What I didn’t say on the BBC

I was on BBC Radio Five Live at about 4AM local time this morning for a good 5 to 10 minutes, talking about the coalition government’s austerity budget. My basic message was that austerity-lite might be defensible but full austerity is "reckless" if government doesn’t understand how it could contribute to a debt deflationary outcome. Let me flesh out my argument here by presenting you with a few comments about debt deflation first and then talk specifically about austerity in the UK and US context.

Stimulus is No Panacea

The pre-crisis Edward took the Austerian view of the issue. Let me give you an example or two. This first one is from June 2008 on debt deflation dynamics.

The Real Problem: Debt Deflation
Debt is a special problem because we live in a fractional reserve banking system. Murray Rothbard, one of the most esteemed economists of the Austrian School, said:

"The Ricardian analysis of the business cycle went something as follows: The natural moneys emerging as such on the world free market are useful commodities, generally gold and silver. If money were confined to these commodities, then the economy would work in the aggregate as it does in particular markets: A smooth adjustment of supply and demand, and therefore no cycles of boom and bust. But the injection of bank credit adds another crucial and disruptive element. For banks expand credit and therefore bank money in the form of notes or deposits which are theoretically redeemable on demand in gold, but in practice clearly are not."
"Economic Depressions: Their Cause and Cure," Murray Rothbard

Basically, Rothbard is saying that inflating available credit through banks’ lending money they don’t have creates a natural boom-bust cycle. Banks go overboard at some point in time, banks suffer credit losses, banks then become more conservative, and credit contracts accordingly.

So when debt is high relative to GDP and disposable income, when debt servicing costs are high relative to income, the contraction of credit is a problem. When credit contracts and banks lend neither to one another or to customers out of fear and in order to protect their own assets, people go bankrupt. This infects the real economy and in turn creates more bad debt, which causes banks to contract credit further in a negative feedback loop. So-called money velocity goes down.

This is what happened to Japan in 1990 and what happened to the U.S. in 1929. Economic stimulus in the form of easy money has no effect on this process because low interest rates and monetary liquidity cannot force people to lend or borrow when credit is contracting. This is also what is happening right now in the UK and in the US. These two countries have much too much debt and cannot take on further credit. Easy money is no panacea because it cannot counteract the inherent deleveraging of an overleveraged financial sector.

What to do?
The BoE and the Fed should allow the credit unwind process to proceed on course. If and when systemic risk appears, the central banks can step in with liquidity at penalty rates. This was the original plan that Mervyn King wanted to adopt. However, he lost his nerve when Northern Rock went to the wall. Had King allowed Northern Rock to fail and liquidated its balance sheet over a longer time frame, we might have been able to pull out of this crisis sooner. But, King and Bernanke have lost their way and are bowing to political pressure.

The Japanese problem is instructive as it actually demonstrates more that easy money is not the way forward. The Nordic Bubble workout of the early 1990s may be the best paradigm for a worried Fed and BoE.

Ultimately, it is the political solutions that will make this crisis longer and deeper.

Credit deflation and the Japanese problem

The subtext here was that Japan has struggled for two decades with debt deflation dynamics in my view largely because they have continued to prop up malinvestment. Had they more readily allowed marginal enterprises to fail, their situation would not have been as severe. Now I know the MMT folks and the Keynesians will disagree and say Japan never added enough stimulus. I’ve had that debate with Marshall Auerback, so I won’t re-hash it here; you can see our posts on this from last November (Marshall: Japan does not demonstrate the failure of stimulus, Edward: Japan: stimulus without reform leads to a policy cul de sac).

But the specific point I was making had to do with the central bank acting as lender of last resort. The Fed was right to provide liquidity to the banks by taking on their assets, but I think it was wrong for the Fed to junk its balance sheet unless it extracted a penalty rate from the banks (something Warren Buffett did in providing capital, I might add). When you see the BoE nationalising a non-systemic bank like Northern Rock or the Fed taking small haircuts for MBS paper which we now see could be put back to the originators, you’ve got a bailout. This is fiscal policy, not monetary policy.

Here’s another one from March 2008 called The U.S. Economy 2008. I said:

“To my mind, this is a re-run of 1980s Japan, where the Japanese have resisted the credit-unwind process. After the crash in 1987, all central banks around the world adjusted to a tighter monetary policy after it was clear the ’87 Crash was not going to cause a depression. Tightening (and the unwinding of the S&L crisis) did eventually result in the 90-91 recession but we pulled out successfully.

Japan did not tighten because the United States requested they keep interest rates low to get the Dollar-Yen exchange rate down (very similar monetary policy to Greenspan’s loose policy post-LTCM and Russian devaluation in 1998). This was a grave error because the result was an even larger bubble, which popped in 1990. The Japanese real estate sector kept going strong until 1992, before it collapsed.

Even after massive stimulus campaigns by the Japanese since then, the Nikkei is easily down more than two-thirds from its all time highs over 15 years later! Japanese residential property prices are half of their peak levels. All the while, the Japanese have pumped money into the economy like mad, running massive budget deficits.

An inflationary monetary policy and Keynesian government spending stimuli are not a panacea to a post-bubble depression. This is a lesson the Fed has failed to take on board.”

My point was that the reason we are in the fix we are in now is exactly because every time the economy hit the wall, we got an asymmetric response from the Federal Reserve in the form of liquidity and interest rate cuts followed by slow-walking the eventual tightening. This is directly responsible for the leverage and moral hazard in the banking and household sectors. When you look at Japan’s attempt to do the same after an extraordinary credit bust, you see that while quantitative easing and fiscal stimulus might reduce some of the pain, they are no panacea. More importantly, it is a return to the asset-based policy that created the overleverage to begin with.

So what should we do then?

If you follow what the IMF prescribed for Asia during the Asian Crisis in the late 1990s, you would go for severe austerity like we are seeing in Spain, Ireland and Greece. This is basically a self-imposed depression in order to eliminate the misallocations of resources created by the credit bubble.

Marc Faber is saying that’s what the U.S needs to do – and doing so would clear up all currency tensions.

