The Economy is Broken – How Do We Fix It?

The Unexplored Causes and Geopolitics of the Great Recession, December 2009

Blaming Bankers and Developers Is Good Fun but Tells Us Little about What Really Got Us into this Recession and the Complexity of Ensuring It Does Not Recur

Many think that the cause of the current crisis was  simply the failure of the banking system to manage many of the new, and some  very old, risks in the financial system. However in some countries there are multiple crises and each need to be analysed separately to understand what really happened. Only by fully understanding how we got into the mess we are in can we ensure we take the appropriate steps to get out of it properly and as quickly as possible.

  1. The International Banking Crisis and Its Real Sources
  2. The Narrower Impact of Asset and Other Bubbles
  3. Other Crises – Loss of Competitiveness
  4. The Resultant Fiscal Deficit
  5. Conclusions
  6. Recommendations

1. The International Banking Crisis  and Its Real Sources

The main crisis, and a truly global one affecting many countries, was the crisis in the international banking system.The genesis of this crisis was summarised by Alan’s Greenspan’s  statement that the pivotal factor was “the underpricing of risk worldwide”. Applied to sub-prime mortgages in America and elsewhere (and European bank lending to Emerging Markets, which are usually ignored but  of very significant amounts) this is an attractively  simple explanation. It however ignores some serious underlying problems. As the International Institute For Strategic Studies (IISS) has put it: “the turmoil in financial markets was thus a trigger for the global recession rather than its fundamental cause.”[ Strategic Survey 2009 , The Annual Review of World Affairs, IISS].

To understand the fundamental cause you have to go back to the East Asian financial crisis of 1997/8. The impact on the East Asian countries of that crisis was significantly magnified by a huge amount of capital flight from each of those countries. The lesson they took from that crisis and the resultant need to go to the International Monetary Fund (IMF) cap-in-hand with the resultant degrading loss of sovereignty, was the critical need to build up foreign exchange reserves to guard against a repetition of that capital flight. To do so they set out to create significant current account surpluses, usually based on deliberately undervaluing their currencies , and so maintaining strong export growth. This enabled  them to accumulate foreign exchange reserves to guard against future capital flight. If held in their local currencies (which were deliberately undervalued)  those reserves would inevitably have led to inflation, lost competitiveness, and a reduction in exports and the current account surplus. The reserves were therefore held in US Treasury Bills,  while the currencies of many of these countries were usually linked to the US dollar.

The other side of this development is quite important. This East Asian policy in essence provided cheap funds to the US government and critically helped to keep the cost of borrowings  in the US low. [The corollary of this , termed the “money glut” thesis, was the excessive growth in US credit from loose fiscal and monetary policy. ] This enabled  companies and individuals in the US  to spend more on consumption,asset speculation (particularly , but not only, property), share buybacks, and takeovers ,rather than investment or savings, without inflation or increased interest costs  spoiling the party.

In short these two sides of the same coin are what are termed  the” global imbalances” – the real  underlying causes of the worldwide Great Recession we now are enduring.

The first well-known side of the coin is the US. The dollar is an international reserve currency, the currency most central bankers want to hold — particularly important to the successful exporting nations in Asia such as China and Japan, who holds significant volumes of Treasury Bills. This simple arrangement means that the US can run quasi-permanent current account deficits (importing more than it exports) , which it has done for many years, and have “foreigners” finance that deficit and its costly  military activities abroad, without the normal “penalties” of a run on its currency, inflation, or penal interest rates. Here in essence financial and political ” imbalances ” come together. The dollar being an international reserve currency (and the only one currently)  means that the US can play by rules not available to any other country, both economically and politically.

The other side of the coin of these global imbalances is less well known and is usually not seen as a  problem.  This is the practice of certain countries, particularly China, Japan, and to a much lesser extent Germany, of  running permanent current-account surpluses from their single-minded focus on exporting , without such being adjusted or ameliorated in any way. This usually involves a deliberately undervalued currency, a significant focus on exports for economic growth, excessive  savings, and relatively inadequate domestic  consumption and  inadequate development of the domestic service sector . Such an approach is highly rational for the country involved and utterly irrational for the world overall.The great economist, John Maynard Keynes, suggested that significant permanent surplus countries should be penalised by taxing their  surpluses to get them to adjust their trading structures back to a state of equilibrium over time, i.e. with the massive surpluses significantly reduced. This has not happened for the simple reason that there is no international monetary/exchange-rate system to make such adjustments happen automatically or to help force them on the individual countries involved.

