Ann Pettifor argues in The Guardian’s Comment is Free discusses some misperceptions about our current economic crisis and argues that the wrong lessons are being drawn from 1929. She writes from a UK vantage but much of the discussion is relevant to the US:
In debates about the financial crisis – on the left and right – there are five oft-repeated economic fallacies.
The first of these is that ‘economic fundamentals are sound’ and that the crisis is limited to a finance sector previously celebrated as vital to prosperity but now somehow detached from the real economy. The second is that the crisis is caused by ‘turbulence’ in the housing market. The third: that the crisis was caused by low rates of interest, in particular monetary easing since 2001. The fourth: that the UK government was guilty of profligacy during the good years. The fifth: that we should remain fearful of inflation.
These fallacies arise because our leaders have not learned from parallels in history; and because they refuse to correctly analyse the long process that has led us to the end-game that is today’s systemic crisis.
The parallel with the Great Depression is frequently drawn, while parallel events that were the cause of the disaster are ignored. After 1918 policymakers liberalised finance under the banner of the gold standard. Winston Churchill reflected on the consequences:
“The year 1929 reached almost the end… under the promise and appearance of increasing prosperity, particularly in the United States. But in October a sudden and violent tempest swept over Wall Street……… The whole wealth so swiftly gathered in the paper values of previous years vanished. The prosperity of millions of American homes had grown up a gigantic structure of inflated credit, now suddenly proved phantom. Apart from the nation-wide speculation in shares which even the most famous banks had encouraged by easy loans, a vast system of purchase by instalment of houses, furniture, cars and numberless kinds of household conveniences and indulgences had grown up. All now fell together.”
For a brief period, lessons were learned. John Maynard Keynes worked with politicians and policymakers to develop a new financial order for the world, with interest rates low and the financial sector returned to its role as servant, not master of the global economy. The Bretton Woods Agreement was not his ideal, but it led to a ‘golden age’ of prosperity unknown before or since.
Tragically, in the 1970s politicians capitulated again to the lobbying of bankers, and set in motion that which caused the Great Depression – financial liberalisation. As in the 20s, the result has been a ‘gigantic structure of inflated credit’. Bankers have lent huge sums at high, not low rates of interest. Very crudely, after adjusting for inflation, rates could be said to have doubled. High interest rates do not inhibit borrowing, but they greatly reduce the probability of repayment.
As a consequence, many firms and households over-extended themselves, and are laden with debts that ultimately cannot be repaid. This is a crisis of insolvency.
Over the same period crises became endemic worldwide. Economies collapsed in poor countries and emerging markets, but also most notably, Japan. The present Anglo-American credit crunch is rooted in the private investment collapse of 2001 – the bursting of the dot-com boom. By 2001, financing to firms had dried up because of solvency fears. Monetary easing and fiscal relaxation by Greenspan and others were a reaction to this crisis; the beginning of the end-game. Few criticised them at the time. “Essentially we took the view that unbalanced growth was better than no growth at all – which was the only other option we had,” the Governor of the Bank of England remarked in 2003.
Households and governments were encouraged to join the corporate sector’s plunge into debt to rescue policymakers – ‘guardians of the nation’s finances’ – from the consequences of financial liberalisation. The low rates of interest that powered the household boom are a consequence, not a cause of the crisis. However cheap and easy money was a privilege reserved mainly for financial intermediaries. Bankers lent to financial institutions at cheap rates. These in turn made ‘easy’ loans available, but often at much higher interest rates to firms and consumers. ‘Teaser’ and NINJA loans (no income no job or assets) became notorious, and real rates of interest paid on mortgages, credit cards etc were much higher than base rates.
Government profligacy was backed because it played a role in keeping the economy afloat through the years of the end-game. Now household and corporate debt, viewed as a share of income are at unprecedented levels in both the US and UK, and government debt is on the rise from already relatively high levels.
On ‘Debtonation 9807’ day, the finance sector finally publicly admitted that a mountain of the debts/assets on its books was bad. That many borrowers were insolvent, with sub-prime debt merely the tip of the iceberg. The consequence, as Irving Fisher analysed in 1933, will be a debt-deflationary Depression – not inflation.
