Macro outline of causes and effects of and predictions for the global financial crisis

The global economy is in an economic depression. This post is a brief outline in bullet points of my macro view of that depression and the global financial crisis which caused it. I highlight causes, effects and predictions. My goal here is to help me crystallize what the real issues are and how they are likely to play out. I think framing the problem in macro terms could be a very useful exercise. Please chime in with your comments and criticisms.

In my view, the still ongoing financial crisis has five root causes:

  1. Excess credit growth and private indebtedness in advanced economies
  2. Combining of financial deregulation with desupervision (and decriminalisation)
  3. Tight coupling and undercapitalisation in the global economy and financial system
  4. Flawed institutional architecture for common currency in Europe
  5. Inevitable policy errors given the number of fault lines

The effect

  • Allowing financial deregulation to be combined with desupervision led to financial fragility throughout advanced economies (See "Deregulation as crony capitalism from Aug 2009"). Low interest rates encouraged excess credit growth, creating an unsustainable credit bubble. When the subprime credit bubble in the US popped, excess leverage in the housing sector outside of subprime led to contagion and a full scale national housing downturn beginning in 2006. (See Ludwig von Mises on Austrian Business Cycle Theory for the negative effects of how low interest rates stimulate economic activity).
  • Slowing US growth led to slowing global growth in 2007.
  • Slower growth combined with excess credit growth and private indebtedness to create mortgage busts beginning in 2007 in countries like Latvia, Denmark, Spain, Britain, and Ireland in particular (see "Irish property dam about to burst" from June 2008).
  • Tight coupling within the global financial system led to financial crisis in 2007 with large scale losses in mortgage-related derivatives markets (See Rick Bookstaber’s "Human Complexity and the Strategic Games of Uncertainty" from Mar 2011 for more on tight coupling).
  • By the end of 2007, the housing downturn took down the US economy and the tightly coupled financial system began to unwind in 2008 via wholesale lending markets.
  • The financial institutions  which were most undercapitalised and most exposed to mortgage-related losses came under attack and failed.
  • The US committed the inevitable policy error with Lehman by allowing it to fail without adequate preparation for the fallout.
  • The financial institutions which were most undercapitalised and most exposed to contagion in tightly coupled system were bailed out in 2008 and 2009.

The policy response

  • Large scale lender of last resort liquidity for financial institutions and fiscal stimulus in advanced economies and China in particular arrested the debt deflationary spiral in early to middle 2009. We are now in a technical recovery.
  • Another inevitable policy error occurred as excess credit growth and private indebtedness in advanced economies, combining of financial deregulation with desupervision, tight coupling and undercapitalisation in the global financial system, and flawed institutional architecture for common currency in Europe were not addressed or were only partially addressed.

The result

  • The euro zone sovereign debt crisis began in late 2009 when investors realised that undercapitalised financial institutions combined with the flawed institutional architecture of the euro area to create unexpectedly high sovereign and bank default risk.
  • The flawed institutional architecture of the European common currency, bank undercapitalisation and tight coupling between euro area countries meant that a crisis that began in Greece would quickly spread to the next weakest link in the euro area until sovereigns defaulted, the euro zone broke up, or the ECB provided an unlimited backstop starting in 2010.
  • Due to political will to keep the euro intact, Greece was bailed out followed by contagion to Portugal and a bailout, followed by contagion to Ireland and a bailout accompanied by contagion to Spain and Italy and the LTRO backdoor partial ECB backstop in 2010 and 2011.
  • Large-scale deficit spending was politically unacceptable outside of euro area and not feasible due to flawed institutional architecture for common currency in Europe. Leaders committed a policy error in Britain and in the euro zone of attempting simultaneous private and public sector deleveraging during a debt deflationary crisis without expecting renewed recession beginning in 2011 (see prediction from "The origins of the next crisis", April 2010).
  • This was followed in 2012 by contagion to Spain because of the effect of the policy error of simultaneous private and public sector deleveraging and Spain’s undercapitalised banking system and to Italy because of tight coupling between Italy and Spain.

The prediction

  • Overall predicted outcome: Economic depression mitigated by correct policy responses or exacerbated only by a series of policy mistakes.


  • The origins of and cure for leveraging cycles are contentious, making debt deflation via defaults, writedowns and depression more likely when private debt is high.
  • Politicians avoid policies not geared to ideological biases of voting constituencies and pro-growth short/medium-term economic outcomes because of election cycles.
  • Policy makers are loath to make very large changes in policy positions because it means losing face and being seen as inconsistent and unreliable.
  • Euro zone political leaders are genuinely committed to the euro zone.
  • The euro zone citizenry generally supports the euro and is afraid of the consequences of a euro breakup.
  • Spain and Italy are too large economically and politically to default or be bailed out by any entity other than the a central bank creator of currency.
  • Greece, Portugal and Ireland are small enough that euro zone leaders believe they can default and/or be bailed out without significant negative effects.
  • Simultaneous deleveraging or cuts in consumption in private and public debt leads to a Fisher debt deflationary spiral when private debt is high.
  • Government deficit spending is generally seen as irresponsible and unsustainable because of comparisons to household budget constraints.