The Great Recession  was essentially caused by these “global imbalances”.  Many  economists were aware of them , but were uncertain as to their impact. Some economists therefore simply ignored them. Others felt they were a positive or would effectively “net out”. Certain elements of the impact of these “global imbalances” were understood, at least by some of the more thoughtful economists, and were seen as a potential problem. From the point of view of many Asian countries you had  the situation of what are best described as developing countries in many cases effectively lending large sums to the US, the most mature industrial country  in the world. This flow should really be going in the opposite direction to these  developing countries (and in fact did until the East Asian crisis), many of whom had capital shortages not excess capital. From a US perspective the impact of these imbalances, and particularly the continued inflow of capital into the US, tended to encourage the industrial/financial  sectors producing non-traded goods, therefore (and as the dollar was being strengthened)  naturally  depressing US exports which would eventually be needed to clear its large and growing deficit. In 2005 in a speech titled “The Global Savings Glut and US Current Account Deficit”, US Federal Reserve  chairman Ben Bernanke, thought the required adjustments  would probably work out reasonably well: “fundamentally, I see no reason why the whole process [ of adjustment ] should not proceed smoothly”.

We now however know that the process of adjustment did not proceed “smoothly” and  can see very clearly the significant negative impact these “global imbalances” have had .

But why and how did it get so bad?

The response of governments and r egulators to the Asian financial crisis starting in 1997 (which hit the US stock market particularly hard, as well as obviously having a major impact in Asia) the internet/  bubble which started to burst in the late 1990s, and the attack on 9/11/2001, led to a concerted effort to avoid recession in the major world economies. This very valid and understandable objective  was to be achieved by adopting anexpansive  monetary policy, particularly by providing incentives to banks to increase credit, to make companies more likely to invest and individuals  more likely to consume. Both would help increase demand for world products. The simple tool, initially adopted by the US Federal Reserve, and then by other central banks, was simply to reduce interest rates to historically very low levels.

The Federal Reserve quickly lowered interest rates in the US to 1%, the lowest level since 1958. For more than 2 1/2 years, long after the US economy had resumed growing, the Federal Reserve funds rate remained lower than the rate of inflation. Simply put this meant that for the relevant banks  money was free. At such low interest rates lending to major corporate customers was providing little of the profit banks had made in previous years from such lending. Banks therefore had a number of incentives (free money, the need for alternative sources of profit, etc) to seek alternative ways of making money. This led to a host of unintended consequences not just in the US, but in many countries worldwide where the same financial structures effectively applied for much the same reasons.

In the EU the ECB (European Central Bank) also kept interest rates at quite low levels, reflecting as much as anything else the policies of the bigger EU members, particularly Germany. This had the consequence of introducing the “concept” if you will to a number of EU states of the likelihood of interest rates staying at low levels for extended periods. This new situation, compared to the previous monetary environment in a variety of countries which had historically experienced higher interest rates, helped fuel some of the attitudes particularly the willingness to borrow, and to leverage business and investment deals, that led to the banking and bubble problems discussed below.

In addition to the positive objectives of avoiding recession and keeping demand high, adopted by  the US and many other governments worldwide, the US government saw the availability of  cheap finance as a way to promote a matter of public policy-making finance available to those who could not buy their own home. This led to “negligent behaviour of a generation of policymakers that sent a simple but radically distortive message to global markets. That message was that the US government  would guarantee the rights of Americans to own  homes and access credit far beyond their ability to afford  those goods in the free market. That a generation of obliging bankers and inadequately sceptical investors were complicit in this assault on market economics shouldn’t surprise anyone”. (Remember the Magnequench: An Object Lesson in Globalisation, by Charles W.Freeman , The Washington Quarterly, January 2009.) This led eventually to a significant increase in credit advanced to borrowers who could not access credit or could not access it at a reasonable rate, by a whole series of financial institutions, including  the well-known mortgage providers Freddie Mac and Fannie May.