Marc Faber, publisher of the Gloom, Boom & Doom report, said the way to resolve the “currency war” facing the world economy is for the U.S. to shift the focus of its economy.

“The currency war can be solved one way: with austerity in the U.S.,” Faber told reporters at a Russian investment conference today in London. “The U.S. needs to redirect the economy to R&D, education and infrastructure expenditure, but instead they want to get spending going again.”

The curious thing is that the US-dominated IMF forced this policy upon the Asian economies but is unwilling to do the same now, a clear case of hypocrisy.

I don’t find the full-on austerity argument persuasive for this synchronized global downturn. Governments and private sectors across the developed economies cannot all deleverage simultaneously without a severe fall in output  – aka Depression with a capital D. Moreover, austerity has cause and effect backwards; it is past malinvestment and bust which has caused an output gap and budget deficit. Focusing on deficit reduction itself doesn’t reduce the deficit. More likely, the private sector’s desire to net save will not be altered and the cut in spending will be met with an equal cut in spending in the private sector – increasing the deficit (see here). So I advocated stimulus to mitigate worst-case outcomes in 2008.  That’s also what we got.

Now that the global economy has stabilised, it is clear we are back to square one regarding the tension over global imbalances. The private sector leverage is still there. And as Simon Johnson says, the public sector leverage has increased dramatically because of the financial crisis. The fact is you can’t get out of this without some kind of deleveraging.

The US and the UK are similar economies. They both had huge expansions in credit and household leverage financed by an expanded and oversized financial sector. They both experienced housing busts and felt forced to bail out the banking sector. They both started from a position of relatively low federal debts that were increased massively due to the fall in output and taxes and the associated increase in fiscal transfers.  They are both running massive deficits. And households in both countries are both massively under-saved (see here for example).

Here’s what I would advocate for the US or the UK.

  1. Avoid massive cutting. Because the US and the UK have retained their own national currencies and cannot be involuntarily bankrupted as a result, I would avoid massive federal cuts in the near-term. Basic national accounting tells you that a reduction in government deficits must be matched by an equivalent reduction in surpluses in the non-government sector. In a post-bubble world that’s not going to happen, instead the cuts will induce cuts in the non-government sector and drag the economy down. The spectre of debt deflation would loom large given the unrealized losses on bank balance sheets.
  2. Focus first on jobs. The primary focus has to be on increasing output because this is mostly about demand. And I don’t mean quick fixes via stimulus or tax cuts. The middle class needs more jobs and higher wages. What the governments should do is what Faber said: help redirect the economy to R&D, education and infrastructure expenditure. Unfortunately, not all of this means shovel-ready employment because much of the job loss is structural – it’s not all aggregate demand (see here).
  3. Cuts should be structural, not cyclical. The government should focus on closing the output gap first. Focusing on deficits is counterproductive when there is massive underemployment and idle capital. However, real resources used by government programs are a drain on the private sector when the economy is operating at full capacity. When all is said and done and we are back to full strength, there will still be a large structural deficit in the UK and the US that won’t be closed via wage and employment gains. I know people make that argument;  the numbers don’t add up. Some like Dick Cheney even advocate large deficit spending in perpetuity. I don’t. Again it’s about resource allocation. So eventually, you will have a choice on how to deal with this. I say deal with jobs now but at least have a plan to deal with this issue (see here). The changes have to either be higher taxes somewhere or changes in places that count like military, healthcare, and pensions. There’s no way around it in an ageing society unless citizens voluntarily work more. The UK is making some of these structural changesregarding the military budget.
  4. Stop QE. It won’t work. It’s just a subsidy for banks and doesn’t have an appreciable direct effect on the real economy. Read my post "A few thoughts on the Fed’s quantitative easing strategy." Some say we should do it anyway. But why if it’s only going to maintain an asset-based economic model which leads to private sector over-indebtedness and moral hazard that induces public sector indebtedness?
  5. Increase savings and reduce debt. Deleveraging must occur. The U.S. and the U.K. have debt ratios in the private sector which cannot reasonably be worked down via wage and employment gains alone. Absolute debt levels have to come down too. And this means higher savings rates. If the US actually saved more in line with its investment, the trade deficit would vanish. The principal way government can induce higher savings is via the incentive of interest income. People don’t save if rates are zero percent. You can’t have permanent zero (PZ) and expect a high savings rate. If the economy makes it through early 2011 without a double dip and jobless claims are receding, it’s time to raise rates. PZ is toxic.
  6. Jobs Program. If you are going to cut the massive doses or monetary and fiscal stimulus, it’s going to be a net detractor to output. Therefore, to increase jobs while the private sector adjusts its hiring needs, you can have add a locally-based, federally funded jobs program to replace unemployment insurance as a backstop. This would be an automatic stabilizer instead of a new permanent feature.

The fact is we are not going to prosper in a debt deflationary environment but we can’t rebalance our economy unless reforms are made. So, that’s my program. It’s certainly not Keynesian. But, it’s also not Austere. Call it austerity-lite if you will. 

P.S. – As I thought about an analogy for the situation, I said to myself “the US and the UK need some major private sector debt surgery. I cannot advocate having the operation without some good painkillers. But let’s be clear, taking the painkillers without the surgery isn’t going to work. If we don’t get the surgery done, the patient is going to be in much worse shape down the line.”

  1. Matt Stiles says

    Good post, Ed.

    As an uber-debt deflation advocate, I obviously am not a fan of government fiscal stimulus. I just don’t think they can efficiently allocate resources. But that is not going to happen under any political paradigm in sight (even the Tea Party would pander to the banks by the looks of it). So if we were to embark on your solutions, I would have to stress the most important theme:

    Forget the aggregate levels. It is the flows within the aggregates that matter. Cutting $300 billion on military/defense expenditure and raising infrastructure spending by $300 billion is NOT a wash. Raising taxes on financial institutions and lowering them on individuals and small businesses is also NOT a wash. It matters immensely.

