Summary: we have a bad case of debt deflation. Although well-described by economists since the 1930’s, this malady was not taken seriously by the mainstream of the profession. Now we have it. This post describes this macroeconomic illness (which will help you better understand events), and possible cures. The diagnosis is simple; the cures less so.
Preamble
Before we begin this depressing discussion of our current ills, let us remember the dismal odds accepted and surmounted by the Founding Fathers. We can hope to earn similar praise from our descendants as John Hancock gave to George Washington in his letter of 9 October 1777, in which Hamilton stated his satisfaction that Washington had done everything possible at the battle of Germantown:
“Something must still be left to Fortune. It is not in Mortals to command Success. But permit me to say, Sir, you have done more on this Occasion, You have deserved it.”
— From The Writings of George Washington from the Original Manuscript Sources, 1745-1799, Volume 9 , John C. Fitzpatrick, Editor (page 351). This is a quote from Act I, Scene 2 of the play Cato by Joseph Addison.
The core of our crisis
We borrowed too much. As I explained here, there are only four ways to solve this problem.
- grow out of the debt
- inflate the debt away
- default on the debt
- socialize the debt — spread it out over a larger population, such as having the government assume the loans
Debt deflation is path #3. The US government is attempting to switch the economic train to track #4.
As I described here, the debt deflation was initiated by the Fed’s tight money policy during the rise in commodity prices (that was just the spark, of course). While this should be obvious to anyone reading the newspapers, it remains contraversal among economists — and is evidently not widely known among educated Americans. The responses to my posts predicting that we would slide into debt-deflation, and those saying that we have done so, ranged from incredulous to hostile.
“Rising loan defaults and failure of financial institutions do not describe anything “deflationary”.
… (one of the less-abusive comments)
We are suffering from a paradigm crisis
Why is our bout of debt deflation so surprising? For 30 years one explanation (perhaps the standard one) of the US great depression has been that the Fed did not adequately respond to the deflationary effects of the 1929-1932 loan defaults and bank failures. Chairman Bernanke is an expert on the history of this period. Perhaps his best-known speech on the topic is “Money, Gold, and the Great Depression” (2 March 2004). Excerpt:
However, in 1963, Milton Friedman and Anna J. Schwartz transformed the debate about the Great Depression. That year saw the publication of their now-classic book, A Monetary History of the United States, 1867-1960. The Monetary History, the name by which the book is instantly recognized by any macroeconomist, examined in great detail the relationship between changes in the national money stock–whether determined by conscious policy or by more impersonal forces such as changes in the banking system–and changes in national income and prices.
… The banking crisis (of the 1930’s) had highly detrimental effects on the broader economy. Friedman and Schwartz emphasized the effects of bank failures on the money supply. Because bank deposits are a form of money, the closing of many banks greatly exacerbated the decline in the money supply. Moreover, afraid to leave their funds in banks, people hoarded cash, for example by burying their savings in coffee cans in the back yard. Hoarding effectively removed money from circulation, adding further to the deflationary pressures.
But, to oversimplify, this explanation conflicts with core Keynesian theory. Keynes did not consider aggregate debt levels to be an important macroeconomic parameter; and his successors did not remedy this oversight. So US household debt levels grew and grew, with mainstream economists complacent or asleep.
From this perspective, our problems result from a Thomas Kuhn-type paradigm crisis in economics, a conceptual blindness to the danger of rising debt. There was an alternative theory, which now plays itself out in our daily news. We must understand it in order to have any chance of weathering this storm.
Debt Deflation
For a clear explanation of our illness I recommend reading “Debt-deflation: concepts and a stylised model“, Goetz von Peter, BIS, April 2005 (56 pages). The following four sectors are taken from that paper.
(1) Introduction
In this paper we explore the concept of debt-deflation. We propose a stylised model to illustrate its key features, including unexpected losses, distress selling, and distributional effects. These features reflect the central place that financial distress occupies in traditional accounts of deflation. The term debt-deflation was coined by Irving Fisher {“The Debt-Deflation Theory of Great Depression“, Econometrica, 1933}, and refers to the way debt and deflation destabilise each other. The issue of stability arises because the relation runs both ways: deflation causes financial distress, and financial distress in turn exacerbates deflation. The former was known for centuries, but the latter was, in our view, a key insight of the debt-deflation literature. This ‘feedback’ from financial distress to deflation can occur through several channels:
Fisher (1933) argued that borrowers attempting to reduce their burden of debt (‘indebtedness’) engage in distress selling to raise money for repaying debt. But repayment in aggregate causes a contraction in the money supply and price level deflation.
