to mend themselves, shall we say. It would have been like Bear Stearns. Bear Stearns, it was voluntarily gobbled up by other financial institutions and they hardly missed a beat, shall we say. And that would have occurred with other financial institutions if, if-there’s a big if, here-if there hadn’t been a panic, Annabelle. Once you get into a panic, then the ballgame starts changing on you.
Annabelle Quince: Since the crisis hit in 2008 there has been a number of investigations into the practices and reward systems of the investment banks in the United States.
US Congressman Henry Waxman [archival]: You have been able to pocket close to half a billion dollars and my question to you is, a lot of people ask is that fair for the CEO of a company that’s now bankrupt to have made that kind of money? It’s just unimaginable to so many people.
You have a $14 million ocean-front home in Florida, you have a summer vacation home in Sun Valley, Idaho, you and your wife have an art collection filled with million dollar paintings, your former president Joe Gregory used to travel to work in his own private helicopter-I guess people wonder…
Annabelle Quince: Has there been any significant change in the way those banks work today?
Steven Keen: No, they’re still doing the same stuff. They still basically finance mergers and acquisitions and share market speculation. And they’re not doing as much housing speculation anymore, for obvious reasons-that bubble’s over-but fundamentally they look for bubbles to finance.
Edward Harrison: We’re back to square one. The banks are… they’re pretty much operating as they did before. The big difference, however, is that it’s likely the banks will need to have more capital in order to function; that is, that the capital buffer will have to be larger; and that’s going to make them less profitable going forward.
I think you may have seen that HSBC, a British bank, just today, in fact, said that they were going to lay off 30,000 employees out of their nearly 300,000. And the reason they’re doing this is basically even though they earned $11 million in the first half of the year, given their enormous capital base that wasn’t a very good return on capital. And they know that they’re going to have to increase their capital, and so what they want to do is cut their costs so that they can have a higher return on capital.
So really, nothing’s really been done except for the capital, and perversely the increase in capital over the short-term may have the effect of causing these banks to try to cut costs in order to make a return on capital that their investors are looking for.
Annabelle Quince: You’re with Rear Vision on ABC Radio National, Radio Australia, via your MP3 player or the internet. I’m Annabelle Quince and today we’re piecing together how and why it is that the US economy is in such a mess.
The crisis in the financial market led to an economic recession-house prices fell, the number of unemployed rose, and US consumers stopped spending. Barack Obama won the US presidential race in November 2008 and in at the beginning of 2009, he introduced a huge stimulus package in an attempt to kick start the economy.
Journalist [archival]: The US president, Barack Obama, has signed his massive economic stimulus package into law. Mr Obama hopes the $1.2 trillion-worth of new spending and tax cuts will help steer the US economy out of recession.
Barack Obama [archival]: I don’t want to pretend that today marks the end of our economic problems. Nor does it constitute all of what we’re going to have to do to turn our economy around. But today does mark the beginning of the end, the beginning of what we need to do to create jobs for Americans scrambling in the wake of layoffs.
Richard Sylla: I think Obama didn’t quite realise the extent of the problem as much as Roosevelt did in the 1930s, but of course the problem was much bigger for Roosevelt, so maybe it was easier for him to understand it. Now, Obama pushed through a stimulus package and it turned out to be, what, seven or eight hundred billion dollars, which is quite a bit and added a lot to the government deficit. That was probably the right thing to do, but maybe there wasn’t enough of it.
Probably half of the United States-you know we are a federal system, I think Australians probably understand that-a lot of the spending of the federal government was offset by reductions in spending by state and local governments. So the net effect of Obama’s stimulus was zero. But of course things would have been much worse had he not had that stimulus package. It just turns out that what we’ve done here in the United States for the last couple of years, in terms of government spending to alleviate the downturn in the economy, what was done at the federal level was offset by cuts in state and local spending. So the net effect of all government spending in the United States has been effectively no stimulus.
Annabelle Quince: Professor Steve Hanke argues that the stimulus package rather than kick starting the economy has actually prevented its recovery.
Steve Hanke: A lot of the stimulus package was spent bailing out these financial institutions and some of it did seep in in shovel-ready public works projects and government projects of one sort or another. That didn’t really amount to too much in my opinion and it certainly didn’t stimulate anything because, paradoxically, it slowed the whole economy down. Because when you run a great big deficit, people get very anxious about it and it puts the brakes on things because people are afraid. They know eventually they’re going to have to pay more taxes, or there’ll be more inflation-one way or another, something has to be done with the debt that they’re running up.
And you have just the opposite of what, you know, many people are taught in economics textbooks-that if you have a bigger government deficit, you have a so-called Keynesian fiscal stimulus, you stimulate the economy. No. You contract the economy. It’s a contractionary policy. So the stimulus package actually is one reason that the economy has been so retarded.
Edward Harrison: It was somewhat effective in terms of getting the economy back by… Basically when Lehman Brothers went down, that was at the end of the third quarter of 2008. By the middle of 2009, the economy was back into a technical recovery. And so basically, in conjunction with the stimulus, the economy moved into a technical recovery and it stayed there ever since.
So in a real sense it did provide the necessary kick to get us through at least a year or so, but already by 2010 you could see that the effects of the stimulus had started to fade and the economy had sort of been in this low-growth phase for about a year now.
US Congress [archival]: The yeas and nays are ordered and the clerk will call the role. [Woman starts calling role of names]
Journalist [archival]: After so many months and so much doubt, finally a vote.
