Archives for posts with tag: banking crisis

I’ve been struck by how weather forecasters face some of the same types of difficulties  that beset macroeconomics. Both have to rely on “natural experiments” (ie events) as a way to test whether they have an understanding of how the system works. In each case, the systems they work with are extremely complex and chaotic. Weather forecasters make a tremendous effort to continuously assess how well their forecasts perform. They recognize that such forecast verification is crucial for progress to be made. The verification process itself is not trivial. Often the most important predictions are knowing when there is a heightened risk of an extreme event such as a severe storm moving from the ocean over the land. It can be much more valuable to have better (though still probabilistic) awareness of possible extreme events than to have precision for normal weather. Weather forecasters fully recognize that; they use a variety of different types of modeling systems and wide variety of verification approaches. An analogy between weather forecasting and macroeconomic forecasting is not a novel idea and the BIS has made the analogy with severe storm prediction methods to call for more probabilistic forecasting to help spot risks of financial crisis.

There is great controversy over whether or not the 2008 global economic crisis was predicted by heterodox economists employing stock flow consistent models. The mainstream macroeconomists claim that such predictions of imminent crisis were continuously being issued by various mavericks and so (just as a stopped clock is right twice a day) harebrained doomsayers eventually got lucky. There is also controversy over whether macroeconomics is entangled with politics. Some economists profess that they are politically impartial scientific observers and technocrats whilst others say that they (perhaps unwittingly) are party to an inextricably political process. Margret Thatcher famously acknowledged that for her,

Economics are the method; the object is to change the heart and soul.

To my mind both these controversies need to be dealt with head on by a comprehensive and transparent program of continuous verification of macroeconomic approaches. It is not enough to have occasional ad hoc predictions leading to an unresolvable mess of anecdotes as to what approach does or doesn’t provide insight. It is also vital for the public to see how the economic policies being implemented are predicted to influence future outcomes. If an economic policy is being implemented and the widespread prediction is that it is going to greatly increase the risk of economic crisis or depression, then the public deserve to know. Comprehensive public forecasts would throw up an endless stream of material for journalists to discuss and for politicians and their economic advisers to be held to account over.

A verification system would work best if every macroeconomics program hoping for respectability continuously provided a standardized and wide-ranging set of predictions (including probabilistic assessments of tail risks) stretching for various time spans into the future (from weeks to many years) for a wide set of countries. It is crucial that every participant provided forecasts for the wide set of countries or otherwise the data would be too thin to spot whether any branch of macroeconomics had managed to develop predictive power. The predictions would be most valuable if they included metrics that had direct real importance. As well as financial measures such as  household income (and discretionary income level) level and wealth at each decile, inflation, GDP,government debt level and current account deficit; I think it would be useful to include unemployment, labor participation, energy use and child mortality rates.

I think much of the problem with macroeconomics stems from a misplaced reverence for microfounded mathematical models. It is great whenever a phenomenon can be successfully described mathematically but we need to face facts and accept when that is still beyond us. Many fields of science make progress without being at a stage where mathematical modelling can provide much insight. Some people make valiant attempts to mathematically model the development of embryos based on diffusion of proteins and such like. As yet however that approach hasn’t been what has driven the bulk of the advances that have been made in that field. The useful models have largely been crude flow diagrams that provide little more than an expected direction for an outcome. Nevertheless it is much much better to actually know whether something is likely to increase or decrease than to have a fancy model that gives you the wrong answer. What I’m calling for is for macroeconomists to simply do their best to predict what the economy will do. The methodology could be as crude as simply having a check list of “good” and “bad” economic policies. Let’s just see what predictive method works best. Bringing this back around to the comparison with weather forecasting, some of the current controversies in macroeconomics are more akin to arguments as to how gross geography influences climate. Some economists predicted that the fiscal regime in Latvia would cause a depression when others said it was a recipe for prosperity. That dichotomy of opinion is as extreme as if we still hadn’t established whether the weather was cooler near the poles or near the equator.

