I have never been “short” as you so painfully call it. And yet what else could you say? Hard up? Penurious? Distressed? Embarrassed? Stony-broke? On the rocks? In Queer Street? Let us say you are in Queer Street and leave it at that.
Edward Ryder in Brideshead Revisited
Western governments are in Queer Street. Absent contagious defaults, this might turn out to be a good thing. The global financial crisis (GFC) which peaked in 2008 and the current global (government) debt crisis (GDC) have reckless borrowing and spending in common. However, while the first produced a set of woeful policy responses from governments, the second shows promising signs of pushing back some of the more egregious theories and assumptions that have guided economic and social policy since the 1930s. Maybe the GDC is the economic crisis we had to have and, to the extent it has been exacerbated by the policy responses to the GFC, perhaps both crises will prove beneficial in the end. There are four interrelated parts to the story: the GFC and its causes; the misguided policy responses to the GFC; the GDC and its dimensions; and finally, the promising policy responses to the GDC which are emerging and which, fingers crossed, may emerge.
The Global Financial Crisis
I don’t intend to go over again, in any detail, the causes of the GFC. However, a brief comment is necessary because the subject has been mangled to death and fiction occupies most of the public record. The GFC was largely misdiagnosed. It is hard to find any account of it that doesn’t attribute importance to greed and incompetence within the financial sector and to the complexities of derivatives. Some of the sillier ones go further in suggesting that capitalism itself was at fault. I referred to a number of these accounts in an article in the April 2010 issue of Quadrant. I noted that greed and incompetence were common human traits and therefore could be given weight as explanatory factors only in a trivial sense. I also pointed out that financial derivatives, however complex, pose no threat if the underlying instruments are sound.
The starting point for exposing the causes of the GFC was the generation in the United States, over more than a decade, of vast numbers of mortgage loans to people who had little or no chance of being able to repay them. From there it is a question of identifying those factors that caused this to happen. As in most catastrophes, a number of mutually-reinforcing factors can be identified: the Community Reinvestment Act cajoling banks into lending into poorer communities; the ability of the banks to sell these loans, and the risk of their default, off their books to the government-sponsored mortgage companies Freddie Mac and Fannie Mae; and the pervasive spending and borrowing culture promoted by years of loose monetary policy and the growing welfare state. The common thread throughout these factors is the offending hand of government. It is imaginative fiction in these circumstances to blame incompetence and greed, or derivative trading; and, most particularly, to blame capitalism. Unfortunately, the policy responses to the GFC were entirely based on the fictional account of its causes. The responses were of three kinds across most Western governments. All were largely premised on the intrinsic frailty of capitalism and the attendant need to save it from itself.
First, measures were put in place to bail out banks and other financial institutions in Europe and in the United States that were holding, or had guaranteed, substantial quantities of AAA-rated worthless assets. For example, the United States government provided a package of guarantees, liquidity access, and capital to Bank of America. An extended guarantee was provided for particular funds raised to support consumer lending. This was all designed to support financial market stability. It also gave a free kick to Bank of America (and its shareholders) which, armed with guarantees, was able to access funding relatively cheaply for a “failed bank” and on-lend at a profit. Banking becomes an easy business if your funding is guaranteed and you engage in high-interest consumer lending.
There is a point in protecting bank depositors. Undoubtedly, as Milton Friedman and Anna Schwartz explain in A Monetary History of the United States, the Federal Reserve’s acquiescence to bank failures and the resulting loss of depositors’ money contributed to the intensity and longevity of the Great Depression in the United States. Apart from mitigating economic downturns, there are sound arguments for protecting banks’ deposits. People cannot function in a modern society without having them and they represent the nearest port of call to the impractical option of storing buckets of cash. At question is the degree to which measures to protect bank depositors should also protect shareholders. There is no good argument to protecting shareholders in a capitalist economic system. It simply sends the wrong signals. Monetary authorities and governments should contemplate recapitalising a bank or otherwise providing guarantees, only if the full benefits of these measures are recovered up to the limit of all shareholder equity. In dire circumstances, that might mean temporarily taking public ownership during the course of finding new private-sector owners. A joint-stock business and its shareholders are separable. Usually a business can and will proceed quite happily with a different set of shareholders.