    If I hear another comment from Keynesians that “we need to increase spending” without specifying exactly what on, I’m going to have a goat. Just because it doesn’t change the models, doesn’t mean nothing changes.

    I’d settle for these kinds of reforms as a compromise to my “Deflation fuer Alle” stance. Although in my heart of hearts, I know that infrastructure spending programs will be squandered to a large degree, billions will be embezzled, bridges to nowhere will be built at the expense of more legitimate projects, etc.

    But if we must tolerate that wastefulness to tear the economy away from the financial sector and put it back (somewhat) in the hands of productive individuals, I’d settle. It still won’t work, and would likely still take decades to return to sustainable levels of debt, but it’s not as bad as the current prescription.

    I still say a combination of:
    default on nearly everything,
    liquidation of assets,
    dissolving the central bank,
    phasing out deposit insurance,
    repeal of legal tender laws,
    bringing all troops home from abroad,
    eliminating the income tax,
    reforming pension programs and,
    eliminating numerous government departments

    Far more painful (for some, less for others). But it’s the only way you’re going to get a rising standard of living in the next 5 years.

    1. Edward Harrison says

      Good one, Matt. Let me play devil’s advocate here on some of these issues like deposit insurance. We know that people aren’t always rational. Deposit insurance like other insurance is a vehicle to prevent this from becoming a problem. But as with other forms of insurance it produces a moral hazard. Isn’t the hazard worth it to prevent the systemic risk? Also, isn’t the real problem fractional reserve banking i.e. the depositors’ knowledge that their deposit funds may not be available in the case of a run?

      On the libertarian issues, I am on the more statist side with Hayek. (I would call it being practical) And what I mean by that is that there is never going to be a true libertarian paradise because a society without rules is anarchy (see here: https://pro.creditwritedowns.com/2010/01/libertarian-paradise-in-somalia.html). A society has to decide which limitations are right for the times and the people. Ironically even Rothbard – who is the chief anarcho-Austrian theorist – talks about certain societal constraints without realizing it. He speaks of limiting fractional reserve banking as if that’s not state intervention. Why can’t I have a fractional reserve bank if I so choose?

      I support abolishing income taxes, bringing the troops home, reforming pensions, ending the fed’s monetary role (but not lender of last resort role) and eliminating many programs. And I could support a phased in end to fractional reserve banking. That’s my current thinking.

      1. Matt Stiles says

        Hey Ed,

        I subscribed to the thread, but didn’t get any alerts. Sorry for my late response.

        I fully believe that fractional reserve banks should exist. But it has to be done with the knowledge of the depositor (and the choice to go to a non-FR bank) that their money is being loaned to someone else with leverage. This is the risk-reward a depositor makes in exchange for interest (return) on their deposit. I also see no problem with deposit insurance for such banks. I just don’t want that insurance to come from the State (and other taxpayers).

        In the past I have advocated for 3 different kinds of banks:

        1) “Asset-backed banks” that hold your ‘money’ denominated in whatever you choose (dollars, wheat, oil, or most likely gold and silver – this could be anything really). They would charge depositors a small percentage of the deposit as their way of making a profit (or even a transaction fee). People can electronically exchange their 11 bushels of wheat & 3oz silver for a flatscreen at BestBuy if they want. BestBuy can then immediately transfer their ownership of wheat and silver into something else if they like. There is no technological/practical hindrance to this anymore. Nobody has to walk into Best Buy with the physical wheat. It can stay in the silo.
        2) For depositors that want to earn interest, they can go to a different kind of bank that will match them with a borrower. The depositor can take the risk of the borrower not paying back, or they can rely on the bank’s knowledge or an outside party. They could even purchase insurance if they wanted.
        3) Fractional reserve banks – which function much like today’s. A depositor can exchange their money for a piece of a mortgage pool or a corporate bond pool or whatever. But explicit is that they do not have direct access to their money. Their deposit is only worth what they are able to exchange their investment for on the open market.

        There is nowhere in that kind of a system that requires any government ascent or insurance. Most likely, different kids of banks would sprout up as well. But key is the elimination of legal tender laws and any moral hazard.

        I wouldn’t say that I advocate an-cap. But I admit that for me, it would be more preferable to state coercion. But unfortunately, it would take decades, if not centuries to develop the necessary private institutions to replace the State. Starting from scratch, I maintain that it is possible. So I’d be with Hayek and the minarchists as well. Reform radically, but don’t abolish the State.

        But nice to see we agree on most things.

  2. ldcdc says

    Great post Edward. It’s actually a solution that makes sense to me, without being purely Keynesian, or purely Austerian. I agree with you that the future out of this will be more income to the middle class, more of the GDP being distributed to the masses. It’s what really went wrong and got us to this point of overcapacity. Much growth isn’t likely to come while everyone is paying down debt or saving, but we can try to correct what went wrong without having an actual depression, with unforeseeable results. If we could by and large imagine how WWII would be fought after WWI, I think WWIII would be beyond anyone’s imagination.

    What I also think though, is that we can’t have the current globalization and fair growth rates for all participants, without fair play. Willful distortions like currency fixing will also have to go. Correct savings/investment/consumption ratios must be found by each country. After all, what is the point of growth if the populations can’t enjoy the fruits of their greater productivity.

    That is, unless someone’s mostly after altering the balance of power, and is willing to pay, and have us all pay the price for it.

    “Far more painful (for some, less for others). But it’s the only way you’re going to get a rising standard of living in the next 5 years.”

    I have no debt, but I have some savings. If depression and bank runs become a reality, I don’t see how I can win. Yeah, you might say I should get cash and sleep on it, but that’s the very definition of how a bank run starts. We might find equilibrium in a state where the bankrupt banks own all the empty houses, and people stay outside in the rain with no jobs. Fully working out the bankruptcies might take decades, enough time for my not yet conceived children to finish school, if there will be any to go to. :)

    “Cutting $300 billion on military/defense expenditure and raising infrastructure spending by $300 billion is NOT a wash. Raising taxes on financial institutions and lowering them on individuals and small businesses is also NOT a wash. It matters immensely. ”

    I can’t say that I disagree with you on that.