Economic policies conducted in various parts of the world over the years do seem (with hindsight) to have made profound transformations to how economies have developed. Consider how Singapore has transformed from the poverty it found itself in at independence to having widespread affluence. The financialization and crisis in Iceland was dramatic but the people there didn’t subsequently suffer the real poverty that for instance occurred in Russia in the 1990s. Perhaps the most shocking economic phenomenon has been the persistent extreme poverty of the world’s poorest two billion people. If the globalized capitalist economy is seen as an integrated system that we are all responsible for, then that is a shameful failure causing millions of avoidable deaths. If, in the developed world, we enact some facilitation for capital flight or agricultural tariff adjustment that led to forecasts for increased child mortality rates across Africa, then the public might recoil with a “not in my name” type protest. Comprehensive forecasts could help to expose such issues.

Macroeconomists often make pronouncements about the worthiness or otherwise of various policies such as monetary policies, tax structures, labor regulations or deficit levels. I simply want them to pin themselves down to making formal predictions as to the outcomes from the myriad of natural experiments that our world economy continuously provides us with as events unfold. Some macroeconomists might counter with the view that their subject is about deep theoretical insight rather than petty forecasting. My view is that such insight is as worthwhile as it is useful for informing a predictive understanding.

Related stuff on the web:

WWRP/WGNE Joint Working Group on Forecast Verification Research

Continually improving our forecasts -Met Office

Moving towards probability forecasting -Bank of International Settlements

Economics Education and Unlearning -Post-Crash Economics Society

Who Are These Economists, Anyway? -James K Galbraith 

What does it mean to have “predicted the crisis”? -Noah Smith

Simon Wren-Lewis Defends the Status Quo -Nick Edmonds

 Are macroeconomics methods politically biased?- Noah Smith

Can economists forecast recessions? Some evidence from the Great Recession- Hites Ahir and Prakash Loungani (link added 30May2014)

Macroeconomic model comparisons and forecast competitions -Wieland and Wolters (link added 20Oct2014)

On Macroeconomic Forecasting- Simon Wren-Lewis (link added 01Jan2015)

Forecast errors -Bank of England (link added 01Jan2015 ht Simon Wren-Lewis)

Larry Summers gave an IMF speech on Nov 8th where he acknowledged that since the 2008 crisis, the USA has had a “jobless recovery” and that the economy is still floundering well below potential. I’m glad that he is drawing attention to all of that. What I disagree with is his suggestion that we need encouragement of asset bubbles as a way to cope with this reality.

It is as well to note exactly what Larry Summers said:

“Then, conventional macroeconomic thinking leaves us in a very serious problem; because we all seem to agree that, whereas you can keep the Federal funds rate at a low level forever, it’s much harder to do extraordinary measures beyond that forever — but the underlying problem may be there forever. It’s much more difficult to say, well, we only needed deficits during the short interval of the crisis if aggregate demand, if equilibrium interest rates, can’t be achieved given the prevailing rate of inflation.

And most of what would be done under the auspices — if this view is at all correct — would be done under the aegis of preventing a future crisis would be counterproductive, because it would in one way or other raise the cost of financial intermediation, and therefore operate to lower the equilibrium interest rate that was necessary. Now this may all be madness, and I may not have this right at all; but it does seem to me that four years after the successful combating of crisis, with really no evidence of growth that is restoring equilibrium, one has to be concerned about a policy agenda that is doing less with monetary policy than has been done before, doing less with fiscal policy than has been done before, and taking steps whose basic purpose is to cause there to be less lending, borrowing and inflated asset prices than there was before. So my lesson from this crisis is — and my overarching lesson, which I have to say I think the world has under-internalized — is that it is not over until it is over; and that is surely not right now, and cannot be judged relative to the extent of financial panic; and that we may well need, in the years ahead, to think about how we manage an economy in which the zero nominal interest rate is a chronic and systemic inhibitor of economic activity, holding our economies back below their potential.”

Throughout this blog I’ve being trying to explore ideas for a reconstruction of our economic system  both to address exactly the “secular stagnation” issue that Larry Summers recognizes AND avoid asset bubble induced financial crises. To me the key is to replace the current tax system with a tax on gross assets.

