Crawl Across the Ocean

Thursday, February 12, 2009

Thoughts on the economic crisis

I thought I’d post some updated thoughts on my views on the current global economic crisis. To be honest not much has changed since I wrote this post a couple of months ago, other than my confidence in my conclusions has increased.

Note that if you haven't already read Stoneleigh's must-read summary of the financial crisis (written almost a year and a half ago, now) you should read that rather than reading this post. (abridged version here)

Some other posts you'd be better off reading before reading my thoughts are as follows:

Steve Keen's Roving Cavaliers of Credit

Martin Wolf, Why Dealing with the Huge Debt Overhang is so Hard

Naked Capitalism, Irving Fisher's Debt Deflation Theory (and read the comments, too)

Mish, Wealth Does not pass three generations

Update: Another good post, 'Recession? No, it's a D-process, and it will be long', from an interview with Ray Dalio in Barron's (via Automatic Earth)
Before I begin it's worth noting the ideologically (from a left vs. right point of view) scattered nature of the people linked above, a group united more in its outsider status vs. the establishment status quo than in any left vs. right political views.

Here are 5 culprits in the crisis, moving from ultimate towards proximate causes:

Human Nature
Bad Regulation (fractional reserve banking, monetary policy to lower interest rates, etc.)
Financial System Leverage

Basically what we have seen is a debt/credit bubble. There are two forces that drive the creation and then destruction of the credit bubble:

1) Increasing financial system leverage along with an increasing ratio of credit money to fiat/currency/non-debt bearing money
2) Increasing inequality as debtors enrich creditors via exponentially rising interest payments.

In more detail:

1) We start with a healthy economy.
2) This healthy economy is growing due to improved productivity, population growth, etc., or maybe because interest rates have fallen.
3) Optimistic and impatient people take on debt believing either that they can earn a great enough return on the borrowed money to repay with interest or that consuming now instead of later is worth the interest payments.
4) Borrowing expands the supply of credit money in the system and this expansion is self-reinforcing in that the optimistic expansion of borrowing creates the money needed to pay back the original loans
5) The self reinforcing dynamic keeps the default rate on loans low.
6) Some of the newly created money starts to go into speculation on asset prices
7) This is again self-reinforcing as rising asset prices collateralize greater lending (think ‘taking equity out of your house’ and prevent losses on defaults (rather than default on your house, sell your house and pocket the profits due to appreciation)
8) The good times allow people to repay their loans which leads to greater inequality, since the rich lend to the poor, if loans are repaid with interest the rich get richer vs. the poor (except in cases where the return on borrowed money above the interest rate exceeds the rate of interest, but this is the exception rather than the rule)
9) The rising asset prices also increase inequality since the wealthy own more assets than the poor.
10) The proportion of the economy devoted to the financial sector grows as the volume of credit expands relative to the size of the economy.

There are four things which can limit this self-reinforcing credit bubble dynamic:
1) People choose to stop borrowing money out of a moral aversion to taking on more debt
2) Regulation prevents further lending (via reserve requirements, capital requirements, leverage constraints, or other restrictions)
3) Lenders choose not to lend any more money due to the increased risk
4) People’s debt to income ratios rise so high (due to the expansion of debt and the rising inequality) that they simply can’t afford to borrow any more money but they do it anyway and begin to default.

If 1,2 and 3 fail, as they have failed us in this latest crisis, then sooner or later 4 will take hold.

There is one way to forestall point 4) and that is to have the government lower interest rates. Since the early 1980’s when interest rates hit 20%, interest rates have fallen. Lower interest rates support higher asset prices (you can buy more house if the mortgage rate is lower) and they lower the burden of accumulated debt levels by reducing the interest payments. In 2001 when it looked like the expansion of the credit/debt bubble was at risk, central banks dramatically lowered interest rates and succeeded in triggering another 5-6 years of credit/debt bubble expansion along the lines described above.

What happens if point 4) happens and interest rates are already pretty much at 0% you ask? You reach our present situation.

What we see now is that (almost) everything that happened on the way up goes into reverse.