  3. industry accountant says

    Ed –

    I too also have to say great post. Pragmatic and sensible, this post acknowledges that a mix of austrian and MMT angles seems to have the best chance of providing a reasonable shot at long-term recovery without utter short-term misery on the part of the populace. A balanced solution like this also prevents our currency from being threatened as it reduces the amount we need to print while improving the perception of our policy choices amongst our neighboring countries/creditors (which also is a important player in currency values).

    While I am probably more sympathetic to MMT type solutions to our crisis, one thing that holds me back is the trade imbalance, which heavily limits the utility of those actions. For me the big way out of that is to get back to producing our own energy first, and then maybe recapturing some of the manufacturing that was sent overseas. The solutions above will get us there

    I would just ask that you probably specify energy in particular (although I know it would make up a good part of the “R&D” and “Infrastructure” initiatives). It is becoming such a critical issue with peak oil and currency issues that I think it warrants a seperate bullet point. I always tell MMT types that while we are far removed from the gold standard, “black gold” will soon be the new de facto standard that will ultimate stop us from just applying x iterations of “QE” and stimulus to our problems. However, if we get off the rock and start addressing that enormous gap (with a mix of nuclear, alternative and some of our own drilling), then we will have much better options in the medium to long run.

    As always, enjoy your insights…

    1. Edward Harrison says

      industry accountant, you can see what I say below in another comment about the connection between low household savings and the current account deficit. The two are twins. If we really wanted to get rid of the current account deficit, we would need to increase the savings level. It is no coincidence that the countries with the lowest savings rates invariably have current account deficits.

      1. industry accountant says

        Hi again –

        Thanks for the reply – I enjoyed the exchange below between ds, marshall and yourself. I don’t disagree with anything here in theory, but allow me to indulge you as one of the working stiffs who is amongst the every day little guys. This will be a little long winded but I think you will see the point.

        On personal savings, you are absolutely correct, and if we think about it, many of the actions that would lead to radically higher personal savings rates come at the benefit of vastly reducing our trade/energy deficits and dependence on foreign imports thereof. Living in smaller dwellings (that suck up less heating/maintenance costs), reducing commutes and leaving exurbia behind, fewer vacations, and shopping locally for food (which reduces dependance on the highly petro dependent production ag food system) would make a material difference in the current account deficit (and energy deficit) immediately. The freed income would likely lead to more investment at home, helping us redevelop/re-capture some of our lost manufacturing capabilities. All in on the up and up.

        Now for someone like me, this makes perfect sense, and you are preaching to the choir. I practice all of the above, saving ~ 30% of my gross. Here is where the problem is – very, very few people I know do this…and when I try to convince them of even some of the benefits I get a combination of the following: “You’re right, but I need my kids in xxx school district”, “I can’t go back to an apt anymore”, “I don’t want to live among ‘them renting’ people”, “Honda’s are too small/uncomfortable, I need a large car” etc etc… This, as they complain weekly about traffic accidents, prices of gas, expensive home repairs. I know, self-loathing and intellectually inconsistent writ large.

        But that is what you are dealing with on the front lines. So yes, it may seem simple to say ‘save more’, but unfortunately I can’t help but note that this is optimistic ivory tower thinking. Hence my little rant on the energy front, and calling for some supply side solutions there. We already have so much infrastructure built on personal cars, suburbia/exurbia, as well ingrained habits/perspectives, that it will be hard to change the big picture absent a huge shock, like say $6/gal fuel. I’d rather not have it occur that way, as many of the bad mad max scenarios potentially come to mind.

        Thus I am hoping that if we make this is a focus point within a sensible larger policy structure like you outlined above, hopefully the transition to higher energy costs will be a heck of lot smoother (and slower as well). Plus we get all those other benefits like you describe below (and I note above)…

  4. ds says

    I am having a hard time understanding your fifth recommendation. At the individual level this argument is quite clear: if you want to reduce debt you need to increase savings. But at the aggregate level this makes no sense. Savings represents a financial claim on someone else. Just as there can be no asset without a corresponding liability, there can be no savings without debt. How can the economy reduce debt without also reducing its savings?

    This is the major problem I have with the QE critics. It is a fact that new savings come from new investment. So if the problem is a lack of savings, how would higher interest rates encourage more investment?

    I like most of your points here in general, and I am no big fan of monetary policy, but raising interest rates would devastate the economy and produce outcomes directly in opposition to your other stated goals. In my mind, the better long run solution would be to abandon monetary policy by leaving the short rate at zero permanently, and instead use fiscal policy to manage output gaps and imbalances.

    1. Edward Harrison says

      ds, increased savings works at the aggregate level as well as the individual level. Remember, we are not talking about an increase in net financial assets which would imply a higher level of debt system-wide. We are discussing a different composition of assets and liabilities within the US financial system.

      Here’s the key. Rob Parenteau has pointed out that the vaunted government/current account ‘twin deficit problem is an accounting fallacy. He wrote:

      The true twin of the CUB is the HB, or household financial balance. And of course, this makes perfectly good sense since most of the trade deficit is in the area of tradable consumption goods

      Read more: https://pro.creditwritedowns.com/2010/06/stimulus-is-no-panacea.html#ixzz131KnVylN

      When the household savings level increases, the current account deficit decreases. So, what you would see if the household sector increased its net saving is a reduction in the current account deficit – a main reason I can’t support Paul Krugman’s calls for protectionism.

      Raising interest rates would devastate the economy if we were in a weakened state which we could be. That’s why I said the rate hikes have to be dependent on the number of people losing their jobs. Notice that Canada is raising rates and re-loading its chamber so they have more bullets to fire in the case of economic weakness.

      As far as permanent zero is concerned, I know Randy Wray calls for this. But it is toxic because it encourages the accumulation of debt. Zero is not a good number when it comes to animal spirits.