Furthermore I suspect that asset bubbles actually worsen the underlying root cause of secular stagnation. Over the long term, the only way that bubbles offer relief is by forcing fiscal stimulus in the form of bailouts to clear up the mess after the bubble bursts. As the bubble builds, the private sector appears to be creating prosperity by itself. Once the burst happens, the damage could more than make up for that except government deficits induced by bailouts mitigate the crunch. It may be politically more acceptable to have such “disaster relief” than to have everyday fiscal stimulus but it is exceptionally regressive and wasteful. The private sector becomes distorted into becoming a bailout harvesting machine.

It might be argued that bubbles act as a sort of asset tax in that they cause wealth to be moved out of safety and splurged on malinvestments -creating jobs in the process. People become employed building ghost estates of unwanted houses or making patent applications for pretend biotech innovations or whatever. However I suspect that the people who predominantly get fleeced by such bubbles are minor savers saving for retirement. Retirees who’s pension savings went towards buying insanely overvalued stock in 2000 are now cutting back consumption as a consequence of having lost those savings. The major players  profited not only at the expense of the real economy but also at the expense of all those “dumb money” savers who bought high and sold low. In that way bubbles actually worsen the wealth inequality that is at the root of the whole problem.

Related stuff on the web:

No, Larry Summers, We Don’t Need More Bubbles -Clive Crook, Bloomberg

Secular Stagnation, Progress in Economics -JW Mason (link added 27nov2013)

The Onion Revealed As Mystery Source Of Larry Summers’ And Paul Krugman’s Economic Insight -ZeroHedge

Secular Stagnation, Coalmines, Bubbles, and Larry Summers -Paul Krugman

The Economy almost certainly needs Bubbles -Michael Sankowski

Why Do the Rich Save So Much -Christopher Carrol

Innovation, Stagnation and Unemployment -Ashwin Parameswaran (link added  30nov2013)

Tapping the Brakes: Are Less Active Markets Safer and Better for the Economy -Stiglitz (link added 21April2014)

appendix (this is an excerpt from the pdf that I started this blog off with)

A zero interest rate policy does not reduce the financial overhead

It is sometimes celebrated that the current ultra-low interest rate regime supposedly reduces the “unearned increment” taken by “rentiers”. Some politicians effuse about the exceptionally low “cost of capital” enabled by the current financial climate. Interest free credit for the financial system means boundless financial leverage. Financial leverage powers the ability of the finance industry to feed off of financial instability and also creates and amplifies such instability.

The current zero-interest rate policy was brought about in Japan to save the Japanese banks after their stock market and real estate price collapse of 1990 and then in the USA and UK after the global asset bubble burst in 2008. Reducing interest rates tends to boost asset prices. Ultra-low interest rates also enable banks to “earn their way out of insolvency” by conducting interest rate arbitrage especially across national boundaries to regions with much higher interest rates. In fact just such a “carry trade” between Japan and the rest of the world provided some of the impetus for the bubble in the lead up to 2008. The impact of zero interest rates runs much deeper than such effects however. Understanding how interest free credit benefits the finance industry requires an understanding of how financial markets extract cash flows via price volatility. Potentially a fluctuating price can be harvested to provide a cash flow. If a security maintains roughly the same price over the long term then that means any 20% drop in price eventually being matched by a 25% rise (4/5×5/4=1), any 50% drop being matched by a 100% rise (1/2×2=1) and any 90% drop being matched by a 1000% rise (1/10×10=1). Obviously, simply holding such a security would provide no benefit as the price would simply bob up and down with no overall gain. However a 50% drop from $100 is a $50 loss whilst a 100% gain from $100 is a $100 gain. The fluctuations in the price are geometric but money is money. The fact that financial holdings can be bought and sold allows that geometric to linear inconsistency to be harvested. Simply periodically rebalancing such a holding against a holding of cash would extract financial gains. Rebalancing across a portfolio of securities with independently fluctuating prices optimises that process.