Governments have no role in protecting shareholders against loss; nor creditors, with the exception of bank depositors. To the maximum extent possible they should allow businesses to fail. If a business is any good as a going concern it almost certainly will be snapped up by new owners at a bargain price. Shareholders and creditors take their chances under capitalism. The reason that governments protect major businesses from going broke—including, as we saw, major vehicle manufacturers in the United States—is that they have (unjustifiably) lost confidence and faith in the ability of capitalist economies to adjust and rebound. When you think like that, the GFC becomes another indictment of capitalism which would simply fail without massive intervention by government. And, in fact, the more governments intervene to prop up failed businesses, the less robust capitalism becomes. In a sense, it is a self-fulfilling strategy. Intervention creates expectations of intervention which, in turn, lessen the perceived penalties of failure. Once that happens, calculations which guard against the risk of failure are not undertaken with the same rigour. Capitalism becomes more prone to excesses and therefore failure for which, of course, intervention is prescribed. Moreover, when salvation becomes expected and is “inexplicably” denied, as in the case of Lehman Brothers, an exaggerated sense of doom descends, as expectations are dashed.
The second kind of response to the GFC, premised on the intrinsic frailty of capitalism, was financial regulation. The main thrust of this regulation was the imposition of increased capital requirements on banks. There is simply no point to this at all. Banks should be required to act more prudently than other financial institutions and be subject, accordingly, to rigorous scrutiny by prudential regulators. They should be required to make adequate provisions for bad debts, and for other risks, based on reasonable expectations of the economic outlook. They should be required to distance themselves from the obligations of any non-bank subsidiary. At the same time, governments and bank shareholders should understand that banking is a business fraught with uncertainty. It is inevitable that banks will lose money when the economy goes into a tailspin. Diversification and taking security over real property, their only robust risk management tools, are inherently and inevitably deficient when most businesses across the board suffer downturns and property values plummet. Within practical limits, no amount of capital can cope with this risk. Imposing onerous capital requirements simply hamstrings banks and leads to the growth of riskier institutions. Bank failures are not a slippery slope to economic depressions, provided contingency measures are in place to protect all bank deposits. The way to provide for this contingency is to impose a levy on banks commensurate with the insurance cost of protecting bank deposits. This will not disadvantage banks provided the community is convinced that all other avenues for investing savings are subject to the risk of loss with no possibility of government bailout.
The third kind of response to save capitalism from itself was massive Keynesian stimulus spending. A number of conservative economists, for example Steven Kates here and Thomas Woods in the United States, using classical or Austrian economic theories, have sought to explain why stimulus spending will not work. Keynesian economists (that is, most economists) are unlikely to be convinced. They believe, as do the governments they advise, that capitalism is inherently flawed in periodically lapsing into long periods within which insufficient demand is generated to take up the production of a fully-employed economy. The answer, therefore, in their minds, is to boost demand; and it is so obvious an answer that those who don’t see it are obtuse. Nor does the experience of moribund economies and intractable unemployment in Europe and in the United States following stimulus spending convince them. They simply believe things would have been worse without it.
It is worth explaining again, from first principles, why Keynesianism doesn’t work. An economy is made up of millions of different products and demands which have to match to a good approximation; otherwise we end up with warehouses full of unwanted products and queues for others. Bringing supply into line with demand for individual products is the job of producers based on their experience of what will sell for a profit and what won’t. It is a hard job, which is why many businesses struggle or go broke. It is also their job to make products and, coincidentally, generate equivalent income with which people can buy products. Synchronisation is the key. Everything must work broadly in sync for the economy to be well. Normally this occurs. Sometimes things get significantly out of sync. Too much of some products are produced: houses in the United States in the lead-up to the GFC, for example. This causes dislocation and, if serious enough, a fall in confidence and unemployment. Economic adjustment begins. Some producers are forced, or decide, to close down; others reassess their business models; new businesses spring up. All are making calculations as best they can while taking account of an uncertain future. The clearer they see the future the more likely it is that confidence will return and growth resume.
Now superimpose on this adjusting economy massive temporary spending by government. On what, you may ask. It doesn’t matter, according to Keynesian economist Paul Krugman; getting aggregate demand up is the key. It requires little insight to understand how disruptive and counterproductive such spending will be. Unless, that is, you refuse to be bothered with messy details which are the stuff of business decision-making, day in and day out. Then you are spared insight and can blunder on. You can be a Keynesian, create havoc, and claim that the havoc would have been worse without you. Economists—who are paid to be economists—can be found everywhere in the public and private sectors spouting this nonsense. Taking them seriously is akin to taking seriously a physicist explaining how to split an atom with a hammer and chisel.