Resulting predictions

  1. Euro zone policy leaders, afraid of contagion, will do whatever possible to keep the euro zone intact. But policy errors due to excessive adherence to previous policy positions will creep in. Result: Greece departure at a minimum.
  2. Deficit spending on a large scale will be politically unacceptable in the US, Canada and Australia until depression deepens there.
  3. The slowing economy will combine with continued simultaneous private and public sector deleveraging to cause a renewed global recession.
  4. Europe will suspend Maastricht 3/60 hurdles and allow ESM to be accessed by banks (See "[Premium] Euro zone policy may turn to relax 3/60 hurdle and to EuroTARP" from April 2012).
  5. The ECB will eventually offer more explicit backstops for Spain and Italy.
  6. The euro zone will eventually accede to Eurobonds.

Hanging Threads

  • Corporatism. The nexus of government and business colluding to benefit private special interests is a big factor in the financial crisis in my view. It’s not clear where I can put this in terms of cause and effect. But when I spoke of "policy failure" in the policy response section, my assumption there was that corporatism was a major factor. Corporatism is also a factor in decriminalisation of control fraud in the financial sector. (See "Corporatism masquerading as Liberty")
  • Labor wage arbitrage. A big factor in creating the preconditions for excess credit growth was the labor arbitrage available to global competitors due to the influx of workers from the former Soviet Bloc, China and India into the global economic system. This has depressed wages in the west and been kindling for debt as a substitute. Pro-reform free market ideology is used to promote this wage suppression and is closely linked to corporatism. (See "A populist interpretation of the latest Boom-Bust cycle", an early post here at Credit Writedowns from Mar 2008.)

I am going to leave it there for now as a first cut.

My contention here is that we are in the midst of an economic depression caused by the five antecedents I identified at the outset. This depression could be exacerbated by committing a series of back to back to back policy errors in quick succession in dealing with the depressions root causes as we saw during the Great Depression. However, even if leaders commit policy mistakes, the depression can be mitigated by attacking the crisis root causes with enough strength to overcome the loss of output from the inevitable contraction of credit.

This is my thesis. Although this pulls together a lot of the thinking from previous posts, I have put this together quickly enough that I might move a few points around and add points over the next hours as the framework solidifies. I will try to add links to posts I have written that cover these points in greater detail as well.

Which of these bullet points, if any, are the most controversial? Why? Do you have a different list of crisis root causes? Why? Would changing any of these lead to alternate potential outcomes? Am I too optimistic or too pessimistic? I look forward to incorporating your responses to this article.

  1. Dave Holden says

    First thing that springs to mind is an antecedent to the antecedents, that being a big increase in the pool of labour. This in and of itself would have been a restraint on developed nation wages but much of that new labour didn’t come burdened with minimum heath and safety laws or environmental regulation.

    And since I don’t see that this has changed that much current policy responses need to take it into account. It’s one reason I find myself skeptical about how effective “inflation” inducing policies can be.

    1. Edward Harrison says

      That is a good point, Dave. It’s one of the things I am leaving to the side for now because there isn’t a consensus around how this problem can be addressed. Another issue I left out were the corporatism that has corrupted government’s dealing with the private sector. The Murdoch enquiries now ongoing show how this works. And I only tangentially pointed to the artificially low rates after the tech bubble as an antecedent because that is still a bone of contention.

      Any other thoughts?

      1. Dave Holden says

        “Any other thoughts?”

        I find it very difficult to gauge whats happening at present but I do think Krugman was close with what he said here on Newsnight last week – essential one of “two impossible things” have to happen either the Euro breaks up (what ever that means – could be a two speed Europe for example) or Germany has to accede to Eurobonds.

        I think some form of Eurobond is more likely. I vaguely recall you postulating something a while back where the ECB backstop bonds at some rate above German levels – I can’t remember the details but maybe something like that.

    2. David_Lazarus says

      Also wages are falling in the US so how can there be inflation, apart from commodity inflation and imported inflation. It could be profit margins increasing as workers rights are eroded. Though that would mean that the US economy will get weaker for the next decade. 

      1. Dave Holden says

         Yes this is my point – I don’t see how monetary policy inspired price inflation can makes its way into wage inflation given deleveraging and the now global and *unfair* competition developed nation workers face. I also don’t understand the mechanisms for it or how monetary intervention would affect the structure of prices for example.

        1. David_Lazarus says

          But we really haven’t had much in the way of inflationary pressure from wage demands for many years. The UK has had stagnant wages since 2003, Germany a similar period, the US has not had real wage growth since 1980. 

  2. Dave Holden says

    “The euro zone citizenry generally supports the euro and is afraid of the consequences of a euro breakup” 

    This to me is  a precarious assumption but I get why you make it, I think it would be closer to the truth if you replaced “and” with “because it”.When I look at UK politics and the tensions involved in fiscal redistribution between the nations on just this small island I’m aghast that people think it can work across such a diverse continent as Europe. That said I can certainly see in the short term a scenario where basic self preservation causes European electorates to reluctantly align behind a do everything needed to save the Euro policy – what ever that may be. 

    1. Edward Harrison says

      Causation is always a problem. I boldly present a narrative of causation here of course but I have stopped short of introducing more causation than the five antecedents I outlined here. So while it seems plausible that Europeans support the euro because they are afraid of the alternatives, I don’t think you can say definitively that fear of fallout causes support. After all the euro was put to a vote in many countries and it had consistently polled favourably in many countries before the crisis.