Rebalancing between financial holdings bids up the prices of whatever is cheap and bids down the prices of whatever is expensive. Such trading moderates the price fluctuations that it depends upon. However, such ‘liquidity providing’ speculation is accompanied by extensive ‘liquidity taking’ speculation that amplifies price fluctuations. If a trader envisions that prices are due to rise (or fall) then she can take advantage of such anticipated price changes.  In an idealised market where no participant had ‘an edge’ such ‘liquidity taking’ speculation would not make sense -the market as a whole would have already priced in any predictable price movement. However in the real world, market-moving levels of finance are controlled by traders who do have ‘an edge’ over the market as a whole. Liquidity panics occur when traders risk losing everything due to the market moving against their leveraged positions. Consequently, increases in the volume of trading activity typically increase rather than decrease price volatility.

Security trading is a zero sum game. For every participant who buys low and sells high someone else has to have sold to them and bought from them. Certain financial securities are firmly linked to the real economy. Commodity futures set the prices for essentials such as crude oil, grains and industrial metals. Producers and processors of such commodities have real world considerations when they decide whether to sell or buy. The real economy provides the “chump” who ends up buying high or selling low so as to provide the trading gains for financiers. Previously, the borrowing cost for the funds used for trading limited such financial extraction. Interest free credit removes that constraint.

The dream of “popular capitalism” was for everyone to own stocks and align with capitalistic interests to benefit from corporate profitability and efficiency. Various government schemes endeavoured to induce households to buy stocks. However a shift in the capital structure of many companies allows much of the potential benefits to slip past “mom and pop” type stock holders. In principle, the stock market provides a mechanism for distributing corporate profits amongst the shareholders. However, companies can decide to take on debt such that much of the cash flow services the debt instead of going to profits. Low interest rates favour such corporate leverage. Corporate debt is encouraged by the current severe taxes on corporate profits. Debt servicing costs are fixed ahead of time whilst the corporate cash flow varies according to the varying fortunes of the company. Once a fixed block of cash flow is pledged to creditors, any variation becomes proportionately much more dramatic for the remaining profits. The consequence is amplified share price volatility. Management payment in the form of stock options especially encourages a capital structure orientated towards inducing share price volatility.

A highly indebted company needs to nimbly keep the debt burden serviceable by either paying off debt if tough times are envisioned or expanding the debt and buying back stock when times are good. In effect the company itself acts as “the chump” using profits for share buybacks and aquisitions -bidding up oscillations in its own share price. Those shareholders who know what they are doing are able to harvest that volatility by buying and selling at opportune times. The benefits entirely pass by the other shareholders who simply hold the stock as the price bobs up and down. All of the gains pass on through to be captured by those who trade astutely. Some shareholdings last for less than a second in an effort to harvest wiggles in the price on a microsecond timescale.

When financial leverage goes wrong, the assets bought on credit may fall in value to become worth less than the money owed. Historically, bankruptcy laws were extremely harsh on debtors and so financial leverage was feared. Without limited liability laws, company owners were personally on the hook for every debt. Nowadays, however, debts can be taken on such that there is an amplification of any gain (which is pocketed) or an amplification of any loss (which becomes un-payable and so is apologized for). The bank bailouts since 2008 have taken this asymmetry to another dimension. The government stepped in and said that it would pay for all of the losses so that none would be suffered by the creditors (predominately also banks and financial institutions in a reciprocal web of lending). Richard Bookstaber summarised the strategy ,

“Innovative products are used to create return distributions that give a high likelihood of having positive returns at the expense of having a higher risk of catastrophic returns. Strategies that lead to a ‘make a little, make a little, make a little, …, lose a lot’ pattern of returns. If things go well for a while, the ‘lose a lot’ not yet being realized, the strategy gets levered up to become ‘make a lot, make a lot, make a lot,…, lose more than everything’, and viola, at some point the taxpayer is left holding the bag.”

Currently, high finance is an extremely complex business. It requires a colossal technological and human effort. The most advanced and expensive computers are dedicated to high frequency trading (HFT). The best and brightest are educated at elite universities to prepare them for the intense battle of mathematical genius that financial trading has become.  Traders pay exorbitant rents so as to have their computers next to those of the major exchanges to avoid even the slightest time delay. A private fibre optic cable has been laid directly between New York and Chicago so as to gain a microsecond advantage for comparisons between the futures and stock markets. It is easy to become beguiled by the sheer complexity and effort of it all. People marvel at superlative feats of human endeavour and the financial markets are the Great Pyramids of our time. That is not to say that it is not counter-productive and essentially moronic.