Minsky (1982) elaborated the concept to incorporate the asset market. He recognised that distress selling reduces asset prices, causing losses to agents with maturing debts. This reinforces distress selling and reduces consumption and investment spending, which deepens deflation.
Bernanke (1983) observed that debt-deflation involves wide-spread bankruptcy, impairing the process of credit intermediation. The resulting credit contraction depresses aggregate demand.
Note that these channels involve features that are quite uncommon in today’s mainstream macroeconomics: among them are losses and distress selling, the idea that debt and deflation destabilise each other, and the notion that the quantity of money endogenously contracts through the repayment of debt. Note also that some standard methods, including the representative agent and log-linearisation, are not well-suited for exploring this territory. This may explain the shortage of formal work on debt-deflation.
(2) Irving Fisher: the level of prices
Fisher sets out a monetary theory of how financial distress exacerbates deflation. Fisher’s argument starts with a state of ‘over-indebtedness’. Agents seek to reduce indebtedness by ‘liquidating’ debt. The first and most important steps in Fisher’s ‘chain of consequences’ are,
Debt liquidation leads to distress selling and to (2) Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits
and of their velocity, precipitated by distress selling, causes (3) A fall in the level of prices, in other words, a swelling of the dollar.Fisher views price level deflation as “the root of almost all the evils” that he elaborates in six further steps. Note that, rather than taking deflation as given, he explains it as the consequence of agents’ attempt to reduce their indebtedness.9 They do so by distress selling, to raise the money for repaying bank loans. Repayment in aggregate reduces the quantity of money, or ‘deposit currency’, which causes deflation. Since deflation is known to increase indebtedness, Fisher’s channel closes the loop of debt-deflation,
… and if the over-indebtedness with which we started was great enough, the liquidation of debts cannot keep up with the fall of prices which it causes. In that case, liquidation defeats itself. While it diminishes the number of dollars owed, it may not do so as fast as it increases the value of each dollar owed. Then, the very effort of individuals to lessen their burden of debts increases it, because of the mass effect of the stampede to liquidate in swelling each dollar owed.
Then we have the great paradox which, I submit, is the chief secret of most, if not all, great depressions: The more the debtors pay, the more they owe. The more the economic boat tips, the more it tends to tip. It is not tending to right itself, but is capsizing. But if the over-indebtedness is not sufficiently great to make liquidation thus defeat itself, the situation is different and simpler. It is then more analogous to a stable equilibrium; the more the boat rocks the more it will tend to right itself.
— ”The Debt-Deflation Theory of Great Depressions”, Econometrica, October 1933
Fisher’s theory was largely ignored by contemporaries …
(3) Hyman Minsky: asset prices
Minsky’s elaboration of debt-deflation incorporates the asset market. He recognised that distress selling reduces asset prices, which (1) reinforces distress selling, and (2) worsens deflation. Regarding the first channel, Minsky wrote,
Fisher does not identify the ways a unit can get cash to repay loans that fall due. […] Once a situation exists where debt payments cannot be made either by cash from operations or refinancing, so that assets have to be sold, then the requirements imposed by the debt structure can lead to a fall in the prices of assets. In a free market, the fall in asset prices can be so large that the sale of assets cannot realize the funds needed to fulfill commitments.
— “Debt-Deflation Processes in Today’s Institutional Environment”, Banca Nazionale del Lavoro Quarterly Review, December 1982In other words, when distress selling reduces asset prices, the resulting losses exacerbate indebtedness, and may lead to further distress selling. As in Fisher, distress selling can be self-defeating. The asset market and distress selling feed back on each other.
Regarding the second channel, Minsky argues that the fall in asset prices reinforces deflation:
If payment commitments cannot be met from the normal sources, then a unit is forced either to borrow or to sell assets. Both borrowing on unfavorable terms and the forced sale of assets usually result in a capital loss for the affected unit. However, for any unit, capital losses and gains are not symmetrical: there is a ceiling to the capital losses a unit can take and still fulfill its commitments. Any loss beyond this limit is passed on to its creditors by way of default or refinancing of the contracts. Such induced capital losses result in a further contraction of consumption and investment beyond that due to the initiating decline in income. This can result in a recursive debt-deflation process.
— Can It Happen Again? Essays on Instability and Finance (1982)In other words, losses from the decline of asset values reduce aggregate spending through a wealth effect.
(4) Ben S. Bernanke: credit
Both Fisher and Minsky emphasised the consequence of financial distress for macroeconomic variables: aggregate spending, the price level, and asset prices. Another channel of feedback can arise when financial distress affects the banking system.