      1. Dave Holden says

         Fair point.

        Just as an aside, and focusing on Europe, I’m skeptical about the degree to which electorates understood how broken a system EZ monetary union was before the crisis, so the fact that some electorates were pro and some weren’t I find interesting, particularly their willingness or otherwise to cede sovereignty to the EU level.

        In the case of the UK, I’ve never been of the opinion that the UK electorate hold their politicians and bureaucracy in high regard, therefore their apparent unwillingness to seriously contemplate EZ membership throughout – despite major political figures pushing for it – suggests to me they hold EU level management in even less esteem. Are Brits just  less trusting/more cynical or do countries where the Euro was popular before the crisis have more/less faith in EU level/national level management?

        Post crisis I think things are different, devaluation must weigh heavily on the electorate’s views of “debtor” nations irrespective of their pre-crisis disposition. How those fears play out and where the breaking points are is hard to know and probably quite volatile. In the case of “creditor” nations I think fears are more diffuse and countered somewhat by an uptick in “moralistic” nationalism. However I think those fears will become more focused as they contemplate what could be the consequences of a disorderly breakup. The dynamic between those two fears suggests to me some debt sharing compromise will be found but I would also describe the situation as precarious.

        1. Dave Holden says

           To be clear I’m talking about electorates here not politicians. Unlike some I read on the blogosphere I have quite a bit of sympathy for the rock and a hard place that *both* “creditor” and “debtor” nation politicians find themselves in at present.

  3. Oldrich says

    Firstly, I would like to say that I am impressed,genuinely humbled and little intimidated when commenting on such a remarkable, well-organized, well-structured, clearly thought-out piece of work. So I just dare to give my little bit.
    1) Europe is under the pressure of Globalization which presses the income of large segments of population downward (mostly the effect of cheap labor and merchandise from Asia)
    2) Some segments of population (if you can call a multinational corporation a “part of population”) succeeded in reducing their tax duties to their respective societies whose legal, institutional and democratic framework affords them their prosperity and provides them with protection
    3) Thus the so called “middle class” finds itself under an increasing pressure to bear the burden of services provided by the state and are simultaneously are subjected to a relentless media massage that they have lived it up and above their means/what is sustainable and “realistic”
    4) Increasing numbers of people are seeing their income (and standard of living) to slip and are falling behind
    5)  More and more people experience a rise in uncertainty and precarity in their lives
    6) They have tried  to keep up and sustain their standard of living by incurring increasing amounts of debt which was provided by the system which was motivated in order to keep itself in the motion and to self-sustain itself
    7) People are being told they need to keep tightening their belts without seeing the light at the end of the tunnel, on the contrary, people feel their is no end to the pain and the best part of their existence is behind them.
    8) The injustice of the idea of paying the debts they have not created and anxieties resulting from the above creating tensions an conflicts between ” the virtuous North” and “the profligate South, among nations and states, even within the States and last but not least tension between distinct echelons of society – what the Marxists called “a class conflict” resulting from the clash between divergent,different interests.
    My solution or “cure”,if you like is : 1) Protectionism – disadvantage and penalize companies using labor in countries with low to non-existent social and labor standards; and on the positive side encourage,stimulate and reward job-creation within the EU
    2] The segments of society that benefited hugely from Globalization have to be made understood that they owe to the society which guarantees them their wealth, prosperity, property rights and last but not least their physical integrity 
    3] Full EU federalization – aspiration towards the United States of Europe modeled after the German corporatist system where all segments of society have their say and which ensures the best compromise between stability, harmony and prospects of growth
    So spake Zara.. ehh.. Oldrich … -:))

    1. Edward Harrison says

      Thanks for the alternate narrative. I think your issues ultimately come down to WHY there was such “Excess credit growth and private indebtedness in advanced economies”.
      A number of competing ideas exist, five of which I can identify rapidly. One is that deregulation, desupervision and decriminalisation in the financial sector caused these firms to leverage up the private sector over the course of a quarter century.Two is that in the post-Soviet era you had competition from large new labour pools in a globalised economy. This created wage pressure and the gap was filled by debt.Three is that after 1980-1982 and the oil shocks, high interest rates and inflation, declining interest rates encouraged debt accumulation such that CBs fought recession via interest rates before leverage had completely unwound.

      Four is that in a neoliberal world, Keynesianism was seen as failed because it was to wedded to fiscal policy and so monetary policy became the ultimate policy tool, creating a supercycle of interest rate declines and higher indebtedness.

      Five is that the nonconvertible fiat currency system inherently allows for excess credit  creation and is unstable.

      I should add that private debt in the US has been rising as a proportion of GDP for 60 years, most acutely since 1982.

      The bottom line here though is that the REASON that private debt is high remains a contentious issue, one reason we don’t have a good fix on policy responses.

      The lack of consensus on why private debt is high means that the fallback solution to high indebtedness is always going to be default, credit writedowns and depression.

      So while I think there is a lot of truth in what you’re expressing, those ideas are certainly controversial and not universally accepted. I haven’t figured out how to insert those ideas properly. Let’s see where I get to in the re-write.

