Wed Apr 14th, 2010 at 04:38:12 AM EST
There is a very insightful, very long guest post in Naked Capitalism:
The Origins of the Next Crisis Edward Harrison Naked Capitalism
William White, the former chief economist at the Bank of International Settlements (BIS) gave an important speech at George Soros' Inaugural Institute of New Economic Thinking (INET) conference in Cambridge. While everyone is casting about for the one magic bullet solution which would have prevented this and future crises, he placed the blame for the credit crisis on short-termism, pointing the finger most notably at economists and their models. White said that the models almost all economists use are `flow' models which leave no room for 'stocks' and thus completely miss unsustainable secular trends.
Video of Wm. White here. (18 minutes.)
In essence, White was saying: "it's the debt, stupid." When aggregate debt levels build up across business cycles, economists focused on managing within business cycles miss the key ingredient that leads to systemic crisis. It should be expected that politicians or private sector participants worried about the day-to-day exhibit short-termism. But White says it is particularly troubling that economists and their models exhibit the same tendency because it means there is no long-term oriented systemic counterweight guiding the economy.
This short-termism that White refers to is what I call the asset-based economic model. And, quite frankly, it works - especially when interest rates are declining as they have over the past quarter century. The problem, however, is that you reach a critical state when the accumulation of debt and the misallocation of resources is so large that the same old policies just don't work anymore. And that's when the next crisis occurs.
Yves Smith was an invited attendee at the inaugural meeting of George Soros's Institute of New Economic Thinking. Edward Harrison is the author of the blog Credit Writedowns, (come the day we actually have some!) and oft times guest contributor at Naked Capitalism, a seeming kindred spirit and, I suspect, to some extent a collaborator with Yves in developing an understanding what has happened in the economy and in finance and what can be done. He has been over some of the ground covered by William White and here he further develops the explaination of why mainstream economists failed to see the GFC coming:
The concentration of economic models on flow
First, from a post called Why economists failed to anticipate the financial crisis"," I echoed White's sentiments when reviewing a widely read piece by Paul Krugman on why economists failed to anticipate the crisis:
Paul Krugman is a Keynesian. So, his prescription is fiscal stimulus. Have the government pump money into the economy and it will alleviate some of the pressure for the private sector. There is some merit to this argument on stimulus. Many Freshwater economists say monetary stimulus is what is needed. If the Federal Reserve increases the supply of money, eventually the economy will respond. This is what Ben Bernanke was saying in his famous 2002 Helicopter speech at the National Economists Club.
Yet, I couldn't help but notice that Krugman mentioned the word debt only twice in 6,000 words. In fact, it is in the very passage above where Krugman uses the term for the only time in the entire article. And here Krugman refers to government debt; no mention of private sector debt whatsoever. I have a problem with that....
This economic Ponzi scheme is what I have labeled the asset-based economy. As with all things Ponzi, it must come to a spectacularly bad end. One can only Inflate asset prices to perpetuate a debt-fuelled consumption binge so far. At some point, the Ponzi scheme collapses. And we are nearing that point. We still have zero rates, massive amounts of liquidity, manipulation of short-term rates, manipulation of long-term rates, and bailouts galore a full 15 months after Lehman Brothers collapsed. This is pure insanity.
The reason economists failed to anticipate the crisis is because they were fixated on avoiding downturns and driving the economy to unsustainable growth rates by using debt to consume today what will be earned in the future. Debt is the central problem. When debt to income or debt to GDP doubles, triples and quadruples, it says you have doubled, tripled and quadrupled the amount of future earnings you are consuming in the present (see the charts here and here). That necessarily means you will have less to spend in the future. It's not rocket science.(Emphasis added.)
Harrison discusses the charts linked in the preceding paragraph and notes that "Debt levels at the end of Q2 2009 are 357% of GDP, a massive increase from the 160% that prevailed in 1982." He then brings up The Doom Loop, citing Simon Johnson and Peter Boone and, of course, himself:
The Doom Loop of ever lower rates and increased leverage
These are not just increases in relative debt loads. We are talking about debt increasing at a rate out of all proportion to the underlying rate of economic growth. This increase in relative debt burdens is quite unhealthy and has created an ever-lower interest rates to prevent economic calamity followed by an ever-increasing severity of financial crisis, the Doom Loop.
What is the doom loop?
It is the unstable, crash-prone boom-bust lifestyle we have now been living for some 40 years, where a cycle of cheap financing and lax regulation leads to excess risk and credit growth followed by huge losses and bailouts. With interest rates near zero everywhere, the doom loop seems to have hit a terminal state where debt deflation and depression are the only end game unless serious reform measures are taken.
Source: The doomsday cycle, Peter Boone and Simon Johnson
Because these measures themselves are deflationary and depressionary (with a small-d), in my view, they will not be taken.
