What I Didn’t Say on the BBC

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

Stimulus is No Panacea

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

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

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

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

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

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

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

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

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

Credit deflation and the Japanese problem

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

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

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

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

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

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

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

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

So what should we do then?

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

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

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

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

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

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

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

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

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

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

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

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

Originally published at Credit Writedowns and reproduced here with the author’s permission.
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