The banking problems of 1930-33 disrupted the credit allocation process by creating large, unplanned changes in the channels of credit flow. … {This} plus the actual failures, forced a contraction of the banking system’s role in the intermediation of credit. … experience does not seem to be inconsistent with the point that even good borrowers may find it more difficult or costly to obtain credit when there is extensive insolvency. The debt crisis should be added to the banking crisis as a potential source of disruption of the credit system. … The effects of this credit squeeze on aggregate demand helped convert the severe but not unprecedented downturn of 1929-30 into a protracted depression.
— ”Nonmonetary Effects of the Financial Crisis in Propagation of the Great Depression”, American Economic Review, June 1983.
In other words, financial distress impairs the process of credit intermediation, and a credit contraction in turn depresses aggregate demand.
——– End except from the BIS study ————–
What’s the cure?
We do not know. The debt deflation — deflation, if you prefer — of the 1930’s was cured by WWII (if you call that a “cure”). Japan’s bout with deflation in the 1990’s was never really cured, as their quick collapse in this cycle shows.
The standard cure for deflation is debt-fueled fiscal stimulus. This can come in many forms (the difference between fiscal and monetary policy blurs at this extreme).
- Keynes advocated massive debt-funded public works projects: The General Theory of Employment, Interest and Money (1936). Build pyramids, or bury money in bottles for people to dig up — it does not matter what.
- Dropping money from helicopters, as described by Nobel-laureate Milton Friedman in The Optimum Quantity of Money (1969).
- Just print it, Bernanke tells us. “{T}he U.S. government has a technology, called a printing press, that allows it to produce as many U.S. dollars as it wishes at essentially no cost.” (source).
Such action, on a sufficient scale, would stabilize the economy, but might be insufficient to restore normal levels of growth. Why that is so will be discussed in another post.
For more information
For an “Economics 101” textbook chapter on Inflation and Deflation: Oxford University Press’ Economics Course Companion.
Ben S. Bernanke on deflation:
- “Deflation: Making Sure ‘It’ Doesn’t Happen Here“, speech on 21 November 2002
- “Conducting Monetary Policy at Very Low Short-Term Interest Rates“, co-author Vincent R. Reinhart (Director, Division of Monetary Affairs), 14 January 2004
- “Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment“, co-authors Vincent R. Reinhart (Governor, FRB) and Brian P. Sack (Macroeconomic Advisers), 9 September 2004
Key posts about the financial crisis
- A solution to our financial crisis, 25 September 2008
- A picture of the post-WWII debt supercycle, 26 September 2008
- America has changed. Why do so many foreigners see this, but so few Americans?, 1 October 2008
- A sitrep on the financial crisis: why has the treatment been so slow, so small?, 8 October 2008
- The new President will need new solutions for the economic crisis, 9 October 2008
- Forecasting the results of this financial crisis – part I, about politics, 13 October 2008
- Forecasting the results of this financial crisis – part II, a new economy for America, 14 October 2008
See all posts about the Financial crisis – what’s happening? how will this end?, and those about solutions to our financial crisis.
Excellent discussion, as always. Fisher, Minsky and Bernanke all discuss important parts of the problem. Fisher’s ponit seems clearly correct, since in a deflationary environment, paying down debt only tends to make the remaining value of the debt greater in real dollars, which I take to be his point. Minsky’s discussion of asset prices deflating due to liquidation seems to add a valuable perspective. And Bernanke appears to be discussing the liquidity trap, which we see at present. Viz., given credit lines from the government, banks hoard the cash instead of lending it out in order to make money from the float twixt the prime rate and the rate banks pay depositors, so as to stanch the hemorrhage from their bad loans. Japan’s banks got caught in this liquidity trap in the 1990s and our banks are now stuck in it.
However, that said, the Great Depression of the 30s had complex and multiplex causes. The Smoot-Hawley Tariff, which we don’t have today, much worsened the situation by shutting down the safety valve of int’l trade. Too, we musn’t forget that in the 1930s there was no FDIC, so many millions of ordinary bank depositors lost their life savings. That hasn’t happened today. There was also no social safety net — today there is. And let’s recall that the Federal Reserve system had only been established in 1913, so its governors were not proactive, and when they did act, they did exactly the wrong thing, contracting the money supply to reduce deficits. Keynes saw their error and expained how to fix that problem.
Today’s central problem appears different from that of the Great Depression: we’ve got liquidity, but no transparency, so banks are refusing to lend. Global shipping has almost shut down due to the difficulty of getting letters of credit. This is different from the overproduction & lack of liquidity in the 1930s.
We should be extraordinarily skeptical of anything Milton Friedman says about the Great Depression or our current situation. Friedman’s nostrums were tried in Chile, with disastrous results. His theories had to be abandoned when the Chilean economy essentially blew up.
