April 2009


Built to fail

By Satyajit Das
Illustration by Jeff Fisher.

At the beginning of the global financial crisis, the destruction of storied financial institutions was an entertaining blood sport: there was a satisfying sense of schadenfreude as the Masters of the Universe received their comeuppance. But the crisis soon spread to the real economy - jobs, consumption, investment - and is now everybody's problem. In the US more than 4 million jobs have been lost, while in Spain unemployment has reached the middle teens. Exports and production have fallen by staggering amounts in Japan, South Korea and Taiwan; an astonishing US$30 trillion of wealth has been obliterated in America alone. The economies of entire countries - Iceland and Ireland - have been ravaged.

The financial crisis coincides with another one: the global environmental crisis. Toxic debt and toxic emissions clamour for politicians' attention. Irreversible climate change, scarcities of food and water, and biodiversity loss are not unconnected to the economic system. Economists and politicians assumed that high levels of economic growth would improve living standards, rescue people from poverty and aid social development, yet most appeared not to recognise any limit to economic growth.

Tim Jackson, a professor of Sustainable Development at the University of Surrey, noted recently in New Scientist that at the 2007 launch of the Redefining Prosperity project, he and his colleagues were accused by a British Treasury official of wanting to "go back and live in caves". Redefining Prosperity was intended to raise concerns about environmental and social limits to economic growth. The global financial crisis has illustrated starkly many of those limits.

A lower-growth future will have significant political and social implications around the world: China and India, in particular, are deeply concerned about being unable to provide jobs for the millions coming into their workforces each year, and Chinese leaders have warned about rising social unrest. The world will need to adjust swiftly to a new economic order, and to reduced expectations. Governments must deal pragmatically with the global financial crisis and its potentially devastating social cost. Demagogic debates about the ideological differences between neo-liberalism and social democracy are unhelpful: in truth, all competing economic philosophies are underpinned by the same reliance on growth - by economic models that were built to fail.

At the fall of the Berlin Wall, when asked who had won, political scientists said capitalism had triumphed over socialism. Economists simply said Chicago - meaning the Chicago Graduate School of Business and its unshakeable belief in free markets, exemplified in the title of Milton Friedman's most accessible work, Free to Choose (1990). The global financial crisis marks the end of this unquestioned advocacy of free markets.

While there were egregious market failures and corporate excesses in the lead-up to the global financial crisis, its lessons may be subtler than was first evident. More than anything else, the crisis appears to be a Minsky moment. In Stabilizing an Unstable Economy (1986), Hyman Minsky hypothesised that excessive risk-taking, driven in part by economic stability, leads to market breakdowns: in essence, stability is itself destabilising. The crisis calls into question much of the prevailing economic orthodoxy; those social and political models based on high and sustainable levels of financial, rather than real-economy, growth; and the capacity of governments and central bankers to exert control over economies.

Recently, in Canary Wharf, the financial district in London's Docklands, I noticed a small street stand erected by the English teachers' union. The two affable recruiters explained that they had heard there was "a bit of financial crisis": well-educated and motivated bankers who were losing their jobs by the thousands might like to consider a new career in teaching. I questioned the adjustment in salaries - a reduction of 60-95% - that the career change would necessitate. One recruiter replied, "If you haven't got a job, then it's not relevant, is it? It was never real money, and it wasn't going to last, was it?"

The years of economic growth may well have been founded on a series of elegant Ponzi schemes, fraudulent pyramid schemes constructed on a grand scale. Global prosperity derived from a fortunate confluence of low inflation, low interest rates and low energy prices. The emergence of Eastern Europe, China and India as economic powerhouses provided low-cost labour, helping to maintain the supply of cheap goods and services, and providing substantial new markets for products and savings.

Governments of every political persuasion benefited from the favourable economic environment. That governments and central banks could control and finetune economies with a judicial mixture of monetary and fiscal policy became an article of accepted faith. Voters were lulled into a false sense of security by a mixture of rising wealth, improved living standards and apparent economic stability.