A) Without new credit expansion to support rising asset prices, asset prices begin to fall
B) Once people default on loans that are no longer fully collateralized due to falling asset prices, banks start to take losses.
C) Once speculators realize the game is up, they start trying to pull their money out of their speculative investments, aggravating the decline.
D) The bank losses quickly wipe out the capital of over-leveraged financial institutions making it impossible for them to lend money, further accelerating the destruction of the credit/debt bubble
E) Even if you give the banks money to lend, they won’t do it, because without the promise of the ever expanding credit/debt bubble, nobody is credit-worthy since they either have too much debt or they just defaulted on their debt.
F) Even if the banks want to lend, few people want to borrow because they are afraid of deflation making their debts harder to pay because…
G) Deflation means that real interest rates are high even though nominal interest rates are 0 because…
H) The one thing that isn’t shrinking is the size of the debts owing since your mortgage doesn’t shrink just because you got a 10% pay cut. So the deflation makes it impossible even for those people who originally borrowed at reasonable levels to repay their now massive and growing debts. This further aggravates the downward spiral.
I) As people default on their debts, the balance between rich and poor is restored as rich creditors lose money to poor debtors. Falling asset prices have the same effect.
J) Only when enough of the debt has been defaulted upon so that the ratio of debt/credit money in the economy to actual debt-free currency is restored to a low enough value and the debtors are no longer being crushed under the weight of their debts can people once again start lending and rebuilding the economy.

So 2 questions arise:

1)How do we get out of the current mess?
2)How do we avoid getting into this mess in the future?

1)How do we get out of the current mess?

We can’t get out by repaying the loans since repayment of the loans will just make poor debtors even poorer. Also, deflation will make repayment extremely difficult.

One way out is through inflation. However, it is unclear that central banks have the will to print the truly massive amounts of money that would be needed to cause inflation in the midst of deflation of a credit/debt bubble. History suggests they don’t as far as I know (although I’m open to corrections, aside from the Weimar Republic which I know about).

Also, using inflation is a bit like stopping a free fall by using rocket thrusters. It will work but you have to be extremely careful not to apply so much force that you fly off into space (hyperinflation).

The best way out, to my mind, is to wipe out the debts in as orderly a fashion as possible. I don’t say this lightly since I have no debts and I would find it galling to see all the people who irresponsibly piled up debts and enjoyed themselves with this spending spree now getting bailed out because collectively all the debtors were too big to fail but I’ll settle for getting screwed over to having a depression which won’t be any barrel of laughs either. Society’s preferred method for discharging debt is via bankruptcy and I believe the government should be trying to encourage a widespread outbreak of bankruptcy to reduce the overall debt levels.

In a nutshell we need to rebalance the amount of currency (money not created as debt) with the amount of debt/credit. We can attack this from two sides, both by printing more currency and by encouraging/allowing defaults on the debt. Once this balance is restored things can start growing again, but we are so far, far from being in balance that it is inevitably going to be painful getting from here to there.

Measures to try and preserve the existing ratio (e.g. forcing banks to lend at gunpoint, negative real interest rates that punish savers and reward borrowers) will either cause another run-up in the bubble leading to even greater pain next time the bubble pops (as happened from 2001-2007, but I suspect we are too far gone to have happen again), or freeze things in place allowing us to limp along Japan style for year after year without ever really getting out of stagnation.

Having government take on debts as private sector debt collapses will help, but only in the sense that raising the flaps helps you land a plane that has run out of gas. It acts as a brake on the collapse in credit money but can only slow it down since moving risk from one holder to another doesn't really change the underlying dynamics.

2)How do we avoid getting into this mess in the future?

If the great depression only scared us straight for a couple of generations (see the post by Mish linked above), it seems unlikely that we can make any permanent fixes here either. Still, I have a few suggestions:

1) 100% reserve requirements for financial institutions – Preventing lenders and central bankers from working together to supply an infinite amount of credit at zero cost will mean that in future, if people want to borrow, they have to find someone willing to lend their actual money, not just give them made up money. In this scenario, although the central bank may want to lower interest rates, doing so will be constrained by the limited supply of people willing to lend out their money at these low interest rates. 100% reserve requirements won’t prevent credit bubbles, because they won’t change human nature (the enduring belief that it’s different this time, it’s different here, the fundamentals don’t matter, etc.), but it will remove one enabling element that supports the growth of credit bubbles, and that’s a start.