In a worst-case scenario, the credit crunch could theoretically be alleviated by government agents giving bank loan officers an ultimatum: start loaning again, or the gov’t will take over your bank and starting making loans at x point above prime, say, 30 basis points. FDR essentially had to use this solution in 1937. It worked.
I believe that most people agree with your posts but don’t respond because you’ve pretty much already said everything intelligent on the subject. Unfortunately that leaves only the unintelligent things for your posters to respond with.
Keynes was operating in a completely different environment when he chose to ignore current debt levels when determining the proper course of action. I’m very curious about what he recommendations he’d make in today’s environment and believe he’d choose a very different course than the policymakers have chosen. His disciples are cautious people who refuse to deviate far from the standard doctrine, his willingness to look at far-ranging alternatives was what made him great.
Your points on the difficulty of defusing the debt crisis are well taken. In your quotes Keynes, Milton, and Bernanke all essentially suggest throwing money at the problem until it goes away.
But the dollar has only two pillars of support; relative scarcity compared to demand, and public (both domestic and foreign) faith in the US government. Throwing money at the problem batters both pillars and risks the collapse of the dollar.
Backing the dollar by borrowing from foreigners doesn’t appear to be politically palatable right now but somebody in the next administration is probably going to have to go to our creditors, hat in hand, and break the news that they (the creditors) will have to give us both more cash and better terms or face total monetary ruin. I sincerely hope that whoever does this will be more diplomatic than the Bush administration was during most of its tenure.
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Fabius Maximus replies: I totally agree with your comments about Keynes. He wrote about the situation during his lifetime. It was up to future generations of economists to expand his work to include the effect of aggregate debt levels. Those that did, like Minsky, did not receive due attention. Perhaps because the political attractiveness of adding debt was too great, few wanted to be the skunk at the party.
Concerning the “…four ways to solve this problem”, number 4 is by definition a subset of number 2. An important question is when and if fear will shift from perceived potential default to the inflationary destruction of fixed income assets. Even if God herself were to guarantee your 4% bond, you’re going to dump it as inflation reaches 10% or 20%. Massive surreptitios buying of fixed income assets by the Exchange Stabilization Fund and complicite foreign governments all along the yield curve will help for at time and probably be tried. The only real answer is to reduce the debt overload through inflation. And it probably won’t take too long for that conclusion to become self evident. Flat out, balls-to-the wall monetary inflation (and who needs a printing press when you have computer blips) is the only real vaccine available, all else is prattle. Massive monetary inflation attacks the problem on its two main fronts, falling prices will halt and reverse, and debt will melt away like ice cream on a hot lazy summer afternoon. The first few years prior to many hyperinlations had rates (if my memory serves me correctly) of about 30%. This is what they will shoot for. In fact, three years of 30% inflation will just about do the trick. Then slam on the brakes. Rentenmark here we come. Nobody has any savings anyway.
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Fabius Maximus replies: Why is government assumption of the debt inherently inflationary? It might be so, but is not necessarily so. Esp as the US government’s debt (from past expenses) is quite low ($6 trillion net), compared to that of other governments. Like most nations, it’s liabilities (promises of future benefits) are mind numbingly high — but that’s another problem, for the future.
As for inflation.
(1) Inflation is a choice. You might be correct that we will take that path, but — unless you have psychic powers — it is not certain.
(2) With an average maturity of aprox 3 years, inflation would have to be very rapid to be effective. Otherwise rolling over the maturing debt would be impossible. Essentially this would be a default on our loans.
(3) As the many attempts to do this in Latin America have shown, this “solution” does not work well. It does look simple on paper, but is less so in practice.
Just a hint from looking at the US Treasury’s “Public Debt to the Penny.” The US national debt has gone up $440 billion in the past 21 days. The Fed, the treasury, the congress is monetizing the debt.
Be very afraid, folks.
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Fabius Maximus replies: As this post shows at some length, we are experiencing deflation. For a high debt economy like ours, deflation is lethal. Inflation (or re-flation) is the cure. Even if we rebound into too-high inflation afterwards, that is easily treated.
To use a bad medical analogy. Consider someone suffering mind-bending pain. We administer powerful drugs. The patient might become addicted, which can be treated later.
Would ‘very rapid’ inflation translate to hyperinflation?