Despite higher oil prices UK headline inflation was just 2.5% in March. But the core rate is falling. In March it fell again, to 1.2%, and since June 2007 it has fallen 0.8%. One has only to walk the high street to witness endless sales, special offers and two for one bargains to note that the real threat to businesses is not inflation – but deflation. Asia and emerging markets have aimed their economic capacity at providing goods and services for British and American consumers. Anglo-American recessions will cut back consumption and render this capacity spare. Factories and labour will become idle, prices will fall and deflation, not inflation, will haunt the global economy.
Sadly, economic fallacies continue to stand in the way of sensible policy-making. The Governor of the Bank of England, for example, in recent evidence to Parliament refused to concede the existence of a solvency crisis and even regards a slowdown in economic growth as helpful in reducing inflation.
In the 1930s it took driven individuals to understand the scale and systemic nature of economic failure, to get a grip on finance, to regulate lending and to subordinate the sector to the interests of the nation and the economy as a whole. At that point it was possible to apply economic remedies. In Britain we had the wise leadership of John Maynard Keynes and the US had President Roosevelt.
Their leadership drew on lessons from the past, and on a correct analysis of the crisis, not on economic fallacies.
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I keep wondering if there will be a trigger, a “aha!” moment that will make a majority realize how bad things are.
Or will we have a grinding down of the economy with consumer sentiment reaching new lows and a slow bleeding of the retail sector, followed by? …you get the idea.
Whatever happens, I do not envy the team who will take over DC in 2009.
Nice diagnosis, but the 1930s policies prolonged the agony. In the US we had a massive and futile attempt to control prices. More companies went out of business and millions of livestock were destroyed while common people starved. It does seem we’re returning to those failed policies of the 30s. Instead, how about we just let those failing financial institutions fail?
Anon
Perhaps the bailouts aren’t as effective as hoped for but at least it reduces the momentumand hopefully the impact of the turmoil as it hits retail and manufacturing.
Frankly, there may be hope for this crisis not to hit 1930s levels partly ‘cos the deflationary threat may not materialise; the choice not to consume (which is the trigger for the deadly deflationary spiral ) presumably relates to goods other than food staples, that is not likely in present times, instead, unrest relating to food inflation is likely to be a bigger threat. But the future is anyone’s guess.
“The Governor of the Bank of England, for example, in recent evidence to Parliament refused to concede the existence of a solvency crisis and even regards a slowdown in economic growth as helpful in reducing inflation.”
Well, I think the day the Governor admits that there is a solvency crisis is the day after every bank has collapsed. If he were to admit there is a solvency crisis, there would be a massive run on banks, not just by individuals, but by counterpart banks in other countries. Even if it’s true, it’s just one of those things a Governor can’t admit; it’s part of the job description.
“In the 1930s it took driven individuals to understand the scale and systemic nature of economic failure, to get a grip on finance, to regulate lending and to subordinate the sector to the interests of the nation and the economy as a whole. At that point it was possible to apply economic remedies. In Britain we had the wise leadership of John Maynard Keynes and the US had President Roosevelt.”
I think Keynes didn’t do a doggone to help in the Depression, and worse, he gave economists the idea that the problem wasn’t overconsumption but underconsumption, and not too much debt but too little debt. The trending upwards of debt/GDP ratio these past fifty years is because of Keynes.
If you, meaning Ann Pettifor, propose theories that differ sharply from the consensus, then the proof you offer must be somewhat stronger as well. This article fails miserably on that count; Some things that need backing not mere asserting are :
Tragically, in the 1970s …
Bankers have lent huge sums at high, not low rates of interest. Very crudely, after adjusting for inflation, rates could be said to have doubled.
She doesn’t provide a time-frame ( is that 70s reference intended to set one ?), she doesn’t tell us about durations and credit quality. Certainly, the paradigm is that real interest rates started going lower from 1982 ( cf the long bull market in bonds ) and were miserably low starting in 2001. She really needed to provide references and proof for her statement – since she doesn’t it I reject it and the implications she derives from it.
The consequence, as Irving Fisher analysed in 1933, will be a debt-deflationary Depression – not inflation.
Despite higher oil prices UK headline inflation was just 2.5% in March. But the core rate is falling. In March it fell again, to 1.2%, and since June 2007 it has fallen 0.8%.
