The key lesson of the 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. $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 noveau 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 also the money advanced to the buyer falls in value.
The GFC has already reduced global trade and cross border capital flows. In late 2008, the World Bank forecasts a fall in global trade volumes for the first time in over 25 years. The Baltic Dry Freight Index, a measure of supply and demand for basic shipping, has fallen 90 % since mid 2008 although it recovered slightly in early 2009. Exports from Japan, Korea, Taiwan and China fell between 10% and 40% in late 2008 also signaling reduced demand for commodities.
The Institute for International Finance forecasts net private sector capital flows to emerging markets in 2009 will be less than US$165 billion – 36% of the US$466 billion inflow in 2008 and only one fifth the record amount in 2007. The projected decline in capital flows is around 6 % of the combined gross domestic product of the emerging countries. This compares to a decline of approximately 3.5 % of combined GDP in the Asian financial crisis and 1.5% in the Latin American crisis.
Investors in US government bonds have expressed deepening concern about the safety and security of their investments. Yu Yongding, a Chinese economist and former advisor to China’s central bank, warned in 2008 that: “If the US government allows Fannie and Freddie [government sponsored enterprises] to fail and international investors are not compensated adequately, the consequences will be catastrophic. If it’s not the end of the world, it is the end of the current international financial system.” Kwag Dae Hwan, head of global investment, of South Korea’s US$220 billion National Pension Fund noted: “The image of US Treasuries as a safe haven has been tainted by the ongoing financial debacle … A big question mark hangs over whether the US can deal with an unprecedented amount of debt. That is unnerving all the investors, including me.“
As the risk of trade and financial protectionism emerges, globalisation of trade and capital flows is reversing – the “flat world” is rapidly going “pear shaped”.
Slowing exports, lower growth and loss of jobs are encouraging trade protectionism. Several countries have implemented trade barriers (import tariffs and export subsidies). The fiscal packages in many countries are “economic nationalist” encouraging spending on domestically produced goods and supporting national champions and local industries. The US, France, Germany, Spain have announced bailouts for domestic companies. Asian countries are seeking to weaken the currencies to support exports to maintain global competitiveness. The US Treasury Secretary recently accused China of manipulating its currency drawing angry responses from Beijing.
Financial protectionism has also emerged. Governments are supporting domestic banks and increasingly “directing” lending to domestic firms and households.
Concerns about immigration are emerging. There have been protests in UK against hiring foreign workers. This has serious implications of countries like Mexico, Eastern Europe, India and the Philippines that depend on worker remittances that are already slowing.
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
The current crisis calls into question the ability of government and policy makers to maintain control of the economy – Lenin’s “commanding heights”.
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 that remains mired in a form of suspended animation. The rest of world’s current struggle is to avoid turning “Japanese”.
In the run-up to the 1929 election, Keynes discovered a seminal political truth about deficit spending. Lloyd George, an economically challenged politician, was delighted when Keynes provided the rationale for spending taxpayers’ money on social programs to bribe voters.
Keynes absorbed this lesson well and maintained a constructive ambiguity throughout his life allowing him to appeal to politicians who favoured government spending and those who favoured middle-class tax cuts. Writing in the Financial Times (5 February 2009) Benn Steil, Director of International Economics at the Council on Foreign Relations, succinctly set out current economic thinking: “when the facts are on our side, we pound the facts; when theory is on our side, we pound theory; and when neither the facts nor theory are on our side, we pound Keynes.”
Correcting global imbalances provides greater challenges. The world has relied heavily on debt fuelled 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, described 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.”
Corrective action will only deepen the recession and disrupt global funding flows. Wen Jiabao, the Chinese Prime Minister, recently indicated that China’s “greatest contribution to the world” would be to keep it’s own economy running smoothly. This may signal a shift whereby China uses its savings to invest in the domestic economy rather than to finance US needs.
Redirection of capital held in central banks and sovereign wealth funds to domestic economies affects the global capital flows needed to finance banking system recapitalisation and spending packages in the debtor countries. Maintenance of the cross border capital flows to finance the debtor countries budget and trade deficits slows down growth in emerging countries and also perpetuates the imbalances.
There is now acknowledgement 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.”
In the GFC, politicians, bureaucrats and central bankers have been exposed to have no more powers than the Wizard of Oz – old desperate men (they are mainly men) behind the curtain running from one lever to another in a desperate attempt to maintain illusions. In the words of the 19th century American humorist Josh Billings: “It is better to know nothing, than to know what ain’t so.”
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.
In the US alone, more than 3.6 million jobs have been lost. In Spain, unemployment has reached the middle teens. Exports and production have fallen in countries as varied as Spain, Japan, South Korea and Taiwan by amounts that beggar belief. An astonishing US$30 trillion of wealth has been obliterated in America alone. Entire countries – Iceland and Ireland – have been savaged.
The GFC coincides with another crisis: the GEC or Global Environmental Crisis. “Toxic debt” and “toxic emissions” increasingly clamor simultaneously for politician’s 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, rescuing people from poverty and social development. No limit to economic growth is recognised.
At the launch of the “Redefining Prosperity” project, Tony Jackson, Professor of Sustainable Development at the University of Surrey, writing in the New Scientist noted that a UK treasury official accused the authors of wanting to “go back and live in caves”. The project sought to raise concerns about environmental and social limits on economic growth. Ironically, the GFC has illustrated the limits and illusions of economic growth starkly.
A lower growth future has political and social implications. For example, China and India are deeply concerned about failing to provide jobs for the millions coming into the workforce each year. One in fifteen migrant workers in China are expected to be out-of-work in 2009. Chinese security leaders have warned about rising social unrest.
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.
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”.
There is no time for “triumphalism” or “mission accomplished” speeches. 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. It also questions the ability of mandarins to control the economic engines.
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. The 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. Politicians and theoreticians are enjoying their “I told you so” moments. Crisis denial, advocated by Lars Nonbye, general manager of the Nonbye sign-making company in Denmark, places a ban on any talk about the crisis from work premises. 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 did 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.”
© 2009 Satyajit Das All Rights reserved.
Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).
This article draws on the ideas first published in Satyajit Das “Built to Fail” in The Monthly (April 2009) 8-13