A major outcome of this crisis is functional economic dictatorship for the SecTreasury, which vastly changes the political and economic landscape of this country; there is nothing in the ‘bailout’ bill limiting the the duration or usability of these so-called emergency powers, and it can be expected that the fundamentally untrustworthy federal government will abuse them to the fullest extent imaginable. Here’s a quote:
“The authority of the Secretary to purchase troubled assets under this plan shall be limited as follows: 1) Effective upon the date of enactment of this Act, such authority shall be limited to $250billion outstanding at any one time.”
page 40, from the text of the bailout bill available here: http://issuu.com/johnwonderlich/docs/latestversionayo08c32_xml?mode=embed&documentId=081001154747-786a3307b0504c8d8456e31d4ef49cba&layout=grey
Option 5: eliminate the debt. Simply cancel all (mostly irregular, possibly illegal) CDO swaps. State “at 0:00 GMT all CDO swaps are null and void”.
For those on the downside of swaps, if they are valuable to the real economy (eg a consumer bank) re-capitalise them. For those on the winning side (their obligation is written off), put in an once off special tax for (say) 10% of their gain.
Result: debt gone. More importantly it removes a transmission conduit from the ponzi economy to the real economy, and it is over. This is ‘ring fencing’, protect the real economy, kill the ponzi one. Similar to what you do if a serious infectious disease outbreak happens.
Ditto for the hedge funds. This is basically an internal economy (or betting house) of its own, with limited links to the real economy. Delete it. If (say) a real bank is hurt by the loss of loans to a hedge fund, recapitalise it. If it is a rich investor, let them take the lossses plus add in another once off emergency tax change, no tax deduction for their loss (this is not being mean, just closing another transmission conduit).
Funds with secuitised mortgages, the Govt buy them at the lowest price (current rates are less than 10c in the dollar). When you buy them, link back to the mortgage holders, send them a letter: “your mortgage is now worth 10% of what it was”. Translated, keep people in their houses at a much reduced cost (this improves society, keeps spending from declining, etc, etc, etc).
Basically de-leverage fast, while protecting the real economy as much as possible. I used an anology in another post, of cutting of an arm to save your life, but this is really a case of expelling something from the body that is harming you, bit like what happens after food poisoning: you are cold and shaking coming from the toilet, feel weak but you quickly recover.
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Fabius Maximus replies: One of the great perils of any economic crisis is quack solutions. Simple! Easy! Fast! Destructive to our long-term health! This is the sort of thing that Congresscritters pick up in Washington bars, find attractive, and enact — to our lasting regret.
Derivatives are not relevant to a discussion of debt levels, as they are risk-transfer devices. A zero-sum game, unlike debt. Like all large, complex financial structures they can collapse — which is why we need regulations. There is wide agreement that the derivative situation requires fast action, before the structure collapses (which it has not yet done). There are several ways to fix this, mechanically complex but conceptually simple. Such as forcing the financial institutions acting as intermediaries to cash out the contracts at their current value.
Much of the rest of this is the “Prince Bountiful” solution, the government randomly scattering money, under the assumption that the government can do so without thought or limit. Your analogy of cutting off limbs is accurate, in that this is randomly cutting off limbs hoping that somewhere in the process the illness will be fixed. However, if it the illness is syphilis, the patient will be crippled and still sick.
People fixate on inflation because they forget what FM pointed out — the velocity of circulation is just as important as the total amount of the money supply. If the velocity of circulation plummets low enough, the money supply can expand hugely without causing much (if any) inflation.
Right now, the velocity of circulation between banks has dropped to near zero. Commercial paper has dried up as a result, letters of credit are all but unavailable, and bond issues require such high interest that they’re being withdraw. This is the same symptom as the Great Depression — velocity of circulation dropping to near zero — but for a different reason. Then, it was because so many savers had lost their life savings and because Hoover’s Fed tightened credit so much, that no money was available. Today, velocity of circulation has plummeted not because they’re illiquid, but because banks are scared spitless of lending to anyone, even the most reputable institutions, because they can’t be sure that even the most reputable institutions won’t blow up and disappear tomorrow due to their derivative exposure.
This suggests that Keynes would prescribe a whopping dose of transparency for the global derivatives market, and for the institutions that are tainted with ’em. Opoen the books and triage all the bad banks, then reinforce the good ones with gummint lines of credit. Incidentally, that’s also what Nouriel Roubini and Roger Ehrenberg have advocated.
What happens when the Fed/SecTres ‘opens the books’ and finds out that all the Big Banks, as players in the MBS / CDO ponzi schemes, are bad? Was Lehman Brothers really much worse than Bear Sterns? I don’t think so.
The gov’t should increase the capital, and the easy loan money, available to all the small banks, as well as providing direct credit to real companies (buying commercial paper) at higher than usual bank costs, and let all the big banks go belly up. For a few years? or perhaps only months, there will be less M&A activity. But, unlike in the Great Depression, the real economy has less need of Big Banks than ever before.