      1. ds says

        Thanks for the reply. To an extent I see what you are saying regarding the composition of assets and liabilities in the economy. The problem I have is how higher interest rates are supposed to lead to a healthier balance of debt and savings across the sectors. Raising interest rates will indeed induce households to save out of a given income, but raising interest rates will also discourage new investment and thus reduce income flows to households. Without someone else dis-saving, the attempt by households to save in the presence of higher interest rates will be self-defeating.

        Parenteau correctly explains the sectoral balances equation you mention, which is that the household balance is equal to the current account balance minus the government balance minus the (non financial) business sector balance. So you are right that if households are saving and government and business are neutral, then by identity the foreign sector must be dis-saving — so yes, the trade deficit will tend to go down when household savings goes up. But this identity confuses cause and effect. The only way in this scenario for households to save while maintaining their current level of income is for the foreign sector to explicitly dis-save — i.e. the foreign sector must start to consume more. Higher interest rates will not do this — in fact, they will encourage the opposite. Higher rates will make the dollar stronger, our exports more expensive, and will thus discourage the foreign sector to spend the balances they have accrued. Once again, on a macro level, this is self-defeating.

        I do agree with you that QE is unwise. The problem I have with monetary policy is that it can only swap out assets in the economy. It can have a positive effect, but only when the assets the Fed takes in are more risky than the ones it puts back. That is the only way QE can repair balance sheets. The problem with this is that it encourages and validates the speculative investors who got us into the mess we are in in the first place. QE can only work by bailing out existing asset-holders, which is exactly not the thing we want to do. Over the past few years we have realized that the housing market is not anywhere as stable and safe as we thought, but by backstopping Fannie and buying MBS in QE, our government is making mortgage paper even safer than it was before! Its absurd.

        This is where I think fiscal policy should play a larger role. If we would have nationalized the banks, wiped out management and forced bondholders to take haircuts while at the same time flooding the economy with an aggressive stimulus, the effect would have been to eliminate the moral hazard current policy is encouraging while at the same time counteracting the aggregate demand failure caused by private sector debt deflation.

        1. Edward Harrison says

          It’s more simple than this. If you have households saving more, consumption decreases. This decreases AD in the economy (which is why Keynesians resist this). But the reduction in AD also reduces the current account deficit. Clearly, the government could offset the loss of AD while the economy moves to full employment, at which point the loss in AD would be irrelevant. But there is no reason to delay the inevitable.

          America needs to save more. If it did, the trade balance would improve dramatically.

          1. Marshall Auerback says

            Americans might TRY to save more in anex ante sense, but you run up against the paradox of thrift. So there has to be an adjustment in some other area: either reductions in the current account deficit or increased budget deficits to accommodate that ex ante savings desire. At present, suffice to say, policy is running in opposition to these objectives. Via QE we are encouraging households to draw down savings and speculate, and we’re on the threshold of electing a Congress far less predisposed to fiscal stimulus. And we’re just at the beginning of a major new tsunami of Chinese imports, so trade deterioration is likely to intensify. All of which will work counter to the objective of increasing American savings. Incoherence reigns amongst our policy makers.

          2. Edward Harrison says

            100% Marshall. The US and especially the UK have it backwards. It should be more fiscal and less monetary if you want to increase the savings rate in the face of the paradox of thrift.

  5. DavidLazarusUK says

    I think that Keynes while commenting on the Paradox of Thrift during downturns, also supported increased savings during booms. This would balance out and mean that over leverage would be harder to achieve. It would be easier to sustain if the BoE and the Fed had targets for savings even during booms.

    I agree with you on “Avoid massive cutting”. This will just cause a retraction till businesses can see the impact on them. Everyone needs time to clear their private debts and governments will have to sustain these deficits till the rest of the economy is in a shape to expand again. There is no crowding out effect as has been claimed by some economists. Once the economy is approaching full employment then start to shrink the state.

    Focussing on jobs will reduce the costs of unemployment and start to rebuild a tax base. This will reduce the deficit naturally and easily as the economy recovers.

    The structural deficit is probably much smaller than is claimed. I very large part is cyclical and not all structural. The banking sector will probably have to shrink as a proportion of the overall economy and their taxes will need to be made up elsewhere. An equalisation of income and capital gains taxes will put the burden on those that benefited from the bubbles and also in future deter speculation on asset bubbles because there will no longer be a tax advantage. In the UK too many people made more from tax free property speculation than they did from other investments or working. The US could even scrap the huge mortgage subsidy as a way of balancing the books.

    I agree about QE all it is doing is inflation bubbles everywhere. None has made it’s way to real businesses.

    I totally agree about the ZIRP and even more so against PZ. These discourage saving and leave the nation vulnerable to international hot money. Who will move depending on the returns elsewhere. Individuals and businesses will still save but their returns will be negligible. This will cut their income and the governments tax take.
    It also damages the pensions and insurance industries. Annuities cannot be properly priced when rates are artificially low. Low annuity returns will harm the incentives to save for pensions. Higher rates of interest might actually make everyone think do I need to borrow? It might actually make labour more valuable, and enable wages growth which is very good for the economy.

    As it stands now there will be a Japanese style stagnation as assets fail to be repriced properly and losses drag on for years. Such ineptitude by central bankers and politicians alike will mean that we have a decade or more of stagnation. Hayek worried about the road to serfdom under governments. It will be worse being a serf under a corporation. So unless there is some reform of the banks and shadow banks the economy will be drained by fees and charges when good, and by taxes bailing them out when they fail.

    1. Edward Harrison says

      Very much on the money. My first reaction to your point about Keynes and saving was : “if not now, when?” And by that I mean, if the technical recovery looks sustainable by mid-year next year we need to move toward addressing the domestic imbalances of low savings and high consumption.

      1. DavidLazarusUK says

        I think now is the best time to do it. It does have its drawbacks. Though the benefits would be worth it.

        A lifting of rates to 4% or 5% over night would be shocking. It will rapidly deflate the remaining property and asset bubbles. It will lead to a sharp drop in property prices, wiping out many financially, but enabling them to restart afresh. It is that, or wait a decade for the prices to fall, like in Japan, sucking up taxpayers money all along, forcing governments to deepen the austerity cuts.