Let me now explain why this useless stimulus spending is proving useful in a way not imagined by its proponents. Quite simply, by worsening the GDC, and without apparent benefit, it has brought Keynesianism into disrepute. If this disrepute survives the inevitable counter-attack by the entrenched vested interest of mainstream economists, the current economic malaise will serve an outstandingly good purpose. The GDC may perhaps represent a turning point towards restoring economics to a sounder footing. More than this, it may also herald a rolling back of decades of social and regulatory engineering which have crippled capitalism and resulted in intractable long-term unemployment in most Western countries. Crippled capitalism is still better than any form of socialism, but why settle for second-best?
The Global Debt Crisis
Unsustainable government deficits and debt and the higher interest rates and policy uncertainty which accompany them could send the world into another deep recession. The situation is threatening. One persuasive indicator of this in Europe is the leading role of Germany and France in bailing out more perilously-placed countries. Germany, and certainly France, on anything but a relative scale, are hardly beacons of prudential fiscal management. “In the kingdom of the blind, the one-eyed man is king”, is particularly apposite. On the other hand, promise sits alongside threat because the policy options facing governments are largely confined to those that will be beneficial in the long run. Unemployment and debt have come together, leaving only a narrow, beneficial avenue of escape.
Unemployment in the United States was 9.1 per cent in mid-2011; in France 9.7 per cent; in Italy 8 per cent; in the UK 7.7 per cent and in Germany 6.1 per cent. These numbers are high enough, but modest when set against Spain, 21 per cent (green jobs notwithstanding); Greece 15 per cent, Ireland 14 per cent and Portugal 12 per cent. Keynesians should (but don’t) question how such high unemployment is possible when public sector spending has bulked so large in the economic affairs of these countries. All have governments still substantially outspending their revenue, with only Germany’s and Italy’s projected budget deficits falling under 5 per cent of GDP in 2011. And this is against a backdrop of onerous debt. The United States government gross debt is projected by the OECD to hit 101 per cent of GDP this year. The comparable figure for France is 97 per cent; Italy 129 per cent; the UK 89 per cent; Germany 87 per cent; Spain 74 per cent; Greece 157 per cent; Ireland 120 per cent; and Portugal 111 per cent.
According to an IMF rule of thumb, 60 per cent of GDP is considered an “acceptable” level of public debt. Some argue that higher levels are sustainable, up to say 90 per cent. It depends on the fiscal position of the country concerned, its rate of economic growth, the level of foreign assets it may have to offset debt and whether contingencies lurk, such as the potential need, as in Spain and Ireland for example, to bail out banks. On any measure, the equation is usually stark for countries burdened by government debt at or close to 100 per cent of GDP and whose economies are moribund with high unemployment. In these circumstances, taxation revenue suffers, welfare expenditure rises, and debt servicing costs eat into revenue. Budget deficits tend to blow out, and add more to debt and to debt servicing costs. It is a vicious circle; no different from that faced by individuals or businesses that get themselves into similar positions. Once debt rises materially above 100 per cent of GDP the problem can easily become explosive, particularly if lenders demand higher rates to roll over maturing debt or to take on additional debt.
It is sometimes said that countries are not like commercial businesses. There is a difference. Countries don’t go out of business; they always remain going concerns. However, like businesses they can default on their debt. And like businesses, and like individuals, once in debt the option of defaulting can only be forestalled by having a rich benefactor, or raising revenue, or cutting costs. Rich benefactors eventually get sick of helping, as Germany and France are demonstrating; this leaves increasing revenue and cutting costs. Increasing revenue is seldom an option for loss-making businesses or for governments presiding over moribund economies. Sure, the “rich” can be taxed a bit more. This is superficially attractive but usually brings in less revenue than its proponents expect, and takes away from private savings which are needed to support investment. Cutting costs is usually the only solution capable of turning the position around.
For governments, cutting costs means spending less; the antithesis of Keynesianism at times of high unemployment. Nevertheless, that is precisely what governments, without exception, are now trying to do. While the aftermath of the GFC showed that Keynesianism doesn’t work, the GDC has driven the point home. The changing stance of the IMF is instructive. The IMF believes in fiscal discipline. It has the role of bailing out indebted governments. However, in January 2008 at the World Economic Forum in Davos, when the GFC was beginning to bite, its managing director at the time, Dominique Strauss-Kahn, called for stimulus spending. This apparently surprised some of his fellow panel members, including the then US Treasury Secretary Lawrence Summers, who were unused to IMF fiscal largesse. The IMF appears to have been chastened by this experience. It produced the result of its annual consultation with the United Kingdom in early June 2011. It endorsed the fiscal consolidation (the buzz term for reducing budget deficits) in the UK. This was despite a backdrop of figures from the UK issued in May showing unemployment at 7.7 per cent, including significant growth in long-term unemployment (those out of work for twelve months or more). Effectively this represents the last rites on the body of Keynesian economics, even if die-hard Keynesian economists like Paul Krugman don’t see it that way. Hope springs eternal among the faithful. The hard-nosed, and that includes governments and parliaments in Europe and the United States (President Obama, with his latest jobs plan, which he announced on September 8, excepted) know a dead body when they see it. They are all trying to deliver fiscal consolidation when their unemployment rates are stubbornly high. They now know effectively that Keynesianism does not work. Might that effective knowledge find increasing expression in universities and in the media?