Letters of credit for shipping is certainly one real thing the gov’t should not allow to be stopped.
There should probably be some big anti-lawsuit law to force a settlement on the interlocking bankruptcies and costs due to failing to fulfil contractual obligations. Otherwise the bailout money will be ‘saved’ by the big banks, and used in defense of and in settlement of lawsuits — surely one of the least effective methods of taxpayer support.
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Fabius Maximus replies: This comment, like much of the commentary about the crisis, looks backwards. The governments of the world have already in effect nationalized the banks. Step by step, in a unplanned and uncoordinated fashion, with a combination of massive loans and capital infusions. That process is almost completed. This is all yesterday’s news.
What this post describes is the larger process of debt deflation, affecting the broader economy. That process is underway, residential mortgages being the first wave. Now the collapse is spreading. The small fiscal programs planned are tiny steps forward to mitigating this downturn, but I suspect they will prove grossly inadequate.
Just for curiosity’s sake, is the Irving Fisher of “The level of prices” the same Irving Fisher who Fred Allen quotes in his book “Only Yesterday” as having said, in September 1929, “Stocks have reached a permanently high plateau.” . . . (read that book probably 50 years ago and as you can see it make a deep impression, since I don’t have a copy close at hand)
if it is, then I would take anything else he said with many grains of salt. “Like the thirteenth stroke of a clock; not only in itself ridiculous, but casting into doubt everything that has come before.” (Attributed to Ben Butler, as he destroyed the murderer’s alibi).
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Fabius Maximus replies: Yep, same guy (see Wikipedia).
Very few economists have any skill at investments (Keynes is one of the few). They are different fields. Like many academics, Fisher’s skill in one field gave him unwarrented confidence in his skills in other fields. A common cognitive error, which should be diminish he accomplishments in his own field. For much the same reason doctors are found to be easy marks by conmen.
I’m no expert, but I’d like to take a crack at this. I think a solution will require portions of all four ingredients, mixed carefully in timely measure. As each portion is implemented, we will have to be careful to watch for when it transmogrifies into some other ingredient, as some are wont to do.
The best would be to grow (#1) and pay down the debt as much as we can. However, in the near term we are going to incur costs to improve infrastructure, educate the next generation, re-educate a workforce, and retool our economy to focus more on productive activities. So we are going to have to spend more in the short run in order to grow in the long run. We must also re-budget our priorities; trade in expensive hard power for much cheaper soft power, etc. And we need to derive tax revenues sufficient to meet our needs. We will have to work much harder and get paid far less.
Naturally, some inflation (#2) will occur, so this can help at the margins, but we should guard against relying on it. Better to continue, if possible, to borrow. This prolongs indebtedness, of course. But if no one will loan us money, then the government will print money if necessary to finance its spending. Let’s make sure future government spending is true investment.
Some healthy amount of default (#3) ought to occur. We cannot make everyone whole. People left standing and holding bad assets are going to be stuck. Losses are going to have to be taken. Having allowed this to come to pass, I suppose taxpayers must share some of the burden. As it stands, though, the moral hazard that our national policy is embarking upon is dangerous. The one virtue of the Great Depression is that no one forgot it; it made an entire generation of people down-to-earth and prudent. Our current national policy runs the risk of doing just the opposite; it may save us momentarily while slowly poisoning our morale. We better figure out what we want the moral of this story to be. Prompt regulatory transparency is a must.
Right now the government is trying to “socialize” the debt (#4) as an emergency measure. I suppose it’s necessary, but it is a corrupting process. Improving liquidity, restructuring home loans, etc. are required to get the spacing right between train cars before they all collide into a big train wreck. Of course, it may be too late already. We will know better after a lag time. In all events, our standard of living will continue to decline sharply for the immediate future. In the absence of real reform and real claw back, this decline may lead to real violence. (An aside: Like schools, police, and fire department, health care might usefully be moved to the social sector, while effecting a cost savings.)
Having said all this, I am suspicious of your formulation:”We borrowed too much.” A lot of assumptions are wrapped up in those four words; is the answer to your riddle folded up inside them too, like a superstring in string theory? Who is the “we”? “Borrowed” how? For what? From whom? How come “too much”? What would be the right amount? Shouldn’t “we borrow” some more? What did “we” do with what “we borrowed”? Where did it go? Did it ever really exist? Does it still exist? Who owes? Can it ever be repaid?
One last thought: As the pain spreads worldwide, the United States is likely to be held responsible for it. We are going to have to learn to deal with that. US:world::Wall Street:Main Street.