        It would mean that the banks would again be insolvent, but this time, wipe out the share and bond holders, and all their tax losses as well. Nationalise the remains. It would wipe out the mortgage backed securitization business as well.

        Then break up the banks. That will solve the too big to fail issue and restore moral hazard overnight. Banks that survived would have to change behaviour to survive long term.

        The UK’s banking sector is too concentrated. Force the banks mortgage arms to mutualise. Next make it so that building societies or Saving & Loans are then the only entities able to lend for residential mortgages. Also restrict the building societies access to money markets. They could have a safety net in the form of a building society regulator, who could be lender of last resort to the organisation. Though if any society needed such support more than twice a year it automatically triggers the entire board’s suspension from any directorships for five years. Such personal moral hazard would mean it is a very last resort. If directors could be personally affected they would be much more cautious, and directors would be much more prepared to keep bigger reserves, that would reduce risks all around long term.

        This means that the housing market would be more isolated from the general money markets and so they would fund mortgages from savings alone. This will encourage savings. They could help raise funds with long dated bonds. This would make rating the bond much easier as it would be society that is the subject of rating not the myriad of sliced and diced mortgages. This would mean that in future building societies would have to be much more careful re lending. A more sober property market with fancy mortgages being banned and only simple repayment mortgages with simple terms. A maximum income to loan ratio of 4 times income and no more than 70% LTV (maybe higher for first time buyers, lower for buy-to-lets) being allowed would make it much harder to inflate a property bubble. It would protect lenders and borrowers alike. With all having the same mortgage limitations they would have to compete on interest rates and service.

        If there was a surge in property prices or lending then the regulator could demand the society make a deposit of capital with them. This would reduce the societies ability to lend so restricting lending effectively. So killing any future property speculation.

        Then split the remains of the banks still further into competing commercial banks, and investment/merchant banks. This could be used to create a dozen more new deposit taking institutions overnight. That will increase competition.

        Ban commercial banks from overseas holdings. This eliminates the possibility of regulation arbitrage.

        Make investment banks partnerships again with partners risking all their personal wealth. That might reduce systemic risk overall as well. Ban them from being part of commercial banks. Then bonuses should be treated as income not capital gains which will eliminate the problems with investment banking bonuses.

        The final policy is a return of capital gains taxes to the same levels and marginal income tax rates, and the end of exemption of homes from capital gains tax would stop a lot of speculation. It would also place the austerity burdens on those that gained most from the bubble as well. It is avoidable. Just don’t sell.

        Also make property taxes payable regardless of whether the property is occupied or not. That would have other benefits. If a bank were to foreclose it would become liable for local property taxes. This would help maintain local government incomes. This would be a immense benefit to US state and county incomes. So rather than holding on to empty properties they would rent them out. It would make banks more willing to rent the property to former owners rather than try sell into a weak market, depressing prices further. This would mean that both banks can avoid the tax and the former owner can still live there as long as they are willing to pay the rent.

        Longer term these could lead to a sober property market that is not an generational tax on the young. It would also cap rising housing benefit claims which is a direct side effect of the property bubble. That would help the governments austerity plans.

        The remains of the banks could be privatised as soon as restructured. Possibly with months and in a position to pay corporation taxes immediately.

        The downside could be a surge in the currency, but the solution could be a return to some form of capital controls. No one would move billions into a market if it were trapped there for a number of years. A 10% return is not as valuable if you cannot get the money when you need it. This could stop the surge to such an extent that exports would not be priced out of their markets.

        Longer term central banks should be marginalised to maintain inflation and saving rates only. There should be an interest rate cap and collar to stop excessive rates and enable sensible long term investment. Governments should return to fiscal policy to maintain full employment even having surpluses when the economy overheats. Relying on monetary policy has not been a great success as it cannot stop bubbles without punishing the rest of the economy.

        1. Edward Harrison says

          David, the problem for the UK in particular is a version of the Iceland problem. It has an outsized bank sector that it cannot possibly bail out. Ireland and Switzerland certainly have this problem and I believe the Danish and the Swedes do to a lesser degree as well.

          If the UK were to raise rates now, house prices would plummet and the former HBOS and RBS would be rendered insolvent. The nationalisation required would put the British into the same situation as the Irish with a 30% budget deficit. I don’t know what you do about this. Obviously, wiping out shareholders and extracting penalties from bondholders before taxpayers is the right way to go, but the hole is going to be very large. I would be afraid of a debt deflationary spiral even so.

          I don’t have a good answer for the UK, honestly. I would like to think seizing bankrupt TBTF banks is the way to go (i.e. a Swedish solution instead of a Japanese one) but the Iceland problem could make this a catastrophe for the British. Let’s see if Marshall has any comments on this. If not, I’ll ping him.

          1. Marshall Auerback says

            The UK can bail out its banks! And it already did it very successfully. The figure everybody focuses on are the gross figures, not the net figures, which are substantially smaller. And unlike Iceland or Ireland, you don’t have a constraint in creating pounds at the stroke of a keyboard.

        2. DavidLazarusUK says

          Yes the UK’s Finance, Insurance and Real Estate (FIRE) sectors are far too large as a proportion of the economy. This has been allowed to happen over the last thirty years. In many ways these problems were kick started by the Conservatives and now they will have to fix them. Unless they take measures to reduce the banks then the problem will only grow. I said nothing about bailing them out. Restore interest rates to long term levels of around 5 or 6%. Allow the banks to be crushed by the market. Only then nationalise the remains. No bail out involved. Impose haircuts on all large depositors and creditors.

          As to how to do it? I would invite all the banking heads to a drink at Number 10 at 5pm on a Friday. Have a giant TV screen on in a conference room with the BBC news on. Then when all are present have the BBC announce a substantial increase of base rates and an immediate end to Lender of Last Resort for the remainder of the year. The bank regulators would have the weekend to discuss winding up the banks. If they have their living wills in place the banks could be broken up rapidly. Yes it would be a problem for one weekend. Though on Monday the banks could announce their new structures and until the changes have been completed customers should carry on as before.

