The System is the Problem

From the BBC:

US credit ratings agency Moody’s has put the UK on negative outlook, meaning it thinks there is more chance the economy may lose its triple A status.

France and Austria, who also share a top triple A rating, have been similarly graded. Italy, Spain and Portugal’s ratings have been lowered.

Moody’s blamed the eurozone crisis for the adjustments.

The UK chancellor remains committed to his policy of austerity whilst the opposition warns this could backfire.

The negative outlook for the UK means Moody’s thinks there is a 30% chance of a downgrade within 18 months.

BBC economics editor Stephanie Flanders said there was no suggestion that the agency would prefer the UK government to change its economic policy of austerity.

Now, I believe that the idea that a Western government bond can today be a AAA investment is very dubious. Simply, the current phenomena of negative real interest rates and debt saturation, and the problems of deleveraging mean that it is very unlikely that an investor in government debt will get back their purchasing power: either by inflation, or by default, most such investors in the next decade will probably lose the skin on their noses. But that is a side issue.

Since David Cameron and George Osborne announced their policy of austerity, my thinking on fiscal policy has somewhat evolved. Given that we know that a high residual debt load has a damaging effect on growth, my view has always been that we need to reduce the debt load as fast as possible. The question was always how we should best go about doing so. I knew from the beginning that there was always a danger that in an economy already dependent on high government expenditure, fast and hard cuts — especially in an already-depressed economy — would probably lead to a contraction in tax revenues, thus producing higher deficits and less debt reduction.

This prospective problem has been expressed quite well in this graph:

Furthermore, because of the high residual debt load, cuts in spending would merely go toward paying down debt. This means that the government will still be sucking just as much capital out of the economy as before. While cutting taxes might prove a huge plus , the presence of a huge debt load means tax cuts will be unaffordable, and thus there would be no such boost.

The greater problem, of course, is that in an economy that is greatly centralised around government, cutting spending very often translates into cutting real output, and real economic activity. Now during an economic boom, this is fine — the growing market can pick up the slack. But during an economic contraction, this just takes the problem of falling output and exacerbates it.  One only has to look so far as Germany under Heinrich Brüning,( or the problems currently afflicting the Euro Zone) to understand the problem:

Bruning applied the [austerity] medicine to Germany, and the resulting backlash was so intense he suspended parliamentary democracy and ruled by emergency decree, setting a fine example for the next guy who took power. After just two years of “austerity” measures, Germany’s economy had completely collapsed: unemployment doubled from 15 percent in 1930 to 30 percent in 1932, protests spread, and Bruning was finally forced out. Just two years of austerity, and Germany was willing to be ruled by anyone or anything except for the kinds of democratic politicians that administered “austerity” pain. In Germany’s 1932 elections, the Nazis and the Communists came out on top — and by early 1933, with Hitler in charge, Germany’s fledgling democracy was shut down for good.

Of course, in the modern world there is a larger problem even beyond fiscal contraction leading to a contraction in real output. This is the problem of fiscal contraction leading to financial collapse. Simply, as Greece have enacted more and more austerity, they have collected less and less taxes. And this means that they are closer to closer to default. Now, because Greece’s debts have been securitised and spread around the European banking system, a default on Greek debt could lead to mass bank insolvencies in European, which could lead to mass bank insolvencies around the world as more and more counter-parties default on their obligations.

As I wrote last month:

As we learned a long time ago, big defaults on the order of billions don’t just panic markets. They congest the system, because the system is predicated around the idea that everyone owes things to everyone else. Those $18 billion that Greece owes might be owed on to other banks and other institutions. Failure to meet that payment doesn’t just mean one default, it could mean many more.

That is known as a default cascade. In an international financial system which is ever-more interconnected, we will soon see how far the cascade might travel.

This is a bizarre situation. The intuitive response to excessive debt — belt-tightening; spending less, and saving more — is not only wrong, but it is potentially dangerous.

Modern Keynesians believe that the answer to these problems is stimulus and monetary expansion: that government ought to increase spending, and that monetary authorities ought to print more money. Essentially, both of these ideas amount to reinflating the bubble. Stimulus allows for the economy to keep ticking over while the private sector deleverages. Money-printing and inflation shrinks the debt relative to the amount of money in the economy. There is a real advantage here: bondholders — as opposed to taxpayers — take a hit as their lendings are repaid in debased currency. As I have noted in the past, I believe (as did Jesus) that creditors are the ones who ultimately must take the hit when it comes to addressing the problem of debt saturation. After all, in a market economy, all investments — even those made to very wealthy debtors — carry risk. Unfortunately, the inflationary Keynesian method hits savers and investors, and those living on a fixed income.

Worst of all, these aids ignore the real problem, which is not the recession at all, but the thing that caused it — the huge preceding credit-fuelled bubble. And therein lies the problem.

As I wrote way back in October:

Modern economics has been a great experiment:


Economic history can be broadly divided into two eras: before Keynes, and after Keynes. Before Keynes (with precious metals as the monetary base) prices experienced wide swings in both directions. After Keynes’ Depression-era tract (The General Theory) prices went in one direction: mildly upward. Call that a victory for modern economics, central planning, and modern civilisation: deflation was effectively abolished. The resultant increase in defaults due to the proportionate rise in the value of debt as described by Irving Fisher, and much later Ben Bernanke, doesn’t happen today. And this means that creditors get their pound of flesh, albeit one that is slightly devalued (by money printing), as opposed to totally destroyed (by mass defaults).

But (of course) there’s a catch. Periods of deflation were painful, but they had one very beneficial effect that we today sorely need: the erasure of debt via mass default (contraction of credit means smaller money supply, means less money available to pay down debt). With the debt erased, new organic growth is much easier (because businesses, individuals and governments aren’t busy setting capital aside to pay down debt, and therefore can invest more in doing, making and innovating). Modern economics might have prevented deflation (and resultant mass defaults), but it has left many nations, companies and individuals carrying a great millstone of debt (that’s the price of “stability”):

The aggregate effect of the Great Depression was the erasure of private debt by the end of World War 2. This set the stage for the phenomenal new economic growth of the 50s and 60s. But since then, there’s been no erasure: only vast, vast debt/credit creation.

And that is the real problem we face today: the abolition of deflation, the abolition of small defaults, the abolition of the self-correcting market.

Neither austerity, nor stimulus are a sufficient remedy for today’s financial problems (let alone today’s economic ones). What is needed is liquidation, so that the old rubbish is cleared out, the system is no longer congested by debt saturation, and new opportunities are opened up.

Simply, everything we have experienced over the last twenty years — from Japan in the ’90s, to America in ’08, to the ramifications of Greece’s default, to the growing trade war between America and China — is a lesson that credit-based money is not robust. It is so weak to the problem of credit contraction that — once the point of debt saturation is inevitably reached — every time there is a contractionary event, monetary authorities must pump the market with new money, and highly-indebted governments must (unless they are foolish like Britain’s present government, and want to see falling consumer confidence, business confidence, real GDP, industrial output, and productivity) maintain or increase spending instead of reducing spending and saving money. Otherwise, the system itself is endangered. It is a fundamentally fragile system. 

Ultimately, nature always wins. Ultimately, the debt saturation problem will be taken care of either by currency collapse, or by defaults (and probably systemic collapse, and a new global financial order), or by war, or by some kind of debt jubilee. I don’t know which. I hope for the latter. It seems kinder.