First, an apology for neglecting the blog this past week as I enjoyed the damp, cold, rainy discomfort of an English seaside resort in August. As a European, I make no apologies for taking my full entitlement to holiday each year, but should have provided warning of my impending leave as I posted last Friday. I regret not being active in the discussion which the Fisher Debt-Deflation Theory prompted, and will follow up with a further post taking up some of the many substantive comments when I’ve returned to my office and can organise myself again.
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We are likely in future to have great debates on the who, how, why and wherefore of the coming recession/depression, particularly if it leads to global conflict and currency realignments that mark the end of Bretton Woods II and US economic hegemony. At base we have the quote I opened with last week:
“Panics do not destroy capital; they merely reveal the extent to which it has been destroyed by its betrayal into hopelessly unproductive works.”
- Mr John Mills, Article read before the Manchester Statistical Society, December 11, 1867, on Credit Cycles and the Origin of Commercial Panics as quoted in Financial crises and periods of industrial and commercial depression, Burton, T. E. (1931, first published 1902). New York and London: D. Appleton & Co
The difficulty is that the policies which financed highly leveraged unproductive works are extremely popular to the extent of representing the culture of at least two generations. While a deflationary recession/depression will make such policies even more costly and destructive than they have been in getting us to the critical point of failure, the same policies are such basic political drivers that without a culture change political and economic change become almost impossible.
It should be obvious that borrowing short through commercial paper to lend long on mortgages and credit cards to bad credits with inadequate collateral is not a sound business model. And yet somehow the alchemy of securitisation with a sprinkling of AAA pixie dust was widely accepted as turning financial lead into gold. It should be obvious that a house, once built, is not a productive asset as it produces no revenue but instead absorbs a high proportion of its owner’s income on mortgage interest, property taxes, maintenance and utilities. It should be obvious that credit card debt, once consumption goods are purchased, produces no productive income stream for repayment of the debt but instead becomes an obstacle to future consumption as debt service eats up a rising proportion of stagnant wages. It should be obvious that a car that weighs twice as much and uses twice as much fuel is not as productive as a car that is small and fuel efficient, and costing twice as much will harm more productive savings and investment with the excess debt borrowed for its purchase. It should be obvious that the financial sector, as intermediaries between savers and productive ventures requiring capital, should never rise to the point where it alone represents over thirty percent of economic activity. Nonetheless, markets all over the world carelessly followed the path of under-production, dis-savings and over-consumption as the path to prosperity rather than a betrayal of capital into hopelessly unproductive works.
It will be a very brave politician indeed that says that young people should save twenty percent cash for a downpayment on their first home (as is the rule generally in countries that never experience boom/bust property cycles like Germany and Switzerland). It will be a very brave politician indeed that says that consumers should save cash to purchase electronic goods and cars. It will be a very brave politician indeed that raises taxes on single family housing and privately owned cars in the face of a sustained housing market crash and sustained high oil prices. It will be a very brave politican indeed that says that the financial sector should not be government subsidised with tax breaks on interest, tax breaks on unproductive speculation, tax avoidance through off-shore registration of hedge funds and private equity, and other magnanimous means of raising election year contributions.
In short, the system which has for sixty years precipitated the greatest debt cycle in history may be inadequate to address the greatest deflationary cycle in history if it chooses to prescribe the same snake oil which sickened the economy in the first place rather than the balanced (fiscal) diet and (strict economy) excercise we all know would be better for us.
Even bank supervisors, who should know better than others that rapid asset growth is the surest indicator of bank failure, chose instead to believe the hype and ignore the reality. Instead of intervening to curb credit excess, regulators congratulated themselves on overseeing a robust and innovative financial sector while rewriting their rulebooks to embrace the market’s delusional ratings-based models for undercapitalising greater and less transparent risks.
If the core problem leading to the current seizure of the credit markets is the misallocation of credit into unproductive works during the boom years, then no amount of new credit will solve the problem unless the distortions promoting misallocation are redressed through fiscal and regulatory policy changes. Bailouts and recapitalisation of failed policies of the past are only digging a deeper hole, betraying more capital of younger generations into the unproductive works financed by the current generation.
Correcting the bias toward betrayal of capital will not be popular or easy. Correcting the bias toward unproductive investments will require a massive change of political structures, financial intermediation channels, savings and consumption habits, and economic incentives which challenge virtually every assumption made by at least two generations of American businessmen and consumers and exported globally.
Regulatory policies promoting misallocation of capital included elimination of restrictions on bank dealing and brokerage of securities and derivatives, self-determined models-based capital adequacy calculation, ratings-based weightings of capital assets, accounting reforms that permitted off-balance sheet financings and acceptance of ill-transparent corporate structures. Re-knitting that sweater/jumper, however ill-fitting and itchy, won’t be easy either.
Consumer credit is viewed as a fundamental necessity by virtually all classes of the workforce. Weaning the populace from borrowing to saving would require a huge shift of policy and popular culture. Few of the generations raised on instant gratification of desire will gracefully or voluntarily shift to living within their means and saving for their future requirements.
In short, there are no easy answers. We have hypothecated our future prosperity to repayment of our current debts. We will live less well in future, as will our children for a time. Whether by inflation or deflation our debts must be extinguished. Savings must be encouraged and must be allocated to productive investments that will yield not just future prosperity but social equity to minimise political conflicts.
Those who sold us or imposed on us the current set of policies and practices will be re-bottling their snake oil under new labels. We must be wary before buying bulk lots in the tens of billions of dollars worth of the same old snake oil that has sickened our economies and political processes already. In the US, I class the bailouts of Bear Stearns/JPM and Freddie/Fannie as snake oil, that perpetuates the subsidies to speculation and unproductive housing markets. In the UK, I class the talk of a cut in stamp duty (a transfer tax on house sales) as similar snake oil. Snake oil, unfortunately, wins elections because it appeals to constituencies that are politically important. As a result, we may be entering a dangerous phase where the democratic structures are biased to economically damaging policies that further harm future growth and prosperity because investment in unproductive works is so widespread as to form part of the popular culture.
Deflation challenges many of the assumptions that work in an inflationary context: “Property is a safe investment.” and “You’ll be fine in equities in the long term.” and “Governments don’t default.” When people are forced to reconsider these cherished touchstones of their financial beliefs, they will also reconsider the cherished notions of their political beliefs. It was under similar conditions that nations in the past embraced racial hatred, ethnic divisions, discrimination against gender/sexual preference, economic imperialism and war as a means of directing public discontent away from threatened elites.
Just bear in mind who sold you the snake oil that sickened you, and be wary of new bottles of whatever shape or size from the same salesmen.
Hattip: Steve Phillips who traced the Mills quote back to the original and corrected my attribution.
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