The major driver of growth was consumption financed by borrowing, particularly in the developed world. Many workers' earnings actually fell in inflation-adjusted terms, because of global competition, but they could borrow against the appreciation in the price of owner-occupied houses and other financial assets. In the new economy, there were three kinds of people: the haves, the have-nots and the have-not-paid-for-what-they-haves.

Private investors, central banks with large reserves, pension funds and asset managers channelling retirement savings - all proved eager investors in the debt that was created. Borrowing drove asset prices ever higher, allowing even greater levels of borrowing against the value of the asset. This virtuous cycle - a positive feedback loop, in finance patois - fuelled the feel-good economy of recent years.

The debt-engineered growth also extended into international trade, and substantial foreign reserves in the central banks of developing countries - essentially national savings - became the foundation for a trade-finance scheme. Currencies such as the Chinese renminbi were pegged to the US dollar at an artificially low rate to make China's exports competitive. This created an outflow of dollars as American consumers purchased more from China than they sold, based on an overvalued dollar. China purchased American debt in dollars to keep its domestic currency at a low value, and the recycled dollars flowed back to the US to finance the spending on imports. This cycle kept American interest rates and the cost of capital low, encouraging borrowing to pay for consumption and imports to keep the cycle going.

Foreign central banks holding reserves were lending the funds used to purchase goods from their country. The exporting nations were not paid - at least, not until the loan to the buyer (the vendor finance) was paid off. Freud once remarked: "Illusions commend themselves to us because they save us pain and allow us to enjoy pleasure instead. We must therefore accept it without complaint when they sometimes collide with a bit of reality against which they are dashed to pieces." The global financial crisis was the bit of reality against which Ponzi prosperity was dashed.

In the response to the global financial crisis, the disease and the cure have been confused. The disease is the excessive debt and leverage in the financial system, especially in the US, the UK, Spain and Australia. The cure is the reduction of that debt: the great deleveraging.

The first phase of the cure is to reduce debt within the financial system. Some of the debt created during the Ponzi prosperity years cannot be repaid, which has caused the collapse of major financial institutions. This process both destroys existing debt and limits financial institutions' capacity to extend credit.

The second phase is to manage the effect on the real economy. The problems of the financial sector have increased the cost, and reduced the availability, of debt to borrowers with legitimate business purposes. This forces corporations to reduce their leverage by cutting costs, selling assets, reducing investment and raising equity. It also forces consumers to reduce debt by selling assets where available and cutting back on consumption.

These negative feedback loops in turn lower economic activity, placing stress on corporations and individuals, and setting off bankruptcies - which trigger losses for the financial system, further reducing lending capacity. Deleveraging continues through these iterations until overall levels of debt reach a sustainable level, determined by lower asset prices and the availability of cash flows to service the debt.

The severity of the financial crisis was underestimated at first. In April 2007, the American Treasury secretary thought the American economy was "very healthy" and "robust": "All the signs I look at," Henry Paulson said, show "the housing market is at or near the bottom." Since the grand-mal seizure of financial markets in September and October 2008, national and international "committees to save the world" have implemented a bewildering and ever-changing array of measures to try to stave off economic collapse. The actions - dubbed WIT (for Whatever It Takes) by Gordon Brown - have focused on trying to stabilise the financial system and maintain growth in the real economy.

Governments and central banks have attempted to remove toxic debt from bank balance sheets and inject capital to cover losses from bad debts, and they have guaranteed banks' own borrowings to allow them to continue to raise deposits and borrow further. The governor of the Bank of England, Mervyn King, summed up memorably that country's support for the banking system: "The package of measures ... are not designed to protect the banks as such. They are designed to protect the economy from the banks." Governments have also provided large measures to stimulate spending and, in the US, support for the housing market; while central banks have cut interest rates to levels not seen for decades (and, in the case of the UK, hundreds of years).