Many countries in the world  copied US banking practices to one extent or another. The logic for this is unfortunately quite clear and very simple. Banks are intermediaries which take savings and risks and reallocate/ reapportion them to various customers to earn a profit. In addition because interest rates were kept low, most Western savers were essentially penalised and borrowing encouraged indirectly by each government who followed the low interest rate policy. It therefore makes sense for the individual in each case not to save-as you are effectively losing money at low interest rates-but instead to borrow to invest, frequently in property. In simple terms governments worldwide did not change this policy until  it was too late.

Each step after this is very simple and very logical. With very low interest rates, and inflation at low levels, but higher than those interest rates, providing effectively free money, leverage soars. It seems to make sense to everyone to borrow. Why save when you only lose on your money?

Taking the US as a good example of what then happened, debt in the financial sector overall increases, personal debt increases and with all the money available and incentives to buy, house prices start to rise. Many banks were not making money lending to their major corporate customers  because of the low cost of money, tight margins, greater competition in the financial sector etc. Many banks then set up investment divisions or began principal  trading or investing on their own  accounts frequently with significant borrowed funds. By 2007 it has been estimated that the principal trading accounts at Citigroup, JP Morgan Chase, Goldman Sachs, and Merrill Lynch had ballooned to $1.3 trillion. To use Irish senator Joe 0’ Toole’s famous expression about benchmarking in Ireland , the continued   increase in house prices converted their homes, in the mind of many homeowners ,  into ATMs. This had the direct effect  of increasing consumption, as homeowners thought the increase in the value their  homes was permanent and effectively they could spend that increase in value, or use it as equity for further borrowing. In the US , personal consumption rose  from its traditional 66% -67% of GDP to 72% by 2007, that latter figure being the highest on record.

The broader economic impact of this in the US was a current account deficit of almost $5 trillion in the years  2000 to 2007 inclusive. This deficit was,  in essence , almost all made up of payments for oil and consumer goods.

The US, and many worldwide, believed that  the  “global savings glut” or as it is strikingly sometimes put , a “wall of money” from Asia, pension fund and other investments, and  recycling of oil profits, would enable the US to effectively ” force ” the world to absorb US dollars for decades to come. Although an attractive idea,  the unexpected consequences soon hit . The first one was that yields began to reduce as cash was being invested in all kinds of assets and constantly seeking better returns. To keep generating good and increasing returns for the huge amount of savings floating around the world, leverage was continually increased in deals; hedge funds were set up with high debt and eventually taking quite high risks;  collateralised debt obligations (CDOs) were structured to turn low-quality mortgages into supposedly attractive investment vehicles;  insurance of the risk of default (frequently from  AIG America’s biggest insurer, now nationalised,) became commonplace ; and inappropriate rating from rating agencies converted high risk financial products (frequently subprime house mortgages) into nominally attractive investments that pension funds  (a huge part of the wall of money) could only  then invest in.

You now had the lethal  combination of a property bubble, a credit bubble, (in other words significant excess leverage or  debt ),  and a huge volume  of financial instruments that  no one really understood  and no one could value in a threatening environment or in any environment other than the perfect future assumed by many such instruments.

While all this was going on there were many other bubbles building up in many areas of the world and in many products, particularly  commodities, notably the price of oil.

When a bubble bursts there are always consequences. With so many bubbles bursting it was inevitable that we would end up with at least a Great Recession if not another Great Depression.

The key question is are we going to learn the required lessons from what happened or repeat the same mistakes? The answer unfortunately is anything but clear.

Looking at the underlying causes again  and the first side of the coin, the US has been forced (at least in the short term) into dealing with some of these imbalances. Decreased consumption (which mainly went into  imports), a declining dollar, and decreases in costs generally throughout the economy, are leading to an increase in exports by the US and a decrease in its current-account deficit. With its decreasing deficit  and with many badly burned individuals and corporations from their binge borrowing, the US is now saving at a great rate, to pay down its excess debt and to replace pension investments devastated by the recession.