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Fabius Maximus replies: As for our debt, this is not a complex thing to see. Look at “A picture of the post-WWII debt supercycle.“
As long as we were discovering antibiotics, television, radar and microwaves, transistors, integrated circuits, big computers, followed by small computers, all the while leveraging fossil fuel, fertilizer, and electric power, we could make a few mistakes in capital allocation and still be Ok. Now, one mis-allocation of available capital into something stupid, like houses in Modesto, and the wheels come off. It is currently much harder to make real progress. Moore’s law is panned out, motors, computers, drugs, are harder to make way better. R&D investments are riskier and so harder to justify. This combined with “Good enough is the enemy of better” is also adding to our problems.
FM: you might be right about the derivatives being a mere technicality that is essentially easy to fix. I agree in essence. However, unless they are fixed, and soon, they can still bring down the real economy. Therefore they are more than a mere technicality for right now they are the speculative tail wagging the economic and political mastiff threatening the health and security of millions.
Most of the people I read a few years back who predicted pretty much exactly what’s happening identified the massive derivative overhang as the key problem. Of course, it is the natural evolution of basing a financial system on leveraged credit – how normal banks work nowadays. Build a house on usury…..
A system rethink would be timely rather than simply trying to deepen the foundations of a house built on sand by ‘paying down debt’ and so forth.
But that ain’t a-gonna happen. We are in interesting times.
Another aspect to this problem. Exports from Japan are becoming more expensive :
But even as stocks were tumbling, focus was firmly on the currency markets, which many believe now hold the key to Asia’s chances of resilience to the coming storm. Brokers in Tokyo warned of the “wildfire devastation” now being caused by the unwinding of the so-called yen carry trade – that vast, global investment practice where the Japanese currency was borrowed on a monumental scale to finance investments across the globe.
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But as hedge funds implode, and investors everywhere race to offload their investments and pay back their yen loans, the trade has reversed and is now rocketing the yen higher. Today, it hit a level of 97 yen against the US dollar, and has surged by around 30 per cent against the pound within the past couple of weeks.
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Fabuis Maximus replies: The broad index of the US dollar (“DXY”) has increased aprox 19% from its mid-July low, making imports less expensive on average. However, our exports (almost the only growing part of the economy) have in turn become less competitive in foreign markets.
FM the debt will all be destroyed anyway. There is simply too much to be paid off. It can be a long agonising process, with absurdities happening, such as tent cities with large amounts of empty and decaying houses available!
Do it quick and clean, get it over with. It will be horrible agony, it is not a clean solution at all, it is a desperate and last ditch solution and so many people will go to the wall that it will take a generation or more to really get over it. The only thing recommending it is that the alternative is worse.
There will be recession/depression anyway so the thing is to the think of the future. With debt destroyed quickly, recovery will be quicker. The last thing we want is a global Japan, a 15 years+ recession, a L shaped recession (depression?). We need an U and as long as all the personal, corporate, State and Federal debt overhangs everyone then a recovery is impossible for perhaps decades.
Another real danger of a prolonged downturn is that human and physical capital rots, so that a recovery is even harder because you have to rebuild everything from nothing to start to get going again.
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Fabius Maximus replies: Do you have any evidence to support saying “the debt will all be destroyed anyway”? Most of it can be paid off if we can prevent a long, severe downturn. Most people can pay their mortgages and revolving loans. Most businesses can pay their loans. The US government’s debt is light vs. other developed nations (social security and medicare are liabilities, not debts).
FM: “Derivatives are not relevant to a discussion of debt levels, as they are risk-transfer devices. A zero-sum game, unlike debt. Like all large, complex financial structures they can collapse — which is why we need regulations.”
I don’t believe this is really true. Because the ‘high-yield’ part of the MBS derivatives were rated as AAA, and thus used by banks as part of their tier 1 capital, banks were able to use derivatives to loan out MORE than the derivative was worth.
It was post-Enron Sarbannes Oxley regulation, which (Gramm pushed) allowed banks to use this as capital that makes derivatives part of the debt creation cycle. House prices as the foundation of debt, but derivatives being used to create more debt, not merely transfer risk.
If you have a link to show this is wrong, I’d be happy to hear it.
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Fabius Maximus replies: This is pretty confused, but I will attempt to explain.
The closest thing to a standard definition of “derivative” is that of the Bank for International Settlements reports, which is also used by most or all governments (including the US); see page 5 of their most recent report (May 2008): forward contracts, swaps, and options. They do not include any form of MBS securities in their totals.
By “MBS derivatives” I think you are referring to are “tranches”, a means of allocating cash flows to different pools of investors in a securitized product. This does not make securitized products “derivatives” in any meaningful sense, nor are they considered as such in the industry.
