Built to Fail: Key Lessons from the Financial Crisis

Minyanville ^ | 16 June 2009 | Satyajit Das

[BGHater]

The key lessons of the global financial crisis (GFC) may be that the current economic order is "built to fail."

The ability to sustain high rates of economic growth, decreed by governments and central bankers, is questionable. The aggressive increase in debt globally resulted in a sharp increase in sustainable growth rates, wherein $4 to $5 of debt was required to create $1 of growth. Approximately half the recorded growth in the US over recent years was driven by borrowing against the rising value of houses (mortgage equity withdrawals). As the level of debt in the global economy decreases, attainable growth levels also decline.

The world used debt to accelerate its consumption. Spending that would have taken place normally over a period of many years was squeezed into a relatively short period because of the availability of cheap borrowings. Business over-invested -- misreading demand and assuming that the exaggerated growth would continue indefinitely -- creating significant over-capacity in many sectors.

The nouveau Jeffersonian trinity -- "whoever dies with the most toys wins," "shop till you drop," and "if it feels good, do it" -- has proved to be unsustainable.

Growth in global trade and capital flows was also built to fail. It was built on a financing model where sellers of goods and services indirectly financed the purchase. When the buyer is unwilling or unable to pay, the seller suffers doubly -- sales fall and the money advanced to the buyer falls in value.

The GFC has already reduced global trade and cross border capital flows.

Slowing exports, lower growth, and loss of jobs are encouraging trade protectionism. Financial protectionism has also emerged. Governments are supporting domestic banks and increasingly "directing" lending to domestic firms and households. Concerns about immigration are emerging.

In an essay titled "The Great Slump of 1930," published in December of that year, Keynes observed: "We have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand."

Failure to Summit

Governments may not be able to address the deep-rooted problems in the current economic models. Government spending, if it can be financed, may not be able to adequately compensate for the contraction of consumption and lack of investment made worse by over capacity in many industries.

Government spending has little multiplier effect or velocity. The badly damaged financial system means that the circulation of money in the economy is at a standstill. While government spending may provide short-term demand boost and capital injections may partially rehabilitate banks, it is far from clear what will happen when all these measures are reversed.

Governments and central banks have limited available tools. Keynes famously described monetary policy as the equivalent of "pushing on a string." Given that interest rates are now at or approaching zero in many developed countries, there is no string at all.

Fiscal policy could be described as "pulling on the same string." The experience of Japan is salutary. Zero interest rates and repeated doses of fiscal medicine have not restored the health of the Japanese economy, which remains mired in a form of suspended animation. The rest of world’s current struggle is to avoid turning "Japanese."

Correcting global imbalances provides greater challenges. The world has relied heavily on debt-fueled American consumption to drive global growth. With 5% of the world’s population, the US is 25% of global GDP, 20% of global consumption and 50% of global current account deficit.

The US needs to decrease consumption, increase savings, reduce debt, export more and import less. The countries with large savings and trade surpluses need to do exactly the opposite: specifically, encourage domestic consumption. Currently both surplus and deficit countries are doing the opposite of what is required.

The challenge is evident in two telling statistics. Consumption is around 40% of the economy in China against over 70% in the US. Average earnings in China are only 10% of that in the US. The size of the adjustment is substantial.

David Rosenberg, an economist from Merrill Lynch, describes the process of adjustment: "This is an epic event; we’re talking about the end of a 20-year secular credit expansion that went absolutely parabolic from 2001-2007. Before the US economy can truly begin to expand again, the savings rate must rise to pre-bubble levels of 8%, the US housing stock must fall to below eight-months’ supply, and the household interest coverage ratio must fall from 14% to 10.5%. It’s important to note what sort of surgery that is going to require. We will probably have to eliminate $2 trillion of household debt to get there, this will happen either through debt being written off, as major financial institutions continue to do, or for consumers themselves to shrink their own balance sheets." There is now acknowledgment that the economic model itself is the source of the problem. Zhou Xiaochuan, governor of the Chinese central bank, commented: "Over-consumption and a high reliance on credit is the cause of the US financial crisis. As the largest and most important economy in the world, the US should take the initiative to adjust its policies, raise its savings ratio appropriately and reduce its trade and fiscal deficits." More ominously, Chinese President Hu Jintao recently noted: "From a long-term perspective, it is necessary to change those models of economic growth that are not sustainable and to address the underlying problems in member economies."