      1. Oldrich says

        Thank you for the addendum and further clarification. I don’t like repeat myself and what others say so I just add my comments on your 5 reasons : 1) And to add the insult to injury, when saved, and recapitalized and let to carry on the business as usual they instead of having a little humility and a moment of “soul-searching” they keep on pushing relentlessly the same discredited “self-regulating market” illusion. For me not – not only a lack of basic decency but also a lack of elementary self-preservation instinct.
        2) For the lower and middle-class in the West the collapse of the Soviet union was a clear negative. The fear of the “Reds”, of the “Marxist revolution” provided a motivation for the political and economic elite to behave more decently and responsibly (a virtue out of necessity) or when a Damocles sword is hanging above you tend to pay attention. Also, “the red danger” and fight and competition with it created a strong motivation  to keep the society united and pull together … so or the spirit “we are in this all together”. Although this attitude changed with the Reagan/Thatcher accession to power.
        3) Have read the former Reagan’s budget director Stockman – Laffer’s curve need inflationary environment to work- a) Volclker’s tightening actions collided with it,.b) unless you wanted to commit a political suicide you didn’t curb spending for the “special interest”, c) “a hard currency” political commitment was inconsistent with Reagan’s policies
        4)the head-spinning rise in the debt-levels helped to provide a provisional “patch”, relief and cover-up for a collapse of society, helped keep people “afloat” who would otherwise fell behind, temporarily prevented tremendous social tension, riots, scenes and pathologies from the height of the Great Depression…. And on a whole it kept pushing the resolution of problem further on to the future
        5) Well…, this one…, there is just heated debate going on… My take is that the perceived “self-regulating” aspect of the Gold standard in synch with the “free market fundamentalist” world-view – you simply cannot under no circumstances put any restrictions and regulations on the “free market”.

  4. David_Lazarus says

    You mentioned allowing Lehman’s to fail as a policy failure. I actually see that as a success but the real failure was the bailout of AIG, simply because its airline insurance arm was systemically important to the airline industry. AIG should have been wound up with the airline insurance wing being temporarily nationalised. The problem is that moral hazard was scrapped to bailout big party donors. That is corruption. 

    The problem with the fail out of Lehman’s was that it mean that every other bank demanded protection and with that mortgage fraud was then overnight decriminalised. That outcome will take decades to repair. 

    The political will to keep the euro alive was not a mistake but it did give speculators an opportunity to test that resolve. First with Greece but will the other PIIGS. The correct response would have been to allow Greece to default on as much debt so that its immediately returned to a fiscal surplus even a tiny one. That would have ended austerity and without destroying Greek industry in the process. Wages in Greece are already low but I suspect that the real debt burden is in the housing market. Looking as a tourist I cannot understand the high prices of hotels knowing how low wages are. It must be rents or mortgages. That means a land bubble. That needs to adjust and is why all the economies where a bubble has inflated will need to start spreading the pain before the country collapses. 

    Now that speculators can see the confusion in politicians responses, playing chicken on front of everyone trying to look tough means that they have thrown the rest of the periphery under the bus as well. Hence the new attacks on Spain. The fact that Greece exit is even mentioned as possible opens up the exit of Spain and that will be very expensive to solve. They cannot save Spain unless they wipe out the banks and all the counter-party risk.

    I do not see the outcome the same way. First what do you mean by correct policy response? If they allow banks to collapse then there will be short spell when the economy is under strain, but alleviated of the huge debt burden the economy could recover very quickly. This was always a debt problem. It might actually be a better solution to a debt jubilee and would restore moral hazard at the same time. 

    Longer term though the solution requires new regulation of banks that caps ability to lend. Once the banks lent more than the GDP it meant that they became to dangerous. So cap their lending if necessary reduce bank leverage substantially and make the ECB responsible as lender of last resort as they have the purse. Sovereign currency users are incapable of providing enough funds especially for an over extended banking system that is common throughout out europe. Until there is credible regulation and supervision this will be the first of many financial crises and that alone will hamper growth. 

    As for outcomes I do not see Greek exit as certain. Maybe they will be pushed to that point but not yet. No one except speculators and some politicians want to see that, especially not the Greeks. 

    Until the there are clear and unlimited backstops for the periphery the eurozone will collapse. Though I cannot see that happening until the Germans say it can, and that applies to eurobonds as well. 

    1. Edward Harrison says

      What is a policy failure? That is a good question. I think that’s actually a hidden assumption I need to spell out in a rewrite. basically, a failure is a political response to the economy that leads to unexpected short and medium-term economic outcomes. The point is that politicians want to manage the economy to make the short and medium term outcomes favourable for re-election, They choose policy in accordance with their pre-existing ideological biases such that they can maximise favourable economic outcomes within the ideological framework of their core constituency.

      An error occurs when the economic outcome that results from a specific political decision is much worse than anticipated.

      Lehman clearly falls into this category. The Lehman decision was driven by an ideological decision to stop the bailouts after Bear and the GSEs were bailed out. The thinking was that this would be manageable. But the reality was that it led to panic and an immediate worsening of the economy. To me that’s textbook policy error.

      The same is true about austerity, by the way. It’s one thing to say austerity is needed even though it will be suboptimal in the short and medium term economically. But of course politicians don’t think that way anyway. Saying austerity leading to economic success in the short or medium term is the reason to do austerity as Osborne has done is a policy error.