Many securitized products have contain mortgages with leverage (i.e., use borrowed funds), with the top tranches being rated AAA (due to their first call on cash from the underlying mortgages). This leverage does not make them “derivatives” in any meaningful sense.
Under our fractional reserve banking system, any asset allowed by regulators as part of a banks’ tier I or tier II capital allows banks to loan out more than the asset is worth. Thatt does not make every asset on a bank’s balance sheet a “derivative.”
Didn’t Minsky advocate 1) Big Government spending and 2) monetary stimulus as the way out of a debt/deflation spiral?
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Fabius Maximus replies: Yes, I believe so. He was a “radical Keynesian”, but still under the big tent. Your point?
Bloomberg perhaps explains my MBS / CDO point better (my emphasis on the CDOs tied to mortgages):
“CDOs parcel fixed-income assets such as bonds or loans and slice them into new securities of varying risk, providing higher returns than other investments of the same rating.
“Credit-default swaps are derivatives based on bonds and loans and used to protect against or speculate on defaults. Should a borrower fail to meet debt agreements, the contracts pay the buyer face value in exchange for the underlying securities or the cash equivalent. An increase in the agreement’s cost indicates a deteriorating perception of credit quality.
“About $254 billion of CDOs tied to mortgages for borrowers with poor credit histories have defaulted, according to Wachovia Corp. Estimating losses on those linked to corporate bonds is difficult because the underlying debt and the structure of the transaction can vary in this private market, said Mahadevan.
“Derivatives are contracts whose value is derived from assets including stocks, bonds, currencies and commodities, or from events such as the weather or changes in interest rates.
“Downgrades of corporate CDOs will force investors to boost capital, according to an Oct. 17 report from Barclays Capital analysts led by Puneet Sharma in London.”
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To FM: While you correct that an MBS is not a derivative, nor is a CDO, the credit default swap derivatives DO use CDOs as the trigger event (my bad in skipping the CDO and CDS steps). Similarly, you are correct that not all assets the regulators allow to be counted as capital are derivatives. What you fail to address is whether or not derivatives like Credit Default Swaps on CDOs are counted as capital on some banks? If yes, then your claim that derivatives don’t matter for debt is certainly wrong.
If CDOs that ARE on the balance sheet go down in value because of fear that the CDS derivative insurance won’t really be covered, the reduced value of CDS leads to a need for a capital increase / outstanding loan reduction. Which is what the financial system is suffering from.
But the key issue is whether the problem is one of liquidity or solvency. I think most of the Big Bank financial industry is now insolvent, and should be rapidly dismantled — while the gov’t tries to do fiscal stimulus to avoid too much high unemployment spillover.
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Fabius Maximus replies: Probably 14 trillion dollars of US wealth has evaporated since this event started in December 2006, perhaps 2x or 3x that (just a guess) for the world. And you are going on and on about this tiny aspect of the problem, as if US mortgages were the center of the universe around which all other things revolve.
This is absurd, but provides a wonderful demonstration of how post hoc ergo prompter hoc is the default reasoning method of the human mind. What came first must be the cause of what follows.
The OTC derivative problem, of which this is a tiny part, is a major risk. I find it astonishing that the US government has not yet moved to defuse this bomb before it explodes. Interest rate swaps, equity and commodity derivatives, and credit default swaps — one of these is almost certain to cause terrible problems in the next year or two, unless the government forces them to settle or net out.
Derivatives are not counted as bank capital (that is too absurd to be worth citing). They are risk transfer devices, not assets in the traditional sense used in calculating tier I or tier II capital under the Basel Accords. The rest of this is too confused to parse.
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Thanks for the article. I miss, however, an important topic: the real economy. The core problem of this crisis is producing less than consuming. That’s why people ask for credit, isn’t it? And the solution is to revert this situation, to produce more than you consume. Just as chinese do. The days of easy credit are gone, in turn, protectionist measures to reduce imports of goods and services must be put in place, free trading empoverishes developed countries, in the long run, because salaries tend to decrease, and countries with less social rights are rewarded by multinational companies: the welfare state foundations are jeopardized.
Debt is a useful and powerful tool. But all tools can be misused.
“Just as chinese do.”
Note that many experts believe that China has also accumulated too much debt, by entities that may not be able to pay it back. Such as their local governments and state-owned enterprizes (SOEs).
“in turn, protectionist measures to reduce imports of goods and services must be put in place”
I don’t believe so. The trade imbalances causing problems — such as between US-China and within the EMU — result from poor public policy in setting currency values.
“free trading empoverishes developed countries”
I don’t believe there is much evidence of that. The major success stories of the last centuries are nation’s that embrace trade (although not extreme free trade); the major failures are those embracing protectionism.
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