Yet it is unclear whether these actions will have the desired effect. "In economics," John Kenneth Galbraith noted, "hope and faith coexist with great scientific pretension." The recent initiatives have not significantly eased credit conditions: the capital provided is sufficient to cover continuing losses, but not to restore lending and financial activity to anywhere near the level required for growth to resume. The money supplied to banks is simply not flowing into the real economy.

Politicians and central bankers have become frustrated at the failure of policy actions to restart normal financial activity. Where governments have taken substantial stakes in banks, there is a noticeable drift to ‘directed lending'. Central banks and governments are increasingly bypassing the banking system and providing finance directly to businesses; at this rate, Federal Reserve may soon issue Americans with credit cards under its own brand.

But debtors still have too much debt and are unable to service it, and until that debt is written down and restructured, credit growth may not resume. Well-intentioned infrastructure spending will take some time to have any meaningful effect. Governments are borrowing to finance their spending, and many countries implementing fiscal-stimulus packages already have large budget deficits and substantial levels of outstanding public debt.

In 2009, governments around the world will have to issue in excess of US$3 trillion in debt: America alone will need to issue around US$2 trillion in bonds (almost US$40 billion a week). This compares to around US$400-500 billion of annual debt issued by that country in recent years. The debt must be issued at record-low interest rates, and it is not clear whether the major buyers of debt - China, Japan, Europe and emerging countries - will continue to buy US government bonds at previous levels, or at all. Wen Jiabao, China's prime minister, offered a timely reminder in February: "Whether China will continue to buy, and how much to buy, should be in accordance with China's needs, and depends on the safety and protection of value of foreign exchange." Yu Yongding, a former adviser to the Chinese central bank, recently sought guarantees that China's US$682-billion holdings of US-government debt won't be devalued by "reckless policies". The US, he said, "should make the Chinese feel confident that the value of the assets at least will not be eroded in a significant way."

The current initiatives of governments and central banks are a hair-of-the-dog treatment. The problems they seek to address can be traced to the high levels of debt accumulated by banks, companies and consumers. In effect, this is now being replaced by government debt and, simultaneously, the debt-fuelled consumption of companies and consumers is being replaced by debt-funded government expenditure. Yet adjustment in the level of debt and asset prices is part of the process through which the global economic system will re-establish itself. Like King Canute, central bankers and finance ministers cannot hold back the tide.

The most important lesson of the financial crisis may be that the current economic order was built to fail, for the global economy used debt and financial engineering to enhance growth, requiring ever more stimulus to maintain performance. The spike in debt globally caused a spike in growth rates. As much as $5 of debt was required to create $1 of growth. Approximately half the recorded growth in the US over recent years was driven by borrowing against the rising value of houses (that is, mortgage-equity withdrawals). As the level of debt in the global economy decreases, attainable growth levels also decline.

The world economy used debt to accelerate consumption. Spending that would normally have taken place over many years was squeezed into a relatively short period because of the availability of cheap borrowings. Business over-invested, misreading demand and assuming that exaggerated growth would continue indefinitely, creating significant over-capacity in many sectors. The nouveau-Jeffersonian trinity outlined satirically by the American historian Andrew Bacevich in his book The Limits of Power - "Whoever dies with the most toys wins"; "Shop till you drop"; and "If it feels good, do it" - has proved to be utterly unsustainable. 

Growth in global trade, based on a model where sellers of goods and services indirectly financed their purchase, was also built to fail. Slowing exports, lower growth and loss of jobs are encouraging protectionism, reversing the globalisation of trade and capital flows: several countries brought in import tariffs and export subsidies. The fiscal packages in many countries are economic-nationalist, encouraging spending on domestically produced goods and supporting local industries; the US, France, Germany and Spain have all announced bailouts for domestic companies. Asian countries are seeking to weaken their currencies to support exports and maintain global competitiveness - the American Treasury secretary recently accused China of manipulating its currency, drawing angry responses from Beijing.

Financial protectionism is also emerging: governments are supporting domestic banks and increasingly directing lending to local firms and households. Concerns about immigration are emerging, too, and there have been protests in the UK against the hiring of foreign workers. This has serious implications for Mexico, Eastern Europe, India and the Philippines, all of which depend on worker remittances.