The vast sums skimmed off from the economy by the vastly expensive finance system could mostly be avoided if money used for financial leverage had a cost such as would be the case under an asset tax system. The useful functions of price discovery and exchange would be better served by pedestrianized financial markets in which all participants interacted on a level playing field. Advanced computers would be rendered pointless if transactions were conducted with a time resolution of minutes rather than microseconds. Such a time buffer would end the vastly expensive arms race in computer technology between elite traders. The current ultra-low-latency trading environment often provides a perfectly continuous price variation down to a microsecond resolution. That much applauded attribute is only of any relevance for ultra-low-latency traders in their quest to out manoeuvre other participants. Whilst advanced technology normally creates such (superfluous) pricing precision it occasionally runs amok creating gross mispricing events such as the “flash crash” of May 2010 and the Knight Capital fiasco of August 2012. A genuinely efficient financial market is one that allows prices to be formed that genuinely reflect supply and demand and does so at minimal cost. Excessive opportunities to “make money” from trading are an indication of a dysfunctional market. However, the current market structure is entirely a concoction for just that purpose. The failure of current financial markets to serve their original purpose is apparent from withdrawals.  Farmers are now making less use of futures to hedge their prospective crop yields. There has been a transfer of stock ownership from households and pension funds to financial institutions.

This post is an excerpt from the pdf that I started this blog off with. I’ve posted it because I hope it also makes sense as a stand alone post.

When Margaret Thatcher made her economic policy changes in the 1980s many economists predicted that the UK would be plunged into a vortex of impoverishment. In fact although the deindustrialization they predicted took place it coincided with increased prosperity by many measures. The resulting economic transformation was viewed as such a success that a broad political consensus was formed supporting those “neoliberal” economic policies. The Labour Party became New Labour and embraced financial deregulation and a transfer of taxation away from property and onto consumption. Wealth boomed for the wealthiest and everyone else was swept into greater prosperity along with them. Similar measures were taken in the USA and had similar results.

When reading recollections of those involved in the instigation of the Thatcher economic policies it is clear that the key aim and result was to shift from an economy where wage inflation out-paced asset price inflation to the opposite. The resulting benefit to those who already were wealthy before the transition is obvious. What needs to be understood however is how the country overall became richer on a wave of asset price inflation. How were we able to afford imported goods so much more easily than before? Seemingly by simply bidding up the price of pre-existing (or even purely paper) assets we were able to pay foreigners to do our manufacturing and provide us with natural resources that much of the rest of the world couldn’t afford.

The answer becomes apparent when the financial connections with the rest of the World are drawn into the picture. The UK became the piggy bank of the world. Foreigners were able to join in and further inflate the stock market, bond market and real estate bubble. Across the developing world, the immensely rich elite of those countries sought secure and lucrative ways to hold their wealth. The UK became a repository of choice for this “capital flight” from the developing world. When the UK bought imported goods, the money paid for them was returned back to the UK to bid up the value of our asset markets. In effect, trade became a flow of real goods (and migrant workers) to the UK in return for account statements. All that the UK needed to produce were electronic or paper documents.

To kick off this wave of financial inflow, interest rates were raised significantly above the (high) rate of inflation. This offered a potential bonanza to those buying UK treasury bonds especially if the consumer price inflation rate could be reduced. Limits on bank lending were relaxed and tax breaks were offered to those taking on debt. The government curbed labour union powers and disengaged from efforts to limit unemployment. This quashed wage inflation and so the inflationary impetus of credit expansion was channelled into asset price inflation.

The flip side of this flow of funds to the financialized developed economies was painfully manifested across the “developing” world. In fact, it made a mockery of the term “developing”. From the time of independence in 1960, Nigerian GDP increased 135% during the 1960s and then 283% during the 1970s. By contrast it shrank by 66% in the 1980s. The Nigerian Naira / USD exchange rate went from 0.78 in 1980 to 2.83 in 1985 to 8.94 in 1990 to 102.24 in 2000. With economies drained by capital flight, the developing world was no longer as able to afford global commodities such as oil, coffee, metal ores etc. That caused a slump in commodity prices and consequent further slumps in the economies of commodity exporters and so yet more incentive for capital flight.

