Some thoughts on the crisis as the G20 prepares to gather

September 21, 2009

 “any pro-capitalist argument must rest on long-run considerations. In the short run it is profits and inefficiencies that dominate the picture”. Joseph Schumpeter

In this quite dramatic financial and economic crisis, it isn’t easy to be someone not completely swayed by the common exaggerations about its gravity, as if it were the end of the world, nor by all the moralism that has been surrounding it. Those who say “wait a moment and think again” have the disadvantage of coming up with more reasoned approaches in an area where sometimes public ire seems to have taken the lead over reasoned discussion. Not that I believe that they matter to anyone, there are so many qualified authorities around, but I’ve been trying to structure my thoughts on the crisis and so share them modestly with anyone who’s interested.

The public’s attention, at least in rich Western countries, has been fed with views that smack of religion rather than anything close to sensible policy discussion. The Catholic Church took up its usual business of stirring up believer’s guilt by condemning the Profit Motive, whereas the Protestant Anglo-Saxons came up with scathing attacks on bankers’ Greed. Eco-fundamentalists say it’s all the fault of consumerism and China discovering it. They say we should go organic and stop economic growth, lest the Four Horsemen of the climate Apocalypse descend upon us and throw us into eternal Damnation. Leftists and communists responded that all we need is to re-nationalize the economy. Nobel-prize winning economists have been swayed by their religious – and star-status-enhancing – instincts. If one believes Joe Stiglitz, the cult for the GDP (gross domestic product) has been a root cause of this crisis. And Paul Krugman has been spreading his blind belief in the benefits of massive bail-out packages, as if they were a cost-free magic manna sent from heaven. Politicians preparing for the G20 summit in September make high-flying statements on curbing banker’s pay, cracking down on tax havens, after having been fixated on regulating hedge funds. Yet they too, only maximise their electoral utility.

How bad is this crisis, actually? First of all, this crisis has been oversold as being the worst since the Great Depression of the 1930s. As Allan Meltzer recently pointed out in a Wall Street Journal article, “the facts we face today are very different than the grim reality Americans confronted between 1929 and 1932. True, this recession is not over. But it would have to get improbably worse before it came close to the 42-month duration of the Great Depression, or the 25% unemployment rate in 1932.” In fact, it looks like we are slowly getting out of the crisis. Therefore the recession is likely to turn out to be a very classic post World War II recession, albeit of the severer type, like the 1973-1975 crisis.

What has caused our current bust? And is it Global Capitalism’s fault? The causes of this crisis are multiple. They have both to do with how the market economy works and with policy failures. One must face it: this crisis is a typical capitalist crisis of boom and bust. Like so many of these, it involves banks. Banks are the intermediaries that channel savings and investments in complex economies characterised by a sophisticated division of labour. Today this division of labour is global. Finance, unsurprisingly, is also global. Yet the mechanism of the good old business cycle is the same. Recurrent fluctuations in a private enterprise economy are caused by the changing outlook for profits. When that outlook is favourable, investment and production increase. The contrary happens when that outlook deteriorates. Rising investment fuels growth. This will produce more profits and further investment. But, the whole process is uncertain, because any act of investment is based on expectations about future relative prices. Every act of investment is necessarily a gamble. The higher one is in the upward slope of the business cycle, the more economic actors are likely to take wrong decisions, given that the availability of good investments is shrinking. In our crisis the diminishing returns on investment were on real estate and in subprime mortgages. One can’t defy gravity. The bubble always ends up bursting. Economic recovery only occurs when the bad investments have been liquidated.

But any boom and bust cycle can be smoothened or sharpened by good or bad policies. In this crisis several blatant policy failures have contributed to the collapse of September last year. Monetary policies: Excessive availability of cheap money due to the flooding of the US financial markets with Chinese savings; the Fed’s accommodating monetary policy that has not raised interest rates early enough and therefore fuelled the housing bubble that has come home to burst. It inly required a very slight increased in Fed interest rates and so the magic was gone. Regulatory failures: US regulations that exempt mortgage lenders from following the usual prudential rules for giving out credit to people who can’t afford a house; tax breaks on homeownership in several countries hit by the bursting of the housing bubble. And there is the failure to regulate the new complex financial products that emerged in the last years and have led to the spread of those toxic assets that still sit in many a country’s banks, waiting to be disposed of.

Why has no-one seen the crisis coming? In fact, contrary to what is often being stated, it is not true that no one saw a crisis coming. The IMF and other economists were discussing the risks of the global imbalances involving China and the US for several years. Doom-sayers like Nouriel Roubini (to name only one of the most prominent) were often dismissed as party-spoiling Cassandras when they pointed to the risks of the housing bubble. Pessimists full of anxiety were calling for the regulation of the new esoteric “structured” financial products called AMBS, CDOs etc. But as most events, the actual shape and timing of the event was impossible to predict. Honest and serious economists don’t even pretend to have any magic predictive power.