US Congress [archival]: If not on that question, the ayes are 74 and the nays are 26…
Journalist [archival]: And with that, the US stepped back from the brink. It ended what many regarded as an unprecedented political struggle. The vote in congress gives the US Treasury immediate access to $400 billion in new borrowing and cuts the deficit by a little over $2 trillion over ten years. And it’s not over. The hard choices about additional savings have now been put to a special committee, which must report back by November.
Senate Minority Leader Mitch McConnell [archival]: We need to quit doing what we’ve been doing. Quit borrowing, quit spending, quit trying to raise taxes, quit over-regulating, and let the private sector flourish.
Steve Hanke: It will start bringing the government spending as a proportion of the total economy-this so-called GDP measure-it’ll bring that down from around 25 per cent to 23 per cent, or something like that. But I do not think what they have done today, as we speak, in Washington DC, is going to change the overall mood and the overall level of confidence in the economy and confidence in economic policy or vision.
Richard Sylla: The United States of America is a country that has always been bailed out by economic growth. I mean, it’s been a country that’s been growing since the beginning, since the 1790s. Generally, when the country has problems they aren’t always solved right away, but higher economic growth generates more government revenue and the problems seem magically to go away as the economy becomes bigger. I suspect that’s what will happen this time, or at least that’s what we can hope will happen based on past experience.
Steve Hanke: The name of the game is, restore confidence you’ve got to shrink the size of the federal government dramatically and talk about things like having a stable dollar is important, having less regulation. You’ve really got to go back and reproduce somebody like Reagan or-in your context-like Lee Kuan Yew in Singapore. Go back to 1965, when Lee Kuan Yew came in, and Singapore was a complete basket case after literally being thrown out of Malaysia. And you came in with a leader who had a vision and he said, ‘Look, we’re not going to waste our time passing the begging bowl, we’re going to have a competitive free market economy and have civil servants that are first class and pay them first class wages.’ And you know the rest of the story. It worked.
Edward Harrison: Really you need to put everyone back to work. You need to take the maximum productivity that you can out of your economy. And so instead of concentrating on cutting government spending, really the United States should be concentrated on reallocating resources to areas of the economy that have prospects for growth going forward. And that would automatically cut the deficit.
To the degree that the deficit’s a problem going forward, it’s largely a question of military spending in the United States, which is much larger than the rest of the world, and also the entitlement spendings; that is, pensions for retirees-state pensions-and healthcare for retirees. Those are the only real questions in terms of the deficit over the long term. All the other stuff is insignificant by comparison.
So basically what we’re doing now is only going to create problems that will make the deficit worse over the short to medium term.
Annabelle Quince: So how do you see the next couple of years for the US and the US economy?
Steve Hanke: Well, two years is quite a long period of time for an economist to be giving a forecast, Annabelle, but I would say for the next year I’m very comfortable with the tack I’ve been on and been writing about. Ever since this fiasco of 2009 occurred, I have said that at best we can expect what’s called a growth recession, and that is we’re growing-there’s positive growth-but the growth is actually at a lower rate than the overall long-run trend rate of growth of 3.1 per cent that we’ve realised in the United States over a long period of time.
So very sluggish growth and a very bad state of affairs, economically. I just don’t see a lot of light at the end of the tunnel right now in the United States-and Europe is even worse.
Edward Harrison: What I think is likely to happen is that we’re going to have some cuts-they’re not going to be enormous cuts, but they’re going to be large enough. The United States is at stall speed right now. Manufacturing is near as a contraction point. We also have monetary policy which has become less accommodative in the US and we are starting to see a lot more job cuts.
So what that means is any sort of shock that we get to the economy will cause the United States to tip into recession.
So I would say that at this point we’re looking at, say, a 30 per cent likelihood of recession. It could be higher going forward, depending on how things progress. And this is exactly the same sort of thing that we saw in Greece when they went to austerity; we saw the exact same thing in Ireland when they went to austerity; that austerity that tipped the economy into recession increases the deficit as opposed to decreases the deficit. And so the United States would be in a worse situation as a result. This is exactly what happened in Japan in 1997 and also what happened in the US in 1937.
Annabelle Quince: Today’s guests were Edward Harrison, economic analyst and the founder of web site Credit Writedowns; professor of applied economics at Johns Hopkins University, Steve Hanke; Professor Richard Sylla, economic historian at New York University; and Steven Keen, associate professor in economics at the University of Western Sydney.
Announcer [archival]: Chief Justice Hughes will administer the oath to Franklin Delano Roosevelt.
Franklin Delano Roosevelt [archival]: This great Nation will endure, as it has endured, will revive and will prosper. So, first of all, let me assert my firm belief that the only thing we have to fear is fear itself.
Annabelle Quince: And if you’re interested in economic history, check out the website for a program that traces the events that led to the Great Depression and the historical arguments surrounding Roosevelt’s New Deal.
Judy Rapley is Rear Vision’s sound engineer and I’m Annabelle Quince. Thanks as always for joining us.
Associate Professor in economics and finance at the University of Western Sydney and author of Debunking Economics: the naked emperor of the social sciences.
Professor of Applied Economics at Johns Hopkins University
Economic analysis and the founder of economic web site — Credit Writedowns.
Professor of The History of Financial Institutions and Markets and Economics, at New York University.
Title: Debunking Economics: the naked emperor of the social sciences
Author: Steve Keen
Publisher: Pluto Press & Zed Books, Sydney & London 2001
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