      On keeping the euro alive, I haven’t labelled it a policy error because I hadn’t considered that issue but I reckon I overlooked it as unrealistic just from a policy inertia perspective.

      1. David_Lazarus says

        I fully accept that politicians operate on a “I need to get re-elected” basis but that meant that after the Lehman’s moment no bank could ever be allowed to be fail. No bond holder could lose a cent, that meant that the euro crisis was inevitable. Politicians were panicked by the reaction to Lehman’s. That was a huge mistake.

        Big past mistakes are the ending of Glass-Steagall and many realise that but why no action to reverse that mistake? That in itself is a mistake. One that means that we will have another banking crisis. Steve Keen has said that the UK will have another credit crunch later this year. That means some banks will fail and then possibility of policy mistakes are huge. I still think that letting Lehmans fail was right. Much of the US banking system was insolvent and the big banks were worst of all. Even five years after this crisis we have more than 900 US banks that are on the danger list. The issue is how do you deflate an insolvent banking crisis? Letting Lehmans fail forced the remaining banks to recapitalise rapidly. The fact that counter-parties were made whole meant that european banks felt no compulsion to build their capital base, as this was a sub prime problem and they had not been involved in sub prime, and incentivised them to double up on their bets because they were too big to fail and everyone now knew it.

        Today I heard a lovely term for why the UK government are pushing austerity. Reverse Ricardian Equivalence. Ricardian Equivalence was discredited years ago so why should its opposite as successful? Though yes it is policy mistake. The only solution is now the Japanese one of extended deficit spending till markets reach a new level and to stabilise GDP. 

        Keeping the euro alive is not a policy mistake. The policy mistakes are in what they are not doing to the banks. They should be breaking them up and telling them that each bank needs to create a bad bank, and hive off all investment banking activities. This is where the big nasty losses have happened this year. Give the banks six months to break themselves up. After which any bank that has not completed the process will be nationalised for €1 with 100% losses for all shareholders and bondholders and management. Look at Ireland and Spain, both had big housing bubbles that threatened to bankrupt the sovereign. By telling banks there is no bail out there will be short term problems but banks will not bring down sovereigns. 

    2. ChrisBern says

      Agree that Lehman was not a policy mistake per se.  True it should’ve been unwound in an ORDERLY fashion, and it wasn’t.  But the fact is Lehman as an institution failed and therefore it should’ve been allowed to fail, as it did.  

      I find it interesting that the failure of Lehman is so often mentioned as a major tipping point in the financial crisis.  Here’s a trivia question that captures some of my thinking about Lehman:  Lehman’s failure was publicly “announced” on a Monday (9/15/08).  Guess how much the S&P 500 fell that week as a result?  Probably quite a substantial fall, right?  Not quite.  The close at the end of the week (Fri 9/19/08) was actually 5 points higher than Monday’s opening!  

      If you want to see when the LIBOR-OIS spread started shooting dramatically upwards, it was really more the following week that it started its major rise, particularly starting around 9/23 when Paulson and Bernanke gave relatively weak/shallow details about TARP in a press conference, confusing investors and allowing them to realize (perhaps for the first time) that things were worse than they thought and that the government wasn’t quite sure what to do about it.  These weren’t my original thoughts but were posed by John Taylor in “Getting Off Track”, and I can’t argue with his analysis.

      1. Edward Harrison says

        That’s pure historical revisionism. I was there blogging it live. You can say Lehman should have failed, sure. I agree. You could even Arthur that a panic was eventually inevitable. But Lehman was the cause of the panic. It’s completely false too say otherwise.

        1. David_Lazarus says

          The Lehman’s bankruptcy may have been crucial but had taken time for counter parties to realise how exposed they were. The problem is that we could still have a Lehman’s moment this week if Bankia collapses. The problem is that banks have been allowed to get bigger which does not reduce systemic problems only increases them. The creation of Bankia was a political decision to hide the problems in the caja’s. 

          We still have banks that are far too big to resolve without creating significant problems, though shrinking them is impossible with the banks current political influence. All the banks that disappeared that week were insolvent but Lehman’s were Goldman Sachs biggest competitor so had to go. Easy with Paulson in charge. The long term issue is that banks need to be structured in such a way that they can be wound up orderly and rapidly. Though with no more mark to market the banks could remain insolvent for longer than we appreciate. 

  5. Icarus says

    We are all robbing Peter to pay Paul and Peter is not only fed up but beat up and broke himself.

  6. Edward Harrison says

    I have already made a few edits to this post but i plan on updating it a bit more later today. One area where i have added a section is “Hanging threads” i.e. issues that I have not stuck in a specific place in the outline. Corporatism is one big issue that I haven’t stuck in there because I can’t really gauge how much a factor that is in some European countries where we have seen a bust or how it contrasts to countries that did not see a bust. I also plan to put in the links to posts that talk more about those issues since this is intended to just be an outline.

    Thanks for the feedback.

  7. Ajrobertson says

    You mention having to make multiple policy mistakes in order to exacerbate the depression. But doesn’t Minsky’s FIH imply that the only policy mistake that need be made is not fixing the root causes?