Making Keynesian economics an historical curiosity is one potential benefit of the GDC. Equally important is its potential for substantially rolling back the welfare state. The size of the debt problem is a product of entitlement spending. It can be solved only by cutting back that spending. In the United States, for example, spending on Medicare, Medicaid and Social Security is 57 per cent of the federal government’s budget and growing. Defence takes 25 per cent, leaving little scope for deep enough cuts elsewhere. Unaffordable pension and other benefits to public-sector workers across states and municipalities add to the problem. Budgets cannot be brought back to a position to stabilise the level of debt, never mind reduce debt, without stringent cuts to entitlements. This applies across most Western countries. Starts have been announced or made in the more perilously positioned countries like Greece, Ireland, Portugal, Italy and Spain and also in the relatively better-positioned countries like the UK, France and Germany. Talk is occurring in the United States—though the heated reaction to Republican Congressman Paul Ryan’s modest plan to cut future Medicare and Medicaid entitlements has not been promising. Much more will be required.
Demonstrations protesting against cuts to entitlements have already occurred in Europe. They can be expected in the United States. A taste of this was evident in demonstrations and sit-ins in Wisconsin last year when the new Republican governor, with a large state budget deficit to manage, introduced legislation to require public-sector employees to contribute to their own retirement pensions and health insurance and to restrict their collective bargaining rights. The absconding across state lines of fourteen Democrat state senators to prevent a vote on the legislation also highlighted just how partisan politics will complicate the task.
Social dissension on a scale of mass public demonstrations, and perhaps even riots, is deeply concerning. But the assumption has to be that democratic institutions across Europe and the United States will be strong enough to withstand the challenge. Leaving this aside, from a purely economic policy perspective winding down entitlements and, its obverse, winding up self-reliance is an unmitigated good. Self-reliance is an essential building block of capitalism. Capitalism is the only economic system capable of producing prosperity and relieving poverty. It is the only economic system compatible with political freedom. It is worth fighting for and facing up to social dissension.
Governments stripped of their Keynesian illusions and faced with high unemployment and an essential need to cut entitlement spending will be searching for solutions to ease the pain. One clear solution that even European governments can’t miss is to reduce artificial barriers to private sector investment and growth. That essentially comes down to reducing regulatory burdens. In a world of green politics and global-warming alarmism this will be difficult on the environmental front. Undoubtedly, the use of less-efficient energy will impose an additional burden on economies and reduce their ability to fund entitlements. However, there is scope for easing regulation in other areas—financial and workplace deregulation, and cutting red tape.
Cutting red tape is the easiest for governments to contemplate and appears to be under way, as does some modest labour market deregulation in a number of European countries. Financial deregulation will be harder because there have been rounds of increased regulation since the GFC. Hope springs in the United States, as it often does. For example, the Republican Party seems intent on repealing the Dodd–Frank Wall Street Reform and Consumer Protection Act passed in 2010, if it were to gain the presidency in 2012.
Substantial labour market deregulation will be tough to accomplish, as will be any rolling back of environmental obstacles to investment, particularly in Europe. The potential lies in the lack of alternatives. Once a government and a society have run down the nation’s wealth and created enormous burdens on a proportionately declining number of taxpayers, the alternatives are limited to becoming progressively poorer or becoming more productive. Freeing the private sector from regulatory barriers is the key to productivity.
The GFC spawned a series of unfortunate and damaging policy responses, just as the economic malaise in the United States in the 1930s led to the New Deal or, to stretch a point, as the economic malaise in Germany in the 1920s contributed to the rise of Nazism. Clearly, economic crises can have unfortunate consequences. The GDC might too, particularly if the need to substantially reduce entitlements results in unmanageable consequences for civil order. Freeing the private sector to flourish is the least painful way out. The hope has to be that governments will stare down special interests, unions and environmentalists, and renew their confidence and faith in capitalism.
Peter Smith is a former CEO of the Australian Payments Clearing Association and a frequent contributor to Quadrant and Quadrant Online.