Here she is no doubt talking about the here and now; is she using price inflation in its own right or as a proxy for the “monetary” phenomenon which would be her way of backing her assertion of debt/credit destruction and the corresponding monetary deflation. I don’t know what she means here so again I ignore it.
Her reliance on core inflation is downright dishonest. And as regards headline inflation – she should at least note that in the UK, the RPI is also published and is:
The Retail Prices Index (RPI) is the most familiar general purpose domestic measure of inflation in the United Kingdom. It is available continuously from June 1947. The Government uses it for uprating of pensions, benefits and index-linked gilts. It is commonly used in private contracts for uprating of maintenance payments and housing rents. It is also used for wage bargaining.
http://www.statistics.gov.uk/CCI/nugget.asp?ID=21
The RPI was at 4.1% in Feb. – and here are the charts for both RPI and headline CPI
http://www.statistics.gov.uk/cci/nugget.asp?ID=19
Mish does a far far better job at advancing his deflationary thesis and persuades me intellectually ( but NOT trading wise – for that I go by a inflation in some things, deflation in others thesis) than this person.
A really poor article.
-K
The writer maintains a central thesis that implies that the economic system would function effectively were our leaders to manage it appropriately.
My difficulty is this: the assumption here is that the economic-market system essentially functions in a semi-autonomous fashion, with intervention by leaders to ensure that it not run wild, and thus prone to crisis. To this degree then, while the economic system is to function semi-autonomously, the political system is required to function through intervention to ensure that that semi-autonomous function does not get carried away. For this to work, the political system, that is our leaders, must maintain some regulatory oversight.
Perhaps it is that the state/government/leaders do in fact have a more intimate association than the writer assumes, one in which there is mutual benefit that itself ensures that regulatory oversight is diminished and that the assumption of both free markets as semi-autonomous combined with government oversight is itself an illusion.
There is an abundance of evidence that government “intervention” is really part and parcel of how the economic system functions, and functions in ways that lead to system crisis. Separating out economic from political intervention may itself be the ultimate myth, one for which we have yet to come to terms with.
Perhaps eventually we need to reconcile what the relations are between government/state/leaders and the “free” market. Resolution of this would presume a fundamental change in both.
In 1929 there was this thing called a “gold standard” that made it difficult to “print money.”
The government is perfectly capable and most likely willing to borrow “unsterilized” money from the Fed for all those new programs and wars that are a comin down the pike.
As I understand it, the Fed has an option not to sell the T-Bills and simply hold them on its books. This is a great joke because the government has now borrowed money from the Fed for which it pays interest. The Fed, being a quasi governmental agency, pays a good percentage of those interest earnings back to the treasury each year, retaining enough to fund its operation.
This sounds to me like a perfect means of “printing money” that a lot of people say can’t happen. Mish, for example, would claim you can’t force people to borrow. Heck, Mish, you can certainly convince the government to borrow when most of the interest they pay comes right back to their own coffers. Those “borrowings” will pay for government subsidies and the result of that will be inflation.
What’s interesting to contemplate is the response of our international lenders to that ploy. Their logical response would be to sell off the dollar. In addition to the true “inflation” caused by the government policy of wanton borrowing, the dollar’s fall against other currencies will further exacerbate the rising cost of living.
Bernanke has made it perfectly clear that “deflation” is not going to happen on his watch.
One might argue that a dollar selloff would cause a rise in long term interest rates but that doesn’t really matter to the government. As long as the Fed holds the notes as assets and refunds accrued interest to the government, the cost of borrowing is basically nil. The interest to pay China is another matter. But the Fed can keep rates low by holding more and more debt on its books when no one bids at what the Fed decides is a “fair” price.
The result will be a dollar collapse – but that’s been the obvious outcome for a long time now.
“The trending upwards of debt/GDP ratio these past fifty years is because of Keynes.”
No. Keynes advocated deficit spending in years of economic decline and building surpluses when growth is strong. Even some politicians have understood that, notably Bill Clinton in 1993 when he risked a huge political fight to get the Federal budget on track to a surplus without a single Republican vote.
Even Reagan and Bush Sr had some residual memory of the need to balance the budget some of the time, but Bush Jr learned from Cheney that budget deficits are a gift from god to their friends in the defense and energy industries. In Cheney’s wonderful formulation: “Reagan proved deficits don’t matter.”