    1. Edward Harrison says

      The question is how long do you have, right? This has played out over years now. And even the crisis has been ongoing for a few years. So what I am saying is that austerity alone won’t get you to a Great Depression for example. You need austerity, followed by bank runs followed by CDS triggers, etc, etc. You need a confluence of things to come together.

      1. David_Lazarus says

        You also need a massive credit bubble to start with. Austerity does have the bonus of weakening the economy so much that defaults and bank runs become a natural consequence. Japan avoided the austerity but they could afford it, because they had huge domestic savings and exports to help fill in the gap. Italy has the savings but not enough of a surplus. The other thing is that we are in a depression, you may not appreciate it yet because many countries are still growing and even the US is growing albeit very slowly because of the deficit. 

        The current policy will mean that the west will be stagnant for more than two decades to clear this debt pile. At least in the thirties they wiped that debt out very quickly. So when stimulus came it was not propping up a pile of private debt. That is one reason why the stimulus programs were so ineffective, they basically propped up the existing bubbles. 

        Longer term the solutions that we need are capital controls so that banks cannot expand so much that they become to big to fail. It would also reduce contagion as banks would not be able to export surpluses so readily, so would have lower foreign exposure.  Another benefit is that with such controls it would drive down interest rates in countries with surpluses, and encourage borrowing and spending there. We also need a cap on private debt and public debt for normal periods to stop bubbles and to keep banks small. We could also do with breaking up all the big banks and reimposing Glass-Steagall. 

    2. David_Lazarus says

      Certainly nothing has been done here in the UK to stop this happening again. In fact we are now hearing talk of another credit crunch here by the end of the year so lets see if our government do something about it this time. I doubt it. They will probably run out the printing presses to resolve this crisis. 

  8. Curt says

    Technology helps us to do better what we have done before.  Technology helps the average person to say cut their lawn better.  Technology helps organizations do better what they have done before.

    Advances in transportation and communication have allowed companies to do what they have done before: find less expensive labor sources.   Technology has had the effect of generating large sums of money for organizations such as individuals, companies, and countries.   But technology has created a huge informtion gap between organizations.   This gap is exploited by most companies, and notably hedge funds to acquire wealth.

    But it is not hard to argue that the vast wealth gaps between groups is destabilizing and that the hedge funds are particularly destabilizing.

    It would appear at first glance that technology is greatly increasing the wealth of the world even if it is not evenly distributed.   That is that if you add up the value of all the assets it is increasing.   But the problem is that as we know markets are not always good at valuing assets.   So we essentially get accounting errors.
    We put McMansions and perhaps Chinese domestic investment on the books at a much higher value than they should be.   Then we do a more rational accounting we wake up to a debt problem.  We value internet companies at a very high value but when we wake up we are not as rich as we think.  Perhaps we value small cute hand held computers too highly and then we wake up with less wealth.  Or perhaps we value a stable climate too little and wake up much poorer.

    Technology is allowing everyone including myself to speak, but few to be heard.  It is a market place of ideas, but there are many bubbles in these ideas.   The market place today is not promoting the best ideas.
    It was clear to many of us that there was a bubble in the real estate market in 2005, but the larger market did not discover it until much later.   Some hedge funds knew about it much sooner.

    You will spend less than 10 hours today contributing your thoughtfulness to the market place of ideas.   Hundreds of hedge funds with small  teams of “smart motivated” analysts will try to use technology and the information gap to make profits.   This activity in many peoples opinions will further destabilize the system.

    You will spend 10 hrs to stabilize the system and thousands of coordinated hours will be spent to destabilize the system.   Who is going to win?

    I guess I see the problem as technology making our actions more powerful, but bad metrics making our choices worse.   So we end up going faster but in the wrong direction.

    It is relatively easy to come up with good ideas that your peers would understand, but relatively difficult to write in such a way that the general public can understand the ideas.

    By a standard metric you have a certain amount of wealth.   If you were to double that wealth you would be twice as well off by a standard metric.   But by other sensible metrics you would not be at all better off.  So why do you spend a few hours trying to make the world better off ( maybe a sensible metric) and huge amounts of your time trying to increase your wealth ( the things you can buy) probably a poor metric.

    I am convinced that small groups of very talented people can use technology to make good changes if they have the right metric.  The hedge funds have the wrong metric, other more socially concerned groups have the wrong technological skills.   I am optimistic that small groups of people can use market place principles to make the world better.

    In theory the market place is wonderful and it depends in theory on information being discovered in a timely fashion.   What is the difference between theory and practice.  In theory nothing.

    A lot of bad investment has been made in the world.   Some people are trying to expose some of that bad investment.   But a greater amount of effort is being made to cover up this bad investment which we call bad debt.   We know there will always be bad investment, but right now we are willfully covering it up in the banks in Europe, in America, and probably in China.   This is not to mention the bad investment in the internet companies.

    How many people would it take to make a document that help people to understand these bad investments.
    Would take 3, 5 , 50?  Because an better understanding of the true state of investment will have trillions of dollars of effect on the economies.   It would it seem be the best investment the world could make.