Simon Johnson described the Doom Loop using pictures of some of the major players from the latest go round the loop (graphic below).
Johnson sees large too-big-to-fail banks at the heart of the problem. Citigroup has been at the center of every major crisis. That is testament to both how important and how dangerous these companies can be. Clearly, these companies are important. For example, the big six banks (JPMorgan Chase, Wells Fargo, Bank of America, Citigroup, Goldman Sachs and Morgan Stanley) own assets equal to 60% of U.S. GDP where it was 20% just a few decades ago. This makes these organizations too big to fail and affords them an implicit federal backstop which tilts the playing field by translating into cheaper funding costs.
Harrison describes how lower and lower interest rates make increasingly large amounts of debt serviceable, how this leads to a debt servicing mentality and then, amusingly, uses Paul Samuelson's vintage 1948 textbook to show how this is unsustainable:
Today few economists regard Federal Reserve monetary policy as a panacea for controlling the business cycle. Purely monetary factors are considered to be as much symptoms as causes, albeit symptoms with aggravating effects that should not be completely neglected.
By increasing the volume of their government securities and loans and by lowering Member Bank legal reserve requirements, the Reserve Banks can encourage an increase in the supply of money and bank deposits. They can encourage but, without taking drastic action, they cannot compel. For in the middle of a deep depression just when we want Reserve policy to be most effective, the Member Banks are likely to be timid about buying new investments or making loans. If the Reserve authorities buy government bonds in the open market and thereby swell bank reserves, the banks will not put these funds to work but will simply hold reserves. Result: no 5 for 1, "no nothing," simply a substitution on the bank's balance sheet of idle cash for old government bonds.
Who knew! Samuelson the seer. He could have been describing our current situation from observation, but was basing this on observations made during the '30s. Plus ça change, plus c'est la même chose.
Harrison then cites Richard Koo's presentation at Soros's Forum on the subject of balance sheet recessions. Koo notes that even with zero central bank interest rates there are no borrowers. Businessmen know they are underwater and use earnings to pay down debt. Zero interest rates are useless as a means of stimulating the economy. This is what he calls "a balance sheet recession. Instead of seeking to make profits, businesses are paying off debt. Growth cannot resume until businesses are solvent and if the government ceases to spend, the economy collapses. Japan has been there.
Harrison concludes thus:
I see the increase in public sector debt in a balance sheet recession as a socialization of losses. If you look at any economy that has suffered steep declines in GDP, what we have seen are a reduction in tax revenue, an increase in government spending and bailouts. This is true in Ireland, the UK, and the U.S. in particular. In effect, what is occurring is a transfer of the risk borne by particular agents in the private sector onto the public writ-large. The magnitude of this risk transfer via annual double digit increases in debt-to-GDP is breathtaking.
Finally, these debt levels are unsustainable for the world as a whole. Japan has been able to run up public sector debt to 200% of GDP because it alone was in a balance sheet recession and its private sector was willing to fund this debt. But, things are vastly different now. Sovereign defaults are likely. The debt crisis in Greece is a preview of what is to come. Those debtors which attempt to most increase the risk transfer onto the public will soon find debt revulsion a very real problem. And what will invariably happen is that a systemic crisis will ensue. Fiscal stimulus is warranted, but deficit spending as far as the eye can see risks a catastrophic outcome. This is a very different world than we lived in during the asset based economy. But it also a different world than Japan has lived in over the last two decades.
There are four ways to reduce real debt burdens:
1. by paying down debts via accumulated savings.
2. by inflating away the value of money.
3. by reneging in part or full on the promise to repay by defaulting
4. by reneging in part on the promise to repay through debt forgiveness
Right now, everyone is fixated on the first path to reducing (both public and private sector) debt. I do not believe this private sector balance sheet recession can be successfully tackled via collective public sector deficit spending balanced by a private sector deleveraging. The sovereign debt crisis in Greece tells you that. More likely, the western world's collective public sectors will attempt to pull this off. But, at some point debt revulsion will force a public sector deleveraging as well.
And unfortunately, a collective debt reduction across a wide swathe of countries cannot occur indefinitely under smooth glide-path scenarios. This is an outcome which lowers incomes, which lowers GDP, which lowers the ability to repay. We will have a sovereign debt crisis. The weakest debtors will default and haircuts will be taken. The question still up for debate is in regards to systemic risk, contagion, and economic nationalism because when the first large sovereign default occurs, that's when systemic risk will re-emerge globally.
I will be the skunk at the garden party and note that the duration of a balance sheet recession brought on by fraudulent investment activities could be significantly reduced were the guilty prosecuted, the fraudulent debts they created are repudiated, and their net worth clawed back as partial restitution. Unfortunately, this requires prying their hands off of the steering wheel. Does anyone know of an example of a parasite that releases a host in order to prevent the death of the host?