Can politicians and policymakers ever maintain control of the economy? Governments and central banks have limited tools available to them. Keynes famously described monetary policy as the equivalent of "pushing on a string"; given that interest rates are approaching zero in many developed countries, there is now almost no string left.

Fiscal policy could be described as pulling on the same string. Japan's experience is salutary: zero interest rates and repeated quantitative easing (printing money, as the Bank of England has recently started to do) have not restored the health of its economy, which remains in suspended animation. The rest of the world must now struggle to avoid turning Japanese.

In the run-up to the 1929 British election, Keynes discovered a seminal political truth about deficit spending. Lloyd George, an economically challenged politician, was delighted when Keynes provided a rationale for spending taxpayers' money on social programs to bribe voters. Keynes absorbed this lesson well and maintained a useful ambiguity throughout his life, allowing him to appeal - now, as then - to politicians who favoured government spending as well as those who favoured middle-class tax cuts.

In 1971, Richard Nixon recanted years of opposition to budget deficits, declaring, in an echo of Milton Friedman, "Now, I am a Keynesian." In the wake of the global financial crisis, it seems that we are all Keynesians again. Writing for the Financial Times in February, Benn Steil, the director of international economics at the Council on Foreign Relations, succinctly set out the current thinking: "when the facts are on our side, we pound the facts; when theory is on our side, we pound theory; and when neither the facts nor theory are on our side, we pound Keynes."

Debt-fuelled American consumption drove global growth. Home to 5% of the world's population, the US accounts for 25% of global GDP, 20% of global consumption and 50% of the global current-account deficit. It needs to decrease consumption, increase savings and reduce debt, export more and import less. The countries with large savings and trade surpluses need to do exactly the opposite: they must encourage domestic consumption. Presently, both surplus and deficit countries are doing exactly what they should not.

Consumption accounts for around 40% of the economy in China, against more than 70% in the US; average earnings in China are only a tenth of those in the US. The size of the required adjustment is substantial indeed. James Quinn, in an interview in London's Telegraph with David Rosenberg, an economist for Merrill Lynch, describes the process:

Before the US economy can truly begin to expand again, Rosenberg believes the savings rate must rise to pre-bubble levels of 8%, the US housing stock must fall to below eight months' supply, and the household interest coverage ratio must fall from 14% to 10.5%. "It's important to note what sort of surgery that is going to require. We will probably have to eliminate [US]$2 trillion of household debt to get there," he predicts, saying this will happen either through debt being written off, as major financial institutions continue to do, or for consumers themselves to shrink their own "balance sheets".

Wen Jiabao, the Chinese premier, recently indicated that China's "greatest contribution to the world" would be to keep its own economy running smoothly. This may signal a shift whereby China uses its savings to invest in its domestic economy, rather than to finance American needs - a move that would only deepen the global recession and disrupt funding flows.

At least there is now some acknowledgement that the economic model itself is the source of the problem. Zhou Xiaochuan, the governor of the Chinese central bank, commented: "Over-consumption and a high reliance on credit is the cause of the US financial crisis. As the largest and most important economy in the world, the US should take the initiative to adjust its policies, raise its savings ratio appropriately and reduce its trade and fiscal deficits." More ominously, Chinese President Hu Jintao recently said, "from a long-term perspective, it is necessary to change those models of economic growth that are not sustainable and address the underlying problems in our respective economies."

"We have involved ourselves in a colossal muddle," Keynes observed in ‘The Great Slump of 1930', an essay published in December of that year, "having blundered in the control of a delicate machine, the working of which we do not understand." In the global financial crisis, politicians, bureaucrats and central bankers have no more powers than the Wizard of Oz: they are desperate old men hiding behind a curtain, running from one lever to another in an attempt to maintain the illusion. As the nineteenth-century American humorist Josh Billings said, "It is better to know nothing than to know what ain't so."

Satyajit Das

Satyajit Das is a former banker and author. His latest book is A Banquet of Consequences.

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