    1. David_Lazarus says

      I do find it highly amusing when Republican presidential candidates criticise how government cannot pick winners ie Solyndra. Then look at banks who are supposed to be run by the brightest and best and refer to themselves as masters of the universe, yet they have in the matter of a decade destroyed banks that were built up over a hundred years plus. Hardly any better at picking winners. 

      We have all being living in a dream where everything has doubled or trebled and we are so much wealthier. No we are not. Housing may have doubled but then so have wages and debts. What cost cents decades ago now costs tens of dollars. Are we wealthier? No it is all an illusion because of the increase of everything else. 

      So many economists are worried about deflation. Why? If there has been substantial inflation of a price then if it goes back to where it started is that really deflation or reversion to the mean? Or even the end of a product as it becomes obsolete. 

  9. curt says

    So what I said in too many words is that we should apply a massive credit write down to our banks, our businesses, our culture, are personal lives, and the environment.  Hmm that is no fun.

    1. David_Lazarus says

      Actually a massive credit write down of all debt would ease the debt burden on families, though needs a reimposition of tough mortgage restrictions so that any write downs are not used to re-leverage into a new housing bubble. Few if any economists are talking about the burden of asset bubbles on the vitality of an economy. Asset bubbles need to be stamped on hard, so that entrepreneurs are not priced out of a market, yet banks benefit from such bubbles as it makes lending almost risk free long term. 

  10. simon chance says

    simon  ;  that is the result of robbing the future.

  11. Oldrich says

    As I am a very unstructured thinker (with my head being in a constant state of flux -:)) it has just crossed my mind further causes of this deflationary depression :
    1) Internet – the effect of the Internet is driving down both the prices of goods and labor (services) is significant; examples – a) massive outsourcing of the Customer service jobs into Asia (i.e. IT, telecom but not only them), b) outsourcing high-qualification jobs into Asia (i.e. software development but also for instance the medical consultancy done via the Internet), c) the relentless pushing down of the sales margins (a notable example is a plethora of various methods websites for getting the lowest price of a given product on a heartbeat – something which would have taken a much more time in the pre-Internet era.
    2) “The Private equity” or “The Wall Street” effect, if you like : The relentless, unceasing pressure to maximize shareholder value, maximize efficiency and cut the costs.  
    3) The steady decline the power of the Labor unions – this has been going for some decades –  a) via natural  economic forces, i.e. changes in the structure of the economy and Globalization pressures, b) shift of the politics to the right, c) effect of the media massage of the “public mind”

    1. David_Lazarus says

      You are right but lets look closer. 

      The internet allowed the outsourcing of service jobs on high wage jobs to places like India, so call centres and programming were easy to shift to India, which offered lots of english speaking Indian graduates better wages than could be found locally yet still undercut US and UK. This might have had far less impact in countries that do not use English as the first language. This has slowed now that such jobs are not so competitive now and that computer systems can mean anyone can be tech support in US or UK. They just run through scripts to resolve customer problems. The US and UK use cheaper labour to do these tasks now. Even domestically it means that low cost operations like Amazon that have warehouses in low cost areas can compete with high street retailers. The internet ended many old business models and we are seeing the outcome in draconian legislation to protect slow moving industries from having to adapt, like movies and music. 

      Private equity has lead to a short time scale for all business investments. Unless it can yield returns within a short time scale it is ignored. This might be why some have complained about regulations. If it can take too long for a project to get through land usage regulations then it means that the project may be abandoned because it cannot add to returns. This is why private equity is usually seen as destructive because they do not add value just trim excess. Though the short term nature meant that all companies took the same attitude to avoid being the next target of conglomerates in the 80’s and early nineties and hedge funds and private equity from then on. 

      The union bashing that has been significant since the eighties is one major reason why wages have been stagnant since then. While it was good for individual businesses it has been bad collectively for the nation. Look at nations that have high union membership such as Germany they have maintained wages and still grown. The cultural impact of the twenties means that they are frugal shoppers and why  banks had to expand abroad as citizens failed to spend. If they did have a credit card it was always paid off every month. So charge card are more popular in Germany than credit cards. The fact that high unemployment became policy from 1980’s on to curb wage demands has lead to inevitable collapse of the Ponzi economies. They coped for a significant time by getting women to work and then ever cheaper credit but each reached the limits with a short period. So before the 80’s you only need a single income to buy a home then you needed two incomes, now youngsters need to club together to even stand a chance. The whole economic model used in the Anglo saxon world is coming to its natural end. That is what we are going through now. 

  12. Oldrich says

    David, thank you, that is a really good amplification of my points.
    I believe what we need now is a critical mass of politicians who don’t believe in the whole philosophy of the economic liberalization, and their decision-making framework and the ideological paradigm lies outside the “economic-liberalism” mindset, who will start imposing restriction on the market forces resulting from the Global competition. First, it will create only small rifts, taking steam from them, to eventually breaking the backbone of these Global forces. 
    Protectionist actions of the EU or of the US – > relation and push-back from China – > further escalation of the conflict -> “the trade Cold War” situation. This will create a different sort of dynamics and equilibrium.
    In the words of Marc Faber …. “the Cold War era was a beautiful equilibrium”. To sum it up, I do regard the whole idea of wanting people to compete with the work-force in the states where the human life has little to no value, immoral and perverse, Ross Perot, former US presidential candidate put it in a more expressive language … “competing with the states where human life has less value than that of a cattle”.