          I do not think that the UK will be as vulnerable as Iceland or Ireland. While the banks were a big segment of the economy we do have other industries. Switzerland do have the same problem but they have been raising capital levels higher than demanded and may not have the bad debts problems of the UK banks. Plus they have all that dodgy money that cannot really go else where.

          UK property prices are still grossly overvalued. I think that they are around 30 to 40% over valued compared to median wages, and that will suck money out of the government over the next decade if we maintain our current policy.
          If the coalition do an Ireland, and have extra austerity budgets then make that an extra 10% further to fall.

          While a big jump in interest rates will cause an asset deflationary spiral, unless we get to the bottom quickly people will still have deflationary expectations. That I think has been a big part of the Japanese problem. If you anticipate substantial falls like I do, why would I enter the market? Those who do enter will be burned as prices continue to slowly slide. This could destroy long term confidence in the market like nothing else. A sharp fall and then stabilisation is much better. Get to the bottom fast and then have fiscal stimulus. Until then rely on automatic stabilisers. Otherwise all that stimulus does is partially reflate the bubbles till the markets tire of the deficits. Another advantage of a quick solution is that the new banks would be paying taxes much sooner as they would not have tax losses to count on. That will reduce the deficit quicker.

          Insurance needs to be reformed but with higher interest rates the pensions market can be saved much more easily.

          Iceland had similar problems guaranteeing the banks. Though the UK and Netherlands responses to the repayment of losses has been bordering on economic terrorism. As long as the government do not go and do something stupid like guaranteeing everybody then the Iceland problem is non existent. The government are not liable for anyone else’s debts.

          Ireland is slightly different. As Marshall has commented the UK can print its own money and it has not guaranteed everyone like Ireland did. That trapped Ireland. The problem for the Irish is that the fiscal austerity measures are actually making the banks even more insolvent and increasing the problems for the Irish government.

          Here we could wipe the banks out without guaranteeing the creditors. That would not increase government liabilities as it did in Iceland and Ireland. Moral hazard is a very good thing.

          Wiping out HBOS, RBS and Lloyds would be inevitable. Small depositors would still be covered which is the majority of customers through deposit insurance. Then we can restructure the banks like the Swedes did. My solution was pure Swedish. With the remains of the banks such as the branch networks could be broken up into a dozen more banks or sold to new entrants like Metro bank or Virgin bank. We could see a return of banks called Westminster bank, National & Provincial bank, Halifax, Bank of Scotland, Williams and Glynn again. All their investment banking arms could be broken up and floated possibly within weeks. The TBTF bank counter parties need to face haircuts. There was an initial liquidity problem and the Bank of England reacted well. Though this crisis was not a simple liquidity crisis. As Meredith Whitney and Nouriel Roubini have commented the TBTF banks were insolvent. I can’t see anything to change that assessment.

        3. Edward Harrison says

          In reply to Marshall:

          Iceland didn’t have that constraint either. it has retained its national currency. So it is not clear to me that this means the UK can in fact bail its banks out. Moreover, just because the banks have already been bailed out once doesn’t mean that further losses are not forthcoming.

          The Iceland problem has nothing to do with national currencies. The problem is the FOREIGN currency liabilities of a domestically chartered financial institution. The Icelandic government could not reasonably make good on paying the foreign currency liabilities of its bankrupt institutions. Analogously, the largest UK have an exposure outside of the UK (particularly in the US) which is an order of magnitude larger than their intra-UK exposure. Were these liabilities to become a problem, the UK can’t just reel off a bunch of pounds. The same is true for Denmark, Switzerland, and Sweden, ALL of whom have their own national currencies. It just so happens the Irish are doubly penalized because of the Euro. But make no mistake, outsized financial sectors are almost always the result of large FOREIGN liabilities that CANNOT be made good by a national currency.

          1. Marshall Auerback says

            Some paint a morbid picture of the UK government having to absorb $4,500bn
            (€3,400bn, £3,100bn) of UK bank foreign currency liabilities – three
            times GDP – and ending up in a debt default and a situation akin to Iceland or
            Ireland. No one should take this argument too seriously. If these
            liabilities, which include non-UK banks, were to become part of public debt, so too
            would a matched £4,600bn of foreign currency assets. The total balance
            sheet would rise sharply but, on a net basis, nothing much changes. In this
            vital respect, the UK is unlike Iceland, Russia and many other countries with
            foreign currency asset and liability mismatches. So I don’t think the
            Iceland analogy holds here.
            In a message dated 10/24/2010 21:43:14 Mountain Daylight Time,

            Edward Harrison wrote, in response to DavidLazarusUK:

            In reply to Marshall:

            Iceland didn’t have that constraint either. it has retained its national
            currency. So it is not clear to me that this means the UK can in fact bail
            its banks out. Moreover, just because the banks have already been bailed out
            once doesn’t mean that further losses are not forthcoming.

            The Iceland problem has nothing to do with national currencies. The
            problem is the FOREIGN currency liabilities of a domestically chartered financial
            institution. The Icelandic government could not reasonably make good on
            paying the foreign currency liabilities of its bankrupt institutions.
            Analogously, the largest UK have an exposure outside of the UK (particularly in
            the US) which is an order of magnitude larger than their intra-UK exposure.
            Were these liabilities to become a problem, the UK can’t just reel off a
            bunch of pounds. The same is true for Denmark, Switzerland, and Sweden, ALL of
            whom have their own national currencies. It just so happens the Irish are
            doubly penalized because of the Euro. But make no mistake, outsized
            financial sectors are almost always the result of large FOREIGN liabilities that
            CANNOT be made good by a national currency.

            Link to comment: https://disq.us/pwd2u

          2. Edward Harrison says

            It does hold. You make the false assumption that those liabilities are going to be matched by assets of equivalent value. In a crisis this is not true. Asset values fall and liabilities do not. Moreover we already know the feds swap lines were given for banks like RBS which had US liabilities and could not roll then over. Without those swap lines, it would have been over for RBS. During the Greek crisis the Spanish banks had similar liquidity issues.