Reagan was able to shift the
burden of reducing the U.S. trade deficit onto Japan and Germany through an indicator system:
i.e., Japan and Germany would stimulate their economies so as to increase the demand for U.S. exports.
Funabashi in fact calls the Plaza Accord “an instrument by which the deficit
country…would be able to push the adjustment burden on the surplus countries.” The burden of excessive economic stimulus in Japan and Germany ended up being a source of domestic economic problems in each nation and a source of instability for external relations among the G7.30
30
Funabashi, Managing the Dollar, pp. 5,6. In fact, attempts to redistribute burdens of
adjustment have been a pervasive characteristic of economic diplomacy from the time of the summit at Puerto Rico in 1976. See Putnam and Bayne, Hanging Together, p. 43.
http://www.g7.utoronto.ca/ govern…larotti_g8g.pdf
The Import Price Index is used to help gauge the impact on inflation from changes in the value of the U.S. dollar. It’s an inverse relationship, whereby a lower dollar typically leads to higher import inflation, and vice versa. The impact occurs with a lag, which can vary by industry from a few months to a few years. This index is released as part of a dual report: Import/Export Price Index, yet the export portion rarely garners attention since it doesn’t feed into overall U.S. inflation.
“Keynes advocated deficit spending in years of economic decline and building surpluses when growth is strong. Even some politicians have understood that, notably Bill Clinton in 1993 when he risked a huge political fight to get the Federal budget on track to a surplus without a single Republican vote. “
Some things I disagree with. Keynes well may have advocated this, but the upward trend of debt/GDP ratio is still “because” of him. Because of his theories, people thought the way out of bad economic times was to spend (by government or by individuals). It wasn’t Greed is good, but Debt is Good. So we went into more and more debt. Unfortunately it never seems to be a “good” economic time where one should run massive budget surpluses.
Bill Clinton never had a surplus. The so-called surplus counted Social Security payments.
“I find it interesting that the Fed has always pushed the idea of transparency for everybody else, but when it comes to the Fed and this transaction, we don’t get transparency, even though we’re the taxpayers,” said Robert Brusca, president of Fact & Opinion Economics and a former chief of the New York Fed’s international financial markets division.
If Chairman Ben S. Bernanke and the New York Fed find it “appropriate,” the central bank may lend “to other primary securities dealers,” the letter said. It said the authority would apply where the New York Fed “finds that adequate credit accommodations are not available to the borrower from other banking institutions.”
Bernanke and other Fed officials have omitted the broader approval from previous statements and testimony on their March 14 decision to rescue Bear Stearns. Two days later, they opened up lending to investment banks at the same so-called discount rate used by commercial banks.
“This is an important detail that the Fed should have disclosed in its previous account of the catastrophic weekend,” said Tom Schlesinger, executive director of the Financial Markets Center in Howardsville, Virginia. Releasing such information in a piecemeal way “tends to undermine the Fed’s reputation for transparency and perhaps more broadly its credibility,” he said.
http://www.bloomberg.com/apps/news?pid=20601087&sid=aNTPg3XfMoIY&refer=home
“You shouldn’t be worried. You should be angry. We’ve just come off a multiyear orgy of irresponsibility and recklessness that’s unprecedented in the history of finance. Where was the government? Where were the regulators? How did this happen?” – Barry Ritholtz, CEO at Fusion IQ.
Foreclosure-investing is the real-estate buzzword now,” said Eric Brown, a former Phoenix home builder who is a managing director of real-estate consulting firm Robert Charles Lesser & Co. “Huge investment companies and individuals are looking to pick up properties cheap.”
Foreclosure Bus Tours has shuttled investors around Detroit, Fort Lauderdale, Fla., and Boston, and it has tours planned in Dallas and Houston as well as Maryland and Connecticut. For $97, investors get lunch and check out several foreclosure properties. Usually, a local real-estate agent and mortgage broker is on the bus to get deals going.
Some homeowners are trying to avoid foreclosure by doing short sales. But Brett Barry of Realty Executives said many lenders aren’t willing to negotiate, particularly on home-equity loans or second mortgages, and that is forcing more people into foreclosures.
