Saturday, 11 October 2008

In the middle of a global financial heart attack...

In the middle of a global financial heart attack,
where is our Dr. House? By Douglas Bulloch.

The plot will be familiar. An unusual presentation of otherwise routine symptoms perks the interest of your favourite fictional genius doctor. Preliminary investigations are followed by treatments that seem to clear up the initial problem, but then the patient collapses and her organs start to fail one after the other. Dr. House then breaks every medical rule in the book in a desperate race against time when, after a suitable interval, he is touched by genius and identifies the original cause, either curing the patient with a couple of aspirin, or reconciling them with their inevitable death.

As with HBO medical drama, so with the global financial crisis. Right now we are in the organ failure stage, and desperately trying to treat the symptoms, but the diagnostic discussions are angry, vengeful and completely unresolved. Politicians around the world are agreeing with every proffered solution for the sake of unity, yet masking their ignorance behind an escalating range of worthless metaphors. Now is not the time to debate the origins of the crisis, they say, but the time to solve it. This position is exactly wrong. The cure depends upon identifying the cause, and until we recognise the cause of this problem, we are doomed to exacerbate it.

The first range of explanations that need to be dispensed with are those of a moral dimension. These cross the political divide. Those on the left blame greedy bankers, and those on the right, feckless borrowers. Neither has any bearing on the problem we are faced with today. Bankers have always been greedy, and heartless, stingy, even cruel. But it is because of these characteristics that they are trusted to look after other people’s hard earned money, not in spite of them. On the other hand, fecklessness is nothing new. Give a ne’er do well money, and he’ll fritter it away without thought for tomorrow. The problem has less to do with the phenomenon of the new super-rich class of banker, nor the sub-prime mortgage defaulter who never had the ability to repay. Both are the unknowing beneficiaries or victims of an excess of money.

Nor is the problem one of regulation or direct political interference. It is true that the Clinton administration pressured banks into offering loans to people of a dubious credit history and limited means. But as long as this was understood and underwritten as a scheme for the redistribution of wealth, there needn’t have been any problem. It may have failed, it may indeed have been expensive, but it is no more the cause of economic meltdown than Enron, the Dotcom bust, or the Iraq War. The toxic debt they produced was at least potentially quantifiable, whereas the ongoing collapse in the value of all property and global equities is not. Furthermore, lack of regulation may be an easy soundbite, but it is rarely accompanied by any estimation of exactly what regulations would prevent a ten-year asset boom followed by its sudden collapse. And it takes no notice of the fact that we have a brand new regulatory institution in London, empowered in accordance with all the latest thinking on financial regulation.

The problem is macro-economic, and if Dr. House were having his moment of realisation he would see that we have been here before, many times. What is more, the cause of the current problem would have been addressed – if not understood – by that most famous of literary simpletons, Chauncey Gardiner. In the film of Jerzy Kosinski‘s short story ‘Being There’, Peter Sellers plays Chance the Gardener, a man who was taken in as a child and brought up in the household of a wealthy man. He never learnt to read or write, only ever worked in the garden, and watched television obsessively, continually changing the channel to receive a stream of fragmentary slogans, songs, and pictures. He was, in short, without personality, an empty vessel devoid of all meaningful content, and after the death of his benefactor was thrown out into an entirely unfamiliar world, which he had only seen in pieces through his television screen. Everyone he met inferred enormous meaning into his gnomic comments, such that he ended up on television advising the President of the United States on economic policy. Drawing on the only knowledge he had, he said that in a garden, first there is spring, then summer, autumn and winter. Then after winter there is spring again. This was interpreted as a comment on the business cycle, and offered by the President as reassurance to a nation in the depths of an unspecified economic crisis.

Only later was it discovered that Chauncey Gardiner was a complete simpleton, but by then he had been elected to head up a major corporation. None of this is to suggest that what we need is a simpleton in charge of the World’s largest economy, however, the roots of this problem are indeed simple, even if the effects are extraordinarily complex.