Economic depression in the developing world was further fuelled by USD  denominated loans made by UK and US banks to third world governments. A sovereign government has no need for borrowing in a currency other than its own. Any public services such as school teaching, road building or construction of sewerage systems etc. could have been provided using local currency issued by the government to pay local people to do the work with taxes payable in the local currency ensuring the value of the local currency. Countries such as Nigeria had trade surpluses. That provided an ample potential immediate source of foreign currency to fund any imports for government use (such as weapons). The only role for USD denominated loans was for adding to capital flight. Meanwhile the western banks profited from the interest payments on the government debt. Political power in third world countries rested on being able to win over powerful cronies with the prospect of facilitated capital flight and so the dire arrangement became further entrenched.

Since 2000 however the developing world has in many cases resumed development. Hundreds of millions of people in the developing world have escaped poverty over the last decade. This has been applauded as evidence that neo-liberal economic policies have extended their benefits to everyone. Perhaps a more accurate view would be that a stage in the process of financialization has now been fully wrung out and so the choke hold over the developing world’s economies is slipping. In order to attract financial in-flows, the ideal monetary arrangement is to have high interest rates above the rate of consumer price inflation and an expectation that both inflation and interest rates will subsequently fall. The market price of any asset that provides a long term cash flow will tend to rise if interest rates fall. If an asset costing $10 yields $1 per year when interest rates are 10% then (very crudely) a drop in interest rates to 5% will tend to reset the asset price to $20. Bringing interest rates down from >10% to <1% provides a phenomenal impetus to asset markets as has occurred since 1980. However, once it is done, it is done and so wealth managers will start looking elsewhere.

A whole raft of other such policies also harvested a one off boost for asset prices. Curtailing labour union power, shifting taxation from property onto consumption, encouraging private pension saving and facilitating private sector credit expansion all added to the performance of asset holdings. What provides a real bonanza for asset holders is when there is a transition from an unfavourable financial climate to a favourable one. Once that transition has been fully priced in, much of the gain has already occurred -especially when asset values are elevated and so assets don’t provide much of an income stream. Once everything has been done to make an economy as hospitable as possible for global “hot money”, the market will price in that favour and then global “hot money” will look for a new home where the next price rises are going to occur.  This makes attracting capital flows an inherently one off rather than a sustainable way to achieve prosperity. Capital flows may unfold over decades and that may give the impression that they have provided a timeless prosperous equilibrium but ultimately sustainable prosperity depends on the real economy.

It is vital to appreciate that macroeconomic malign effects don’t require any malign intent on anyone’s part. En-mass, people simply endeavouring to manage their finances as best as possible can inadvertently cause massive waste and destruction whilst all the while being entirely oblivious of it. It is analogous to tragic incidents when people get crushed to death in large crowds. No one person is to blame, the crowd surges and crushes without any person in the crowd acting reprehensibly. That is not to say that there is not a responsibility to take crowd control seriously – quite the opposite. Some of the politicians and technocrats at that vanguard of neo-liberalism actually aimed to alleviate poverty. Their reasoning was that if money is pampered then it will spring forth rewards that can be dispensed to good causes. In their view, capital flight supposedly means that global money is continuously being deployed wherever it can earn the most. That is taken to mean that overall global wealth is maximised and so there is more to go round. The key mistake in this is that it conflates claims over real tangible sources of wealth with the underlying real tangible sources of wealth themselves. Whenever that mistake is made, policy makers inevitably fall into the trap of simply facilitating an expansion in the paper claims over wealth whilst losing sight of the underlying reality required to back-up those claims with the real economy. The true responsibility for policy makers is to ensure that the monetary framework is constructed so as to align with the real economy such that what is best for money becomes what is best for the real economy. If left to its own devices, the financial system will wander away from that ideal.  A financial system built by the financial system will direct resources towards expanding the financial overhead borne by the real economy.