A US think tank, the McKinsey Global Institute, estimates that the current crisis has destroyed a bigger proportion of household wealth in the US, in real terms, than was lost during the Great Depression. Contrary to what many governments and others expect, the US consumer (and many other consumers worldwide) , and many corporates, will  not return to their pre-recessionary pattern of consumption and investment until their excess debt is repaid down and the loss in their pension investments recovered.  This could take  five years or more . For this reason the Economist has recently  stated “crudely put , therefore, American spending is about US $760 billion short of the amount required to return the economy to full employment. Martin Feldstein of Harvard University, who makes a similar calculation, calls the shortfall  a  ‘black hole’. If no other source of spending takes over to fill the gap, then sales  will stagnate, employment will fail to recover and household incomes will falter.”[ A Special Report on the World Economy, The Economist, October 3, 2009.]

The US is therefore likely to be forced to deal with its trading side of the global imbalances, but at a lower level of trading, or economic activity if you will, than in pre-Great Recessionary  times, over the next few years.

However such an important change in the US does not necessarily mean that the dollar will lose its international reserve status. Many believe this must happen without considering in detail likely replacements. Analysing all the  possible replacements of the US dollar as a reserve currency to the world, it is clear that the euro, the Chinese renminbi, and IMF Special Drawing Rights, all of which are considered possible alternatives,  face significant hurdles to fully  replace the US dollar in the short to medium term. As one study has put it: “By process of elimination, it is clear that the dollar will remain the principal form of international reserves well into the future. It will not be as dominant as in the past, for the same reasons that the US will not be as dominant economically  as it once was. In the short run, the euro will gain market share, especially in and around Europe. In the longer run, the renminbi’s  role will  also grow, especially in Asia. But for as far as one can see clearly into the future, the dollar will remain first among equals.” The same study does not see IMF Special Drawing Rights (“SDRs”) completely  replacing any of these currencies anytime soon. Such an attempt in the past failed and  “the IMF would have to become more like a global central bank and an international lender of last resort. And this clearly is not going to happen overnight.”[ The Dollar Dilemma, The World’s Top Currency Faces Competition, by Barry Eichengreen, Foreign Affairs, September/October 2009.]

Longer  term the dollar will be slowly joined by other international currencies, and it is clear from history that reserve currency competition improves market discipline amongst the countries whose currencies are so used. Interestingly the positive benefits to the US, both economically and financially, of its role as an international currency being reduced are becoming obvious to some while others see such a development as a necessity. The reason for this is the likely  growing US budget deficit and the impact such would have in the medium to long term on its external current-account deficit, thereby undoing the positives I set out above.

The most recent projections by the Obama administration and by the Congressional Budget Office show  that  in the short run, as a result of the current crises, and  over the next decade or so, as baby boomers in the US age, itsbudget deficit will exceed all previous records by a huge amount. What many do not appreciate is that higher budget deficits , if not financed by domestic savings , generally increase domestic demand for imported goods and foreign capital and thus  generate larger current-account deficits. They also inevitably lead to the relevant country’s currency appreciating. Based on this understanding the Peterson Institute For International Economics project that “the international economic position of the United States is likely to deteriorate enormously as a result, with the current account deficit rising from a previous record of 6% of GDP to  15%  (more than $5 trillion annually) by 2030 and net debt climbing  from $3.5 trillion today to $50 trillion (the equivalent of 140% of GDP and more than 700% of exports) by 2030. The  United States would then be transferring a full 7%  ($2.5 trillion) of its entire  economic output to foreigners every year in order to service  its external debt “.[ The Dollar and the Deficits   How Washington Can Prevent the Next Crisis, by C. Fred Bergsten, Foreign Affairs, November/December 2009.]

The exchange-rate of the US dollar is a major factor in generating this unsustainable position. Bergsten explains why: “Moreover, the international role of the dollar makes it difficult, if not impossible, for the United States to keep its currency at the  exchange rate that would support prosperity and stability in the US economy. This is because the  exchange rate of the US dollar is, in large measure, the residual outcome of other countries using dollars to intervene in currency markets to meet their own exchange-rate targets: by weakening their own currencies to enhance trade competitiveness, they push the dollar towards overvaluation.” His solution is twofold. Firstly encourage international reserve currency widening over time, by getting the euro and the renminbi to join the US as international reserve currencies. Although this will not be easy it will eventually occur  through the natural evolution of both currencies and geopolitical developments particularly if the US was to actively push for such a development, clearly explaining why. Secondly the IMF should continue to increase its issuance of Special Drawing Rights (“SDRs”). Bergsten points out that the G20   created US $250 billion of SDR’s in April 2009 which were allocated by the IMF in August 2009. This took the  SDR share of global reserves  from the previo level of  under 1% to about 5%. Bergsten recommends a process of distributing SDRs annually, “perhaps totalling  $1 trillion over the next five years”.