2) Fixed and conservative margin requirements for asset purchases (say, a minimum 25% down payment for a residential mortgage, 50% for stocks and maybe a few other asset classes, and 100% for everything else, including cars and sofas). This will help prevent the self-reinforcing cycle of rising asset prices and expanded credit from getting out of hand.

This list from Karl Denninger wouldn’t be a bad way to start either:

I picked out a few of his suggestions that I liked the best, but they almost all make sense in the American context (the Canadian banking picture is a little different than the U.S. one, in particular we have the appropriate history and culture to manage a more concentrated banking sector than the Americans do).

3. Repeal the "Bankruptcy Reform" law. Consumers must have the same right to go bankrupt and discharge debts that corporations have. Banks and others who grant loans must have this Sword of Damocles over their head - you make a bad loan and the borrower can file Chapter 7 and stick you with it, without exception. This will immediately collapse the outrageously overpriced bubbles that remain and are credit-driven, including post-secondary education.

[Ed: We didn't have this 'reform' in Canada, but in general loosening our bankruptcy laws to match the more debtor friendly American laws would help]

4. Remove the obscure little change made in the EESA/TARP legislation that allows Bernanke to set the reserve ratio to ZERO for banks, and set it statutorily to 8%. Enhance the law by declaring that ALL funds taken in by a bank irrespective of their source are subject to the 8% reserve requirement (thereby removing the "sweeps" exemption that started this mess.) This will force leverage in the regulated banking system to no more than approximately 12:1.

[Canada has no official reserve rates. Leverage is constrained instead by regulatory capital requirements but the principle remains the same, constrain financial industry leverage to a set ratio - and *enforce* this limit.

5. Set the lawful leverage limit to 12:1 for all investment banks and other entities including hedge funds. Any firm that wishes to be domiciled or operate in the United States must comply. Period. I know what the counter-argument is - "they'll go somewhere else." Fine! Go blow up some other nation's economy. We've had enough of it.

6. Said 12:1 leverage limits must apply to all assets. Yes, even US Treasuries. If you hold it at most (for the safest assets) you can gear it at 12:1. Period.

7. Ban all off-balance-sheet vehicles; no exceptions of any sort. If you have control of it or are responsible for it in any form or fashion you must consolidate it on your balance sheet. "Shell corporations" set up to evade this requirement that have no capital or assets of their own are deemed a fraudulent shell company. Close the SIV loopholes.

9. Bar the trading of derivatives contracts by commercial banks except where those contracts are backed by or insure a hard asset (e.g. a CDS on an actual bond or mortgage) and they are exchange-traded with a central clearing counterparty and thus guaranteed "good". If some Hedge Fund wishes to write or hold naked CDS and immolate themselves that's fine, but they cannot blow regulated financial firms (including insurance companies) to pieces nor can they distort share and debt-pricing mechanisms in the public, regulated markets.

11. All derivatives traded by regulated financial entities must be cleared and traded through a public exchange with a central counterparty, nightly margin supervision and published bid/ask/open interest.

12. Extend bank fraud statutes to explicitly cover actions taken by The Fed or any banking or financial institution in violation of statutory limits and name the members of the board of any such institution as personally responsible for violations. This stops the game-playing where institutions feel free to be "fast and loose" because all they will get is a slap on the wrist by FINRA or the SEC. With these offenses being federal criminal offenses the calculus changes immediately on what someone will and will not attempt.

14. Stop trying to prop up asset (especially house!) prices. Instead, preach the truth - affordable housing means no more than 28% of your income goes toward all housing expenses, you should put 20% down, and you should not take anything more aggressive than a 30 year fixed-rate loan. For many areas this means median home prices must still contract. A house is shelter, not a speculative vehicle.

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  • Dear Declan,
    Thank you so much for posting this collection of articles dealing with the current credit crisis. I found your blog only by a chance and haven't had time to go through all the links or read your article fully, but it's bookmarked now and I will take time to study it a bit more. As a Toronto realtor I feel I should have a bit better knowledge of what is going on. You saved me a great deal of time searching for information, thank you!

    By Anonymous Anonymous, at 11:27 PM  

  • You're right on target. There is a bit of good news, however, that might at least ease the affects of the crumbling economy. It looks like the number of employers that are outsourcing to Canada is on the rise. At least some talented Canadians will be able to take advantage of this and bring in some extra money that way.

    By Anonymous Anonymous, at 6:39 AM  

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