Robert Peston gave a superb free public lecture on Thursday evening. He is a peerless public speaker and summed up the global financial crisis with crystal clarity. Part of his theme was that, once the 2008 crash had occurred, we were left with no alternative to our current predicament. To be honest I wholeheartedly disagree with that. I think we are where we are because extraordinary measures are being taken to get us into this pickle.

Robert Peston described how, over the past 200 years until 1980, credit growth in the UK had kept pace with economic growth. After 1980 however, credit expansion soared* whilst economic growth increased modestly -following the previous trend line. Debt owed between UK financial institutions ballooned to ten trillion pounds –as much as the gross assets of UK households. In 2008 that disparity came to a crunch when it became clear that the expanded stock of debt did not have a correspondingly expanded revenue stream to service it. Debt is only worth as much as the debtor is able to repay. The crashing revaluations in 2008 were because it belatedly became apparent that debtors were only going to be repaying according to the level of the economy. The face value of the debt was a fiction that came about because lenders had (indirectly) simply been lending more to service the existing debt burden.

Robert Peston said that journalists (including him) let us all down by failing to forewarn us all of the danger of unsustainable credit expansion. He said that in hindsight we should never have inflated the credit bubble. That is very noble of him but I wonder whether we have also been very foolish in how we have reacted AFTER creating the bubble. Have we thwarted an absolutely vital part of our economic system? Capitalism has a tendency to fail to distribute financial surplus back to debtors. Economic growth traditionally occurs in fits and starts, as credit fuels expansion, until a crash and default reboots the system; then, after much tragic waste, capitalism rises phoenix-like to repeat the process. Unless unsustainable debt gets sloughed off with such defaults, the debt strangles the economy like an outgrown shell for a crab. As money gets diverted away from consumption and investment towards instead paying down debt, the economy contracts and that further reduces the ability to service the debt.

The government response to the 2008 crisis was to backstop the debt and to prevent it from being written down as it needed to be. That was not a pre-existing obligation of the government. Potentially, the insured deposits in the banking system could have been backed fully by the government  (so ensuring uninterrupted function of the payment system) whilst bond holders for the ten trillion pounds of debt between UK financial institutions could have been left to resolve defaults in a purely commercial, private sector, manner. Presumably holders of bank bonds would have taken debt to equity conversion such that they would have become the new owners of a smaller less leveraged financial system. Robert Preston stated that that approach was avoided partly because it was feared that insurance companies would then have become insolvent since they too were major holders of financial sector bonds.

The financial regulators are charged with the job of ensuring that things never get to the point where bail outs are needed. Clearly they flunked that obligation. Radical (but simple) regulations could in principle vastly reduce financial fragility (see post). But if regulators do mess up and banks or insurance companies fail, I think we need a radically different mind-set about what sort of bail outs get done. Currently the approach is to bail out the core of the problem although the bail-out is justified on the basis of how the core problem connects to the wider economy. Obviously it would be stupid to blunder into a scenario where say hurricane damage was left unrepaired, whilst building workers were left unemployed, simply because a banking crisis had wiped out the insurance companies, leaving everyone’s insurance claims unpaid. To my mind however the appropriate government response should be to step in and directly pay those insurance claims and NOT to bail out the bank bond holders, way upstream in the chain of causality. Clearly the whole scenario is the result of a gross lapse of government financial regulation so it seems fine to me that the government steps in to pay such insurance claims. In a civilised country we should expect that when we insure our house (or even insure a ship against shipwreck), financial regulation should have ensured that any offered insurance can be honoured.

My whole line of argument may seem contradictory. On the one hand I’m saying that bank bond holders should not be protected from the realities of capitalism and on the other hand I’m saying that people should be able to blithely rely on insurance companies being able to pay out. My point is that there should be a very select few crucial financial services that are extremely conservatively regulated and have an absolute government back stop. The payment system and insurance against real events (eg insurance of buildings, vehicles, ships etc.) fall into that category. Critically the government backstop needs to not be for the provider companies but rather of the claims from the customers. So a failing insurance company would still fail but the government would write the cheques to pay the insurance claims of customers when that happened.