What should be done about this crisis? Clearly, the priority should be given to addressing the root causes of this crisis? This involves: prudent and well-thought-through regulation of the financial system as it is now, and of the new financial products that have emerged in the recent years; clean-up of the banking system (buy away the toxic assets); reassessment of monetary policies and finding effective ways of avoiding asset bubbles getting out of hand; rebalancing of the economies with surplus savings (China in particular but also many Asian economies and countries like Germany) and current account deficits (the United States but also the United Kingdom among others); winding back policies that unduly promote house-ownership; promote consumption in saver countries and savings in consuming countries; strengthen institutions to warn of an incipient crisis, such as the IMF’s Financial Stability Board. But these are complex tasks that cannot be undertaken in a short period of time lest costly blunders be made. They are also dull, politically explosive, and not amenable to quick fixes. So what about hedge funds, bankers’ pay, tax havens? Although looking closer at how to regulate these areas isn’t per se a bad idea, these have not caused the crisis.They have been a side-show. The structural causes lie elsewhere.

 Are we going in the right direction? The answer is a qualified No. Qualified, because there have been moves in the right direction on discussing international and domestic financial regulation, for example. But we are only at the beginning of a long process. Qualified, too, because one cannot deny that the bailout packages injecting millions into national economies have maintained a minimum of confidence in the economy. Beyond that, there are risks of major mistakes. The first is that many overdue changes in the financial system will not be done, due to the political process in Washington/Wall Street, Beijing, London, Brussels. There’s also reluctance of member states to give proposed supervisory bodies in the International Monetary Fund (FSB) or the European Union (Systemic Risk Council) appropriate powers. There’s simply too, the reluctance of rich countries to clean up their banks, thus perpetuating the current shortage of credit.

The second problem lies in the fiscal measures taken to counter the crisis. These risk choking off a still fragile return to economic growth.

It is important to find a sustainable path back to economic growth. This is why: Economic growth is not a cult-object irrationally pursued by economic fundamentalists. It is one of the most important – if limited – indicators that correlate with the rate of activity and development of a given country. When growth levels are low, those that suffer most are the silent majorities and the poor, the unemployed, the outsiders. This is not “trickle-down economics” but a fact. China’s and India’s examples are the plain proof of this. The moment these plugged into the global capitalistic production system, and therefore increased their rates of growth, these have, in less than a generation, produced a middle class as sizeable as the European Union each. That’s a billion Wretched-of-the-Earth less than in the 1980s. And they have improved everyone’s well-being. Anyone reading this article on his/her laptop or iPhone, might find it useful to be reminded of this. A similar process has taken place and Central and Eastern Europe, where plugging into European production networks has considerably increased well-being in the formerly bankrupt socialist economies.

After this digression, let me return to my argument. The life-support given to our economies in the bailout-packages, if pursued for too long can have deleterious effects. In fact it already does.

First, there is the basic rule of undergraduate macroeconomics stating that public investment “crowds out” private investment. The Heavy Hand of government renders the busy forces behind the Invisible Hand lazy and reluctant to put in their weight in the pursuit of prosperity. Or to put it less poetically: by pouring tons of money into the economy, the government contributes to rising interest rates, therefore rising borrowing costs. This in turn dis-“incentivises” private investment. The other alternative to rising interest rates is to create inflation, which leads to other economic disasters.

Second, the political-economy consequences can be devastating. Government agencies and industries that are put under life support tend to develop incestuous patron-client relationships that can lead to harmful economic decisions, in particular the resort to protectionism. This is precisely what is happening in the car industry of the US, Germany, France in particular. It is a morally laudable goal to want to avoid excessive unemployment. But the car sector is simply suffering from overcapacity and produces cars that the consumer no longer wants. The life support given to these industries delays their restructuring, slows down productivity, and diverts energies and public resources from more productive and beneficial activities. Furthermore, these industries develop a complacency that leads them to demand the kind of protectionism that will spare them the effort to restructure. The US’ recent decision to slap 35% duties on Chinese tyres, is such an example. Another example is the failure of the European Union to finalize the signing of a free trade agreement with South Korea. The uncompetitive elements in Europe’s car industry are blocking a deal that would provide Europe the opportunity to sell more products to South Korea, not least medical technology and environmentally-friendly high-tech products. Environmentalists in particular should also be wary of the bailout packages and the emerging protectionism. China’s activist rescue activities lead it to over-invest in the kind of heavy industries (steel, chemicals, cars) that contribute to the country’s ecological crisis. The rise in anti-dumping measures across the world is also a problem. These measures are always taken to the benefit of uncompetitive industries, chiefly among them the metals sector in Europe, the US, but also India and other emerging markets. These sectors are strong CO2-emission producers. In the EU they are the ones that lobby most in favour of obtaining gratis permits in the EU’s cap-and-trade scheme, for example, thus not exactly showing they are willing to contribute to the common good.

An economic crisis is an opportunity to become more efficient, and to drop productive activities that are no longer socially optimal. A plunge into government activism and protectionism is certainly not the right response to our current challenges. As a not-so-humoristic nod to readers with their heart on the “left” and on the “green” side of things: we simply need more people on this planet to be able to afford organic food! There’s no way around favouring growth and good old conservative macroeconomic policies. Let’s not be blinded by the forces that try to reign in Keynes’ “animal spirits”. Only their freedom of acton will bring us socially desirable benefits, even is the process is fraught with crises. Good policies can on top of that contribute to absorbing the shocks.


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