Lenders won’t deal
“Lenders just won’t deal, and it makes no sense because it’s only going to cost them more money, particularly when the houses are going for so cheap at auctions,” Barry said.
Hello 1934
“In fact, attempts to redistribute burdens of
adjustment have been a pervasive characteristic of economic diplomacy from the time of the summit at Puerto Rico in 1976. See Putnam and Bayne, Hanging Together, p. 43.”
Well hell, what’s the point of having an empire if you can’t exploit your junior partners?
sk,
I agree with you that more proof backing her assertion on “real interest rates have doubled” would have been welcomed. However a couple of things jump to mind. A/ she does say that while bank lending was at low rates, it was not the case for end-users. Real interest adjusted for inflation and at the level of consummers is what is interesting, what were the real rate on ninjas? B/ she is offering this as a backdrop point to her real point, that this is a crisis of insolvency. I think few here disagree, although some have, that it is the case and not merely a liquidity crisis. You cannot run a 30 x leverage without your equity capital being wiped out by a 3.3% down trend in asset prices. All the calls for “mark to market” rule suspension is yet another semi direct observation of this “unrealized” insolvency.
Therefore the main point of her argument, that financial deregulation has brought about the current crisis cannot be dismissed off hand. Many talk about the repudiation of the Glass-Steagal act as the end-game. By allowing lenders to securitize and offload their debt, the banks have bypassed the depression era limitation of 10x leverage in the system, resulting inentities being leveraged north of 30.
The number 10 may have been too low for modern finance but clearly the current amount of debt/capital ratio of 30 is proving too high. Again it seems trivial since a 3% variation is enough to bankrupt you.
Greenspan recently made the comment that we just didn’t have the models to correctly price risk at that level of leverage. I buy that argument provided that statistical noise variation of asset prices isn’t enough to drown out the signal, to use a physics parallel.
Either way we clearly do not understand risk in a fine grained enough manner to be playing at this level of systemic leverage. That being the case, greed will only take us into those waters because after all the bankers are playing with my money, not theirs. That being the case I am all for the solution employed by our fore-fathers, namely an artificial limit on the leverage. Let our great grand children rediscover greed and question our wisdom of imposing a legislative limit.
I am no expert, but I do know this. Life in the US is gonna change and not for the better. The only thing any of us can do now is try to protect our own butts. This is gonna suck.
Good comments, except for 9:31 PM, which was spam.
Well said SK, I agree that the unsupported assertions (starting with the claim that rates doubled…) render the entire argument specious.
“The first of these is that ‘economic fundamentals are sound’ and that the crisis is limited to a finance sector previously celebrated as vital to prosperity but now somehow detached from the real economy. The second is that the crisis is caused by ‘turbulence’ in the housing market. The third: that the crisis was caused by low rates of interest, in particular monetary easing since 2001. The fourth: that the UK government was guilty of profligacy during the good years. The fifth: that we should remain fearful of inflation.”
Clearly she doesn’t read the blogs (then again nor do government officials apparently).
Comment brings up a good point which is what is the optimal capital structure for the global economy? And for that matter will the RoW let the US operate at such high levels given the malignancy that is transmuting across the globe – Mizhuno got it last week. If indeed there is a reversion t the recent “norm” then the GCBs and exporters will only have themselves to blame. With current leasdership wed to the idea that the past decade is/was a revertable mean is the most worrisome of all.
as for fdr i’ll leave it to Shales / Rothbard. Read somewhere that FDR might get some credit from saving US from socialism, which is kind of a ironic statment in the here and now, no? Perhaps it was satire.
“High interest rates do not inhibit borrowing, but they greatly reduce the probability of repayment.”
As YS points out high interest rates according to who? And neednt those intetrest rates be measiured against the returns being generated. TO borrow a phrase from excel: circular reference!
I suppose we can agree that sound money matters.
Good comments, except for 9:31 PM, which was spam.
Actually it wasn’t spam at all… you just didn’t get the joke. Read the article “Washington Lobbying Sets Record in 2007”
http://www.liveleak.com/view?i=0ab_1207948795
You thought that my claim of a 1000% return on an investment was spam, but in fact it describes the incredible return on investment that companies receiving by “buying” our legislators.