Limits to Growth

The GFC’s seriousness and gravity is unquestioned. Initially, the world viewed the destruction of financial institutions as an entertaining blood sport. There was a sense of schadenfreude as the Masters of the Universe received their comeuppance. The "financial" crisis has now spread to the "real" economy: jobs, consumption, and investment. It is now everybody’s problem.

The GFC coincides with another crisis: the Global Environmental Crisis (or GEC). "Toxic debt" and "toxic emissions" clamor simultaneously for politicians' attention.

Irreversible climate change, scarcity of vital resources (food and water) and falling biodiversity are not unconnected with the existing economic system. Economists and politicians implicitly assume that high levels of growth drive increased living standards and rescue people from poverty and social development. No limit to economic growth is recognized.

Demagogic debates about the ideological differences between neo-liberalism, compassionate capitalism and social democracy are unhelpful. In truth, all competing economic philosophies are underpinned by the same reliance on growth and built-to-fail economic models. The world needs to adjust to a new economic order and a world of reduced expectations. In the short run, the primary focus surely should be to dealing pragmatically with the GFC and its potentially devastating human and social costs. There will be time enough for recriminations and blame.

Dead Economists

At the fall of the Berlin Wall, when asked, "who won?" political scientists cited the triumph of capitalism over socialism. The economist’s response was simply: "Chicago". The reference is to the Chicago Graduate School of Business and its unshakable belief in free markets, exemplified in the title of Milton Friedman’s most accessible work: Free To Choose (1990). The GFC marks the end of unquestioned advocacy of free markets. Wang Qishan, Vice-Premier of China, tartly observed: "The teachers now have some problems."

The GFC brings into question much of established orthodoxy of economic models and approaches. It calls into question social and political models based on high levels of economic growth and financial-, rather than real-economy-driven, growth.

The GFC also questions the ability of governments and their policy "wonks" to control the economic engines. As Wolfgang Münchau, columnist for the Financial Times, observed on June 14: "Instead of solving the problems to generate a recovery, the political strategies have consisted of waiting for a recovery to solve the problem. The Europeans are relying on the Americans to generate growth. The Americans are relying on the Chinese, who in turn are waiting for the rest of the world."

Recently in Canary Wharf, the financial district in London’s docklands, I noticed a small street stand erected by the English Teachers Union to recruit teachers. Two affable recruiters explained that they had heard that there was "a bit of financial crisis." Well-educated and highly motivated bankers who were losing their jobs by the thousands might like to consider a new career: teaching.

I questioned the adjustment in salaries -- a reduction of 60% to 95% -- that the change in careers would necessitate. One recruiter’s response stays with me: "If you haven’t got a job, then it’s not relevant, is it? It was never real money and it wasn’t going to ever last, was it?"

Different strategies exist for dealing with the GFC. The most productive strategy may be to use the GFC to redirect talent and resources into the real economy and adjust living standards and expectations of economic growth.

As Keynes wrote in 1933: "We have reached a critical point. We can ... see clearly the gulf to which our present path is leading … [If governments do not take action,] we must expect the progressive breakdown of the existing structure of contract and instruments of indebtedness, accompanied by the utter discredit of orthodox leadership in finance and government, with what ultimate outcome we cannot predict."

[Vaduz]

Key Lessons from the Financial Crisis keep Obama and company away from the cash box.

[Dick Holmes]

A bit doomy-gloomy, wot?