The underlying problem stems from attempts to control or contain the business cycle. Growth, if it is real growth has to go in phases. There must be periods of consolidation in which costs are trimmed processes rationalised and strategies re-examined. If legislators attempt to delay a downturn they do two things. First of all, they sustain firms that have grown accustomed to inefficient business practices, and by doing so, weaken the whole economy. Secondly, they exacerbate the consequences of the eventual downturn.

The particular manner in which the current business downturn was deferred until now was particularly pernicious. We now know that keeping interest rates low in order promote growth fuelled a credit boom that drove up the price of assets and equities. If this had happened in one isolated economy, then this would have fed through to inflation fairly quickly, as rising property prices inevitably feed through to a rise in living costs, and impact on production and distribution costs. But in a context of rapid globalisation, consumer prices were further held down by the lowering of average labour costs through the transfer of manufacturing capacity to Asia.

The past ten or so years have seen the mature phase of this process play out before our eyes. 1997 saw the deliberate lowering of interest rates in the face of the Asian currency crisis, for which Alan Greenspan was hailed as a genius. This strategy was repeated on numerous occasions and global growth kept moving forward, investment flows accelerated on the back of cheap debt, trade imbalances ballooned, property prices kept on going upwards.

Now we face the prospect of unsustainable levels of debt secured against hugely overvalued assets – similar to the problems faced by Latin America economies in the 1980s – and as the assets fall in value, so increasing amounts of debt becomes bad debt; the sub-prime category was merely the lowest hanging fruit. Greedy bankers played their role in all of this, as did feckless borrowers, but the underlying problem was the artificial lowering of the price of credit by the US Federal Reserve – and by extension many other central banks – in an ingenious reinvention of Keynesian economics. Debt is after all just another kind of printed money. Bad debt especially so.

One way to avoid this would have been to have truly independent Central Banks which set their own measure of what constitutes inflation, including property prices. To his credit Mervyn King has been warning about unsustainable levels of both debt and property prices for years, although he had no power to act against them. Another suggestion would be to measure GDP by netting off accumulated debt, thus debt fuelled growth would be excluded from economic indicators, and Gordon Brown’s ‘end to Tory boom and bust’ would have been exposed as a sham from day one.

Keynes famously remarked that, in the long run, we are all dead. However, the philosophical truth of this remark should be measured against its economic meaning. The ‘long run’ in economics indicates an abstract point in the future, in which all assumptions concerning what is fixed are held to become variable. What he meant when he said this was rhetorically the same as the politicians currently urging action before considering the cause of the current problems; in other words, we are faced with problems that we need to solve, the ‘long run’ consequences are the problems others will have to solve tomorrow. The trouble is tomorrow always comes, and as a rule of thumb, the economic ‘long run’ looks to be about ten years, not so ‘long’ after all.

The current efforts to provide liquidity to the banks are understandable, and probably necessary, but the deferment of any analysis of the origins of this problem will lead to outcomes economists would describe as ‘sub-optimal’ – in English, catastrophic. Of the many things that need to be understood and acted upon, almost all of them have been known about for years, including these simple, if unpalatable truths: Milton Friedman’s Nobel Prize was well deserved. The business cycle is our friend. Retail Price Inflation (RPI) is not the same thing as real inflation. Central Banks cannot control real inflation by measuring only parts of it. Economics is quite simple really. Simple problems can be solved by a simpleton. And beware of anything you don’t understand.

When Dr. House sees symptoms that he does not understand, he investigates, even beyond the point of death, in order to find their cause. In our race to treat the symptoms of this global financial crisis, we must not forget the cause. Government ownership of the banks, liquidity injections, and reductions in interests rates may count as life support for the time being, but in the ‘long run’ we need to let the banks get back to banking – rather than laundering deliberate debt inflation – rehabilitate the business cycle, and learn to live within our means.

© Douglas Bulloch
Researcher, International Relations Department, London School of Economics.