A number of important positives would then arise, particularly from this second recommendation. Countries can then buy SDRs to build up their reserves without having to run large trade and current account surples, thereby reducing pressure on the global trading system and the  dollar. As we have seen above this is particularly important to many countries, especially in Asia. In addition if the IMF created a “substitution account“, national monetary authorities could exchange or substitute unwanted dollars and other unwanted currencies  in return for SDRs  without affecting global markets. As Bergsten puts it “This would both reduce the risk of future market disruptions and contribute to an increased role of SDRs  – an important step because any significant diversification of China’s, Japan’s, Middle Eastern countries, or Russia’s dollar holdings , or even rumours of such diversification, could adversely impact both  the US (by driving  down the dollar precipitately )and  the euro zone countries and other countries whose currencies were bought up ( by pushing their exchange rates up to uncompetitive levels).” There is no doubt that if achieved the combination of these two recommendations would lead to a more stable international economic and financial system and help deal with the imbalance I have analysed above.

There are of course political implications and the issue of how likely countries are to make these significant changes?

Losing its international reserve currency privilege would mean the US accepting a politically  less hegemonic role in the world . This makes sense as the level of hegemony and related power of the US was uniquely high at the beginning of the recent Bush administrations. The US and many other countries have since learned that even in those circumstances the US has a better chance of getting the policies it wants delivered through cooperation with others rather than confrontation , particularly in the economic and financial area, if it acts in a reasonable fashion. President Obama is,  I believe, attempting to usher in such an approach – probably the most important change facing him. In addition,  as Bergsten has put it: “the Obama administration has signalled its desire to move in this direction. It  has  called for a  US recovery that is  “export-driven rather than consumption- oriented.”  It has  rejected the restoration of the US role as “world consumer of last resort” and has counselled  other countries to pursue their  own recoveries by expanding domestic demand rather than relying on export -led growth.” Having “talked the talk” the US now needs to “walk the walk.” Simply put,  necessity may force it to do so.

However to match a  reduced US role, other countries have to “step up to the plate” otherwise a significant amount of “international public goods” risk being lost. Interestingly not too many other countries are rushing to replace the US! Why? Part of the reason, is that focusing more on international requirements than on national interests carries costs, and not too many countries are willing to bear such costs particularly in the current economic/political situation. As Bergsten has explained , “In the past half century, every other country whose currency has been a candidate for major global status  –  from Switzerland and West Germany in the early post-war period to Japan later in the 20th century and the members of the euro zone today – has overtly  rejected the opportunity or adopted a studiously neutral stance toward  it.”

The three countries who most need to match the US move on its global imbalances, the other side of the coin if you will, are the major countries running permanent current-account surpluses from their exporting activities. The principal countries are China, Japan, and to a much lesser extent, Germany, none of whom can be expected to “step up to the plate” in this area anytime soon unfortunately.

Firstly, with respect to China there are a number of reasons why it is in no rush to reduce its export dependence and turn its currency into a worldwide reserve currency. To operate a worldwide reserve currency you need significant market reforms and openness,  and you cannot hold on to the ability to directly manage the currency  exchange rate and banks lending decisions. All of these developments would impact significantly on the Chinese communist party’s ability to control its economy in such a way as to ensure its continued hold on power. It will therefore manage these reforms carefully. China has made clear that it does not expect its role in international financial markets to change dramatically until it has completed a lengthy process of financial reform and development, as part of the process of making Shanghai an international financial centre, which it hopes to complete by  the year 2020. This development should be strongly encouraged and supported by other members of the G20.

Switching its focus from exports markets (particularly to  the US)  to the home market requires increasing consumption and decreasing savings in China . Both are unlikely. A significant amount of personal savings occurs in China because of its citizens’ distrust of its future economic developments, inadequate social safety nets for a rapidly ageing population, and to provide for education. In addition a huge amount of savings in China are held by companies. Energy and capital costs to companies are  artificially subsidised – therefore both are overused. This results in the situation where in a supposedly communist country, capital, via profits,  is being much better remunerated than labour. And with an absence of proper corporate governance requirements, companies can continue to hold on to excess funds without coming under pressure to return them to their shareholders. Thus  the impact in China of subsidies to industry (many directly or indirectly state-controlled) and its form of economic planning and development to date has been to increase the share of national income going to capital (via profits), rather than labour, which of course also depresses  internal consumption. Until subsidies are overhauled and China changes the basic nature of its economic development, thereby increasing the share of national income going to workers, increasing consumption in China is very unlikely. Until these structural imbalances, deliberately designed to maximise exports (partially through an undervalued currency), maximise savings (which are inadequately remunerated through deliberate government policies ), and therefore effectively minimise consumption, are fundamentally changed, China will not be clearing its “global imbalances” or taking on a full  international reserve currency role .

In Japan, with a declining and rapidly ageing population , the removal of its “global imbalances” would require significant reforms  to boost domestic spending, especially on services, and reduce the high level of savings. Such reforms, which would also require letting the currency float to a more reasonable level,have been notably absent for the last decade or so, but may be attempted by the new government there. As this  would require massive and fundamental change in Japan. Its dependence on exporting and current-account surpluses is therefore unlikely to decrease significantly for some time .

The situation in Germany is somewhat different . Germany ran  small current-account deficits during most of the 1990s and swung into surplus only in 2002. It is economically part of the EU and uses the euro . Its role in creating “global imbalances” is unclear and contested. Its focus should be on boosting domestic spending, especially on services, and reducing  savings. Particularly if the world economy recovers as slowly as I believe it will, Germany’s reliance on the export market will of necessity have to reduce.

There is one other way that “global imbalances” could be eliminated. This is contained in an interesting study assessing China’s financial influence in view of its recent economic success. It says: “One aftermath of the Asian financial crisis was that the affected regimes  were determined never to have to go back to the International Monetary Fund hat  in hand. A significant reason for the amassing of hard currency reserves during the Breton Woods  11 era was to avoid this contingency. The tight coupling of the global economy caused export-dependent economies to face significant downturns because of the collapse in demand from OECD economies. These governments will likely respond to the current crises by creating the trade equivalent of currency reserves – a   protected space of demand for national champions.   The most direct way to do this will be to boost domestic consumption while restricting competition from foreign producers. This kind of decoupling would contribute to the unwinding of the macr economic imbalances caused by the Bretton Woods 11 arrangements. It would  also reduce whatever constraints economic  interdependence has placed an aggressive financial statecraft in world politics”. [ Bad Debts Assessing China’s Financial Influence in Great Power Politicsby Daniel W .Drezner, International Security, Fall 2009.]

Such a change is theoretically possible. However it would take significant time to build up national industrial champions and to switch the industrial focus from the export to the home market. There is no sign yet of such a major change in the exporting countries of Asia, or in Germany for that matter. Unfortunately therefore we face a future where the significant global imbalances that led to the current Great Recession are unlikely to be eliminated in the near term . To help do so, the dollar’s role as the international reserve currency has to be significantly reduced. In addition this would also require something like The International Monetary Clearing Union suggested by John Maynard Keynes in 1944, where countries would receive credits for balance of payments surpluses, which would be subject to confiscatory taxes if they got too big. The suggestion by the British Prime Minister, Gordon Brown, that we should design “trigger points” for action to tackle current-account surpluses and deficits may be a step in this direction. The IMF helping the leading industrial states undergo a form of financial/economic “peer review” is a first hesitant step on a difficult but  very important road.

The harsh reality therefore is that not alone will the underlying cause of the Great Recession, the “global imbalances “ not be eliminated in the medium term,  but the two key factors that led to it,”, bad banking and a variety of asset and other bubbles, still threaten the current very weak recovery.

The first, an effectively unregulated  banking system, has not yet been adequately and comprehensively reformed. Already one can see signs of the  excess compensation culture in the US beginning to reappear and  the focus on short-term gains is again  evident. The Obama administration released its  proposals on regulating the financial sector in a lengthy White Paper, issued on June 14 2009 . Surprisingly little attention was paid to this White Paper. A recent review of the history of the financial crisis and the Obama administration proposals, after noting that the finance, insurance and real estate industry spend $223 million on lobbying  in the US in the first half of 2009, had this to say:” On balance, the White Paper… was disappointing … What is clear, however, is that the Obama administration has lost leadership of the issue of reforming Wall Street.”

“In fact, much of Wall Street has already returned to the aggressive practices that were widespread before the crisis, including high levels of compensation and  the creation and trading of risky derivatives contracts. And  profits of financial firms, such as Goldman Sachs and JP Morgan Chase, often based on the same sorts of trading as in the past, are for the moment rebounding.”[ They Didn’t Regulate Enough and Still Don’t, by Jeff Madrick, The New York Review, November 5, 2009].

It does appear that the EU will address some of the key issues that led to the banking crisis we are currently enduring. However it is likely  that they will  not deal with all the relevant problems identified above.

In addition many banks, worldwide and not just in the US, remain fundamentally weak and with cultures that have not changed fundamentally or adjusted to the new way of business required in the post Great Recession era, if we are not to repeat the same mistakes and generate a similar if not much worse crisis.

Secondly, economist, Nouriel Roubini, who identified some of the key issues leading to the current  recession, is now concerned about emerging bubbles in many asset classes. Many regulators still do not accept that stopping bubbles is part of their job – they say it is very difficult to identify what is a bubble and also very unpopular to stop it at the wrong time in the wrong way.

In concluding  this part of the analysis  it is important to appreciate the very different impact of the banking crisis on countries worldwide . Because of its central role in the “global imbalances” and its highly aggressive and highly leveraged banking system, the US was always going to be badly hit. Many EU countries were similarly impacted upon because of unwise lending on property or to emerging markets. However a number of countries were impacted minimally by this international banking crisis. Canada, with a conservative well-regulated banking system, was barely touched. Australia was also not significantly impacted upon, while the overall banking system in Spain came out of the crisis quite well. Clearly in some countries, regulation, and perhaps the general culture of the country, inhibited serious banking crises. The Chinese banking system, which is not part of the international financial system as it is still under the direct control of the government there, was not significantly affected. It Is known to carry significant irrecoverable loans to state and other corporate entities in China, some of whom feel no great obligation to repay their debts. The Japanese banking system has  gone through significant trauma for the last decade and a half attempting to deal with significant irrecoverable loans which they were not prepared to take a write-off on. The current crisis therefore had minimal impact there.

Many countries worldwide have been economically and financially weakened by the fallout from the banking crisis generated by the “global imbalances” set out above. Some countries were further weakened  by the fallout from asset and other bubbles; by letting their cost base/competitiveness get out of hand; and by the resultant fiscal deficits from all these crises. I now briefly look at each of these crises in turn.

2. The Narrower Impact of Asset and Other Bubbles

What is clear is that while a small number of countries through regulation, historic experiences, and perhaps social and cultural preferences, avoided the current banking crisis, significantly more countries avoided  bubble problems, particularly  bubbles in the property market. This suggests  that the focus on why such bubbles occurred in a number of countries, including Ireland, must look to internal sources rather than blaming international villains. Certainly the availability of cheap finance and the  expectation of interest continuing at low levels (compared to historic norms) together with regulators not considering stopping asset bubbles as part of their job,  led quickly to serious problems when bank lending was also not controlled by the relevant regulators. In view of the fact that bubbles did not happen worldwide, even with a  broadly-based banking crisis, the focus needs to be on what went wrong in Ireland and what can be done to avoid a repetition. As human nature will not change , the focus must be on the objectives and role of regulation and proper banking reform.

3. Other Crises  –  Loss of Competitiveness

In a much smaller number of countries, on top of a banking crisis and a bubble crash, a third issue arose – a loss of competitiveness on export markets due to significant increases in the cost base of the country. Obviously any country suffering three  major crises at the one time will have significant difficulties –  much greater than other countries in the world that suffer from at  most one or two crises at this time.

Ireland is an example of a country suffering from three  crises at least. In  a process called “benchmarking” the wages, salaries and pensions of those working in the public sector were benchmarked (with upward  only adjustment allowed) against the private sector, without full allowance for the generous pensions available in the public sector and the guaranteed employment therein, and without benchmarking Irish costs against international norms  and in terms of output from the relevant activity . Funding the  resulting pay increases out of  short-term taxation receipts from property bubble assets,  meant a “hard fall” had to occur. It duly did. In the meantime Ireland’s cost base got seriously out of line with that of its major export competitors.  Increased pension costs in the public sector (as they are, apparently, fairly uniquely, tied to current salaries for the relevant grade not the salary level at the  date of retirement), leading to a significant increase in  the cost of all state services, including energy, putting additional pressure on private sector costs.The  outcome was  a significant increase in inflation in Ireland (compared to its export competitors) and the related significant increase in its cost base overall.

Credit Suisse in March 2009 ranked Ireland’s competitiveness in the  EMU as second worst after Slovakia. This is part illustrated by the sharp deterioration in Ireland’s current-account position from a surplus in 1998 to a significant deficit in 2008. Of the EMU countries, Ireland was seen as overall the second most vulnerable to significant financial difficulties (after Greece), principally because of the size of its budget deficit, the extent of foreign ownership of its assets, having the highest level of credit (corporate and private) relative to GDP, but mainly for having the most overvalued currency i.e. being the worst in terms of trade competitiveness. Allowing this  to occur was a significant failure. Allowing it to occur in an economy uniquely open and reliant on exports to generate its national income, was nothing short of a national calamity and a massive leadership failure . This is particularly the case when many commentators, economists, independent bodies, and newspapers repeatedly warned  of the dangers of the benchmarking approach.

In Ireland then one may legitimately attach  blame to  bankers and developers for the impact of the banking crises and the property bubble, partially  generated by the global imbalances analysed above. However responsibility for allowing Ireland’s cost base to become totally uncompetitive, and placing the public and private sectors in direct opposition because of the unfortunate impact of benchmarking (worsened by  reductions  in salaries, wages, and benefits in the private sector with the onset of the Great Recession ), lies directly  with Irish political leaders, the Department of Finance, senior civil servants, and the trade unions and employer representatives involved in the whole benchmarking/social partnership process. This is a responsibility that none of these individuals or organisations appears willing to accept, many of them deliberately diverting attention from their own role by blaming the usual suspects — bankers and developers.

There  is  a strong argument that the broader social partnership process (copied from the German industrial partnership process to help reduce industrial unrest) has had negative implications in Ireland. Initially introduced in Ireland to deal with a tiny minority of militant trade unionists working in the state-owned  monopoly electricity  supplier, the process was eventually widened to other state-owned companies, and eventually to a permanent structure where major economic, social, and political decisions were  made by the “social partners”, rather than the Dail, the Irish parliament. The result was a situation where elements of the public sector trade union movement acted as if they  formed  an alternative government , the vast majority of  elected politicians having no role to play in key legislation or in the major issues impacting on the country. All this meant  a public sector widely seen as requiring massive reform (a fact agreed by the relevant trade unions) and with wage, salary and pension costs significantly in excess of the private sector and of many international comparators, in a country facing at least three economic and financial crises from the simultaneous impact  of the banking crisis analysed above, the property crash , the benchmarking process here discussed , and the resultant massive fiscal deficit.

4.  The Resultant Fiscal Deficit

Each of the three crisis analysed above inevitably led to significant pressure on the public finances in the country involved. The withdrawal of credit, because of a banking crisis, inevitably leads to a reduction in consumption and investment by individuals and corporates. Fairly quickly this leads to a reduction in national income and an increase in national expenditure on unemployment and other social welfare measures. This can and usually does  lead to a significant fiscal deficit. This has happened in many countries worldwide. The impact of a bubble bursting is quite similar in terms of its impact on national income and expenditures. This happened in a number of countries worldwide. Ireland’s benchmarking process, which took “one off “receipts from the bubble years and used them to pay fixed long-term amounts in terms of wages –  and pensions based on the increased wages  also led to  an increased fiscal deficit. Ireland, fairly uniquely, therefore very quickly  amassed a significant budget deficit through having three crises occur at the one time.

5 . Conclusions

The world has faced crises of this nature before. However  the ongoing process of globalisation (in its economic, financial, and cultural impacts particularly) has inevitably much worsened, through instant communications, the impact and extent of the positive on the way up during the bubble years, and the inevitable downward correction during the “adjustment” years. It is therefore likely, other things