    1. David_Lazarus says

      There are ways to unwind the problems, but losses will need to be taken. One thing that is always mentioned as a problem that exacerbated the Depression was protectionism, but that might be overblown. What we do need are capital controls. That will isolate banks, and stop them transferring money across borders overnight which allows banks to shift surpluses offshore and causes problems when financial firms collapse. Lehman’s created problems in the UK because several hundred million of its UK branch funds were transferred to New York the night it collapsed. The UK branch  of Lehmans could have been sold off as a going concern with those funds. The same also applies to missing MF Global investor funds that have disappeared from UK and Australian investors but are not recoverable because of very weak investor protection in the US. These funds would not be allowed to have crossed the border so would not have been lost. It could seriously impact the ability of companies to transfer price to shift profits offshore and would also boost corporation taxes in the countries where those profits are generated. Trade need not be affected but it will make their deficits easier to manage. 

      The biggest problem long term is the quality of economics graduates that are being churned out. They will peddle a discredited economic theory because they do not know better. 

      Another thing that I feel has been serious overstate is the need to attract foreign direct investment. t might be helpful but is not crucial. If an investment is worth while having FDI is not essential. China has managed to build its self into an industrial powerhouse with relatively little foreign investment. Sure Taiwan and Hong King have invested very heavily but China regards both as part of mainland China anyway. All they really need are the skills and they can hire those if necessary. They can buy in high tech machinery and build their own space and high speed rail programs. 

      1. Oldrich says

        I particularly like the comment about the necessity to produce a new breed of economists who are not so radically steeped in the neoliberal/libertarian paradigm. That is pretty much a hit of the bull’s eye.
        What is really sad and enraging is the the whole attitude – after bringing the entire system on the verge of collapse of apocalyptic magnitude and having their skins salvaged, they seem to have shaken off all shame and in fact carry on like “well, the Government is always the problem, let us let the free markets do its magic”.
        China, for me, exemplifies the fact the Capitalism can work in a totalitarian system and doesn’t need Democracy and a free society. 

        1. David_Lazarus says

          Markets do work, but it is not always the governments fault that they fail. Regulations need to be simple and effective, and regulators need teeth to enforce them. Market participants especially in financial markets rig the market so much that the ordinary investor is a sucker. Even so called professional investors like pension funds and hedge funds can be vulnerable to dark markets, where there is little scrutiny. So there need to be regulations to protect even professional investors, from people who treat their customers as muppets. The problem is complete deregulation leaves many at the mercy of unscrupulous operators no matter what market it is. 

          One thing that many politicians have not considered this time that they were very aware of in the thirties was extremism. The New Deal and the housing programs were to ensure that workers had a stake in society. Without which the rise of communism was a real threat. Maybe they think that this time, they will have instead a corporation dominated state. Though when corporations run amok the last people that the public will accept as their leaders are bankers. 

          As for bringing the economy to the verge of collapse well we still have some $700 Trillion of derivatives that could still do that to us. Though I would imagine that if there is collapse in the Eurozone as many wish that the Europe’s banks will collapse and that will mean bankruptcy for the big US banks. So if the Fed is determined to create hundreds of trillions of new dollars they might find that they are the new pariahs. So we are still not out of the woods as far as problems by a very long way. Not until debts are manageable and incomes are growing will there be stability. 

          1. Oldrich says

            One the most eye-opening movies showing that there are no limits to human depravity and utter unscrupulous cynicism in the pursuit of profits was the great documentary “Enron – the smartest guys in the room”. It was particularly shocking to watch the scenes from the employees – management meetings only a couple of weeks before the collapse – the blatant lies and deception on one side and sheer naivete and blind almost religious faith in the company on the other.
            One of the things that really bothers me is the Roosevelt-bashing. He is accused of all sorts of things – being a dictator, of bringing totalitarianism into the US, of screwing the currency by taking it off the Gold standard, of stealing people’s gold, of sinning against the free market ideology… These people fail to realize what was going on back then … millions of unemployed, droves of people migrating the country, middle class destitute, hundreds of banks shutting down, thousands of businesses bankrupt, society on the verge of total collapse, and internationally Fascism on the rise in Europe, the Imperial Japan embarking on militarism and the conquest of Asia, Stalin in power …. These libertarian fanatics should visit his grave every year, bow and kiss the tombstone to express the gratitude for saving the system.
            And I do believe that nowadays there is much greater threat in the rise of some form Fascism not Communism. 

          2. David_Lazarus says

            I do think that Neo Classical/Liberal economics is at the end of the road. Though I suspect that economists will double down on policy to kickstart the economy. Yet I have seen blogs that have said that we have had 50 years of Keynsian failure. Which is news to me. I though that economists were all monetarists since 1980. They all demand supply side reforms i.e. slash the power of workers. Such theories seem to be one trick ponies and only worked because of falling interest rates. The problem is that low interest rates encourage mal-investment, and discourages savings. These combined lead to the weakness of the financial sector, who relied on interbank funding and ever higher leverage to cope. If you piece together the parts of the puzzle that is the US economy I am not hopeful about the next decade. Nothing is being done right at the fed to fix the crisis. It is extend and pretend on a grand scale, one which will send the world in to a Depression. 

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