We need the rest of the financial system to be the zone where losses are absorbed. Finance is all about competing attempts to strive for exponential growth (1) . Obviously it is impossible not to have plenty of losses in any such system. A line has to be drawn between on the one hand insuring against shipwreck and on the other hand credit default swaps or derivatives for hedging interest rates or currency exchange rates etc. It needs to be made absolutely explicit that narrow “Main-street” insurance is government backed whilst financial derivatives are at the mercy of counterparty risk and are in an utterly separate system prone to failure.

Another justification sometimes given for the 2009 bailouts was that pensions relied on stock market prices. If there is concern that people relying on private pensions will suffer from a financial crash and government intervention is deemed appropriate to help them; then that would best be done by paying the pensioners directly by increasing the universal state pension paid to every pensioner. It is important to remember that low stock market prices would mean those saving for future pensions would be expected to get higher returns. So any such bailout of pensioners could be offset by taxes on those saving. Conversely current interventions to inflate stock prices hinder future pensions.

In 2009, Gordon Brown and Timmy Geithner were hailed as heroes for “saving the banks”. What exactly did they save? My fear is that all Gordon Brown did was to convert a near instantaneous necessary contraction of the banking system into an agonisingly slow, multi-decade contraction. What we “gain” is the maintenance of tens of thousands of elite banking jobs for the interim. Because the big UK banks RBS and HBOS were taken into state ownership, those jobs in effect are extraordinarily highly paid government jobs.  My fear is that the political establishment was so proud of having facilitated the “wealth creation” of banking expansion, that vanity clouded their judgement when it came to letting that “wealth”get written down. Stephen Hester has described the current role of the investment banking division of RBS as, “…to diffuse the largest balance sheet risk time bomb ever assembled in history”. That “time bomb” was assembled in the first place by the very same people now “diffusing” it. It is an utterly pointless exercise. The ledger could just be wiped and those people could be left to get on with something else. We might as well be employing those people to walk around behind Gordon Brown, in procession, applauding. The elite investment bankers are recruited from the worlds brightest and best. They are sort after (and needed) for alternative jobs. A tragic irony is that many would rather be doing something else.

In his lecture, Robert Peston described how, as the financial sector pays down the debts it owes itself, government debt takes its place. If debts are not written down, that is all that can happen. The banks gather money from the economy and use it to pay down their own debts. That money consequently disappears from the economy instead of circulating around being taxed. The consequent lack of tax revenue leaves government finances in deficit and that deficit replaces the intra-financial corporate debt with government debt. Unlike corporate debt, government debt has no way of defaulting. We are stuck with it unless we create a tax that can retire it. Maturation of government debt is simply a conversion to bank reserves which themselves are really a sort of government debt. I also think it is greatly mistaken to believe that a bloated stock of government debt has no malign effects (see post “Political consequences of risk free financial assets” and the section “A zero interest rate policy does not reduce the financial overhead” on page 18 of this pdf).

*The economic transition that took place in 1980 is explored in “Isn’t a financialized economy the goose that lays our golden eggs?” on page 10 of this pdf)

(1) see “Monetary expansion attempts to realise the miracle of compound interest” on page 17 of this pdf)

Related stuff on the web:

Scenarios for Recovery: How to write down the debts and restructure the financial system – Michael Hudson

Debt and deleveraging: Uneven progress on the path to growth – Mckinsey Global Institute

Insure depositors, not banks – Steve Randy Waldman

Paul Krugman’s Economic Blinders – Michael Hudson

Sheila Blair’s Bank Shot- NYtimes

The Destructive Implications of the Bailout – John P. Hussman

Robert Peston

Yes Virginia, The banks really were bailed out -Steve Randy Waldman

How an unloved bail-out saved America- FT

Not everyone can de-lever at the same time- Bill Mitchell

Secret Fed Loans Gave Banks $13 Billion Undisclosed to Congress- Bloomberg

The Crash -BBC

Goldmans Jan Hatzius on Sectorial Balances – Business insider

The “Lessons” that Wall Street, Treasury, and the White House Need You to Believe Five Years After the Collapse of Lehman Brothers – Bobert E. Prasch (link added 23Sept2013)