            The UK situation is exactly equivalent to Iceland. Large foreign currency liabilities by domestic bank, national currency. The difference is the size of the domestic economy and the relative lower size of the banks. This makes the Iceland problem less probable but not non existent.

          3. Marshall Auerback says

            Agree on this. I just don’t think you can extend the Iceland analysis to the UK. That was my only point. But the assessment here on Iceland is correct. Of course, I think Iceland made a mistake. Rather than bankrupting themselves, they should have offered to repay their liabilities in krona, and done it over a much longer period of time. Why should an entire nation have to suffer for the stupidity of a few greedy bankers?

        4. Edward Harrison says

          I was looking for some background material on Iceland and found this from the Economist making the same point I made. Notice that ALL of these countries have their own national currency. That part of the debate is spurious. The question is liabilities in foreign assets during a crisis when asset values are falling:

          Also see Marshall’s counter here (https://pro.creditwritedowns.com/2009/05/uk-canary-in-the-coalmine-or-light-at-the-end-of-the-tunnel.html)

          The reality is that the situations are identical. The question is in regards to the size of the domestic economy, stability of the banks’ assets, the fragility of the business model, the level of international support, etc in mitigating downside risk. There is no difference between Iceland, the UK, Switzerland, Denmark or Sweden. Notice the part about swap lines. If Iceland had received swap line support, then… And had Britain not received it…

          The balance-sheet of Britain’s banking system, at 450% of GDP, was half the (relative) size of Iceland’s at the end of last year. But that is still high. Like Iceland, Britain does not have a global reserve currency, such as the dollar or the euro, to draw on if it needs to act as lender of last resort. Its net foreign-exchange exposure is nil, but Iceland was in a similar position, and its banks have not been able to liquidate foreign assets to cover their foreign debts.

          Mr Buiter acknowledges that Britain has access to currency swap lines from the world’s biggest central banks, which would help it prevent a run on the banks. But he argues that the cost of this insurance will make London less competitive as a global financial centre. He thinks this makes a good case for Britain to adopt the euro. Among larger European countries, he says, the British government’s exposure to its banking sector is by far the highest. “Switzerland, Denmark and Sweden are in a similar pickle,” he adds.

          Iceland found, to its peril, that its access to the leading currencies was not as sure as it had hoped. In fact, as troubles mounted, it succeeded only in securing swap lines worth €1.5 billion ($2.3 billion) from three Nordic central banks in May, hardly enough to prevent a run on its banks. The Federal Reserve, the European Central Bank (ECB) and the Bank of England all rejected Iceland’s requests, stating, according to the Central Bank of Iceland, that the Icelandic financial system was too large relative to the size of the economy for plausible swap lines to be effective. They also wanted Iceland to talk to the IMF, which the authorities appear to have done only half-heartedly at first.

        5. Edward Harrison says

          Here’s one more on Iceland by Willem Buiter, with whom Marshall disagrees about the UK. Think about this in the UK context and then read his article on the UK linked after the quote:

          Even if the banks are fundamentally solvent (in the
          sense that its assets, if held to maturity, would be suf-
          ficient to cover its obligations), such a small country –
          small currency configuration makes it highly unlikely
          that the central bank can act as an effective foreign cur-
          rency lender of last resort/market maker of last resort.
          Without a credit foreign currency lender of last resort
          and market maker of last resort, there is always an equi-
          librium in which a run brings down a solvent system
          through a funding liquidity and market liquidity crisis.
          The only way for a small country like Iceland to have a
          large internationally active banking sector that is
          immune to the risk of insolvency triggered by illiquidity
          caused by either traditional or modern bank runs, is for
          Iceland to join the EU and become a full member of the
          euro area. If Iceland had a global reserve currency as its
          national currency, and with the full liquidity facilities of
          the Eurosystem at its disposal, no Icelandic bank could
          be brought down by illiquidity alone.


          1. Marshall Auerback says

            I agree with this argument. And Iceland also had a huge number of foreign currency deposits, which is not the case in the UK.

        6. Edward Harrison says

          Marshall, you’re right. The UK in particular acted in a harmful way toward Iceland – and this was purely a political decision in order for Labour to win over voters IMO. It didn’t help much, did it?

          1. Marshall Auerback says

            No, it didn’t help Labour, although the recent budget by the Tory-LibDem
            coalition seems almost perfectly designed to ensure that Labour gets back
            into power again in 5 years’ time.

            In a message dated 10/25/2010 6:55:08 A.M. Mountain Daylight Time,

            Marshall, you’re right. The UK in particular acted in a harmful way toward
            Iceland – and this was purely a political decision in order for Labour to
            win over voters IMO. It didn’t help much, did it?

        7. DavidLazarusUK says

          The differences between Iceland and the UK financially are huge. Many Icelanders had mortgages in foreign currencies, which has meant a lot of pain for them, when the crisis hit. The same applies to many east european countries as well, with mortgages in Euros but incomes in the local currency. In the UK only a few have foreign currency mortgages.

          1. Marshall Auerback says

            Agree with you David.

            In a message dated 10/25/2010 9:36:14 A.M. Mountain Daylight Time,

            DavidLazarusUK wrote, in response to DavidLazarusUK:

            The differences between Iceland and the UK financially are huge. Many
            Icelanders had mortgages in foreign currencies, which has meant a lot of pain
            for them, when the crisis hit. The same applies to many east european
            countries as well, with mortgages in Euros but incomes in the local currency. In
            the UK only a few have foreign currency mortgages.

            Link to comment: https://disq.us/pxxig

          2. Edward Harrison says

            I think its a moot point unless there is a crisis. We can sit here and blithely dismiss it now but the fact is RBS and HBOS both would have been bankrupt if not for the Federal Reserve and its swap lines

          3. Edward Harrison says

            We’re talking about bank liabilities here not assets.

            Edward Harrison
            Sent from my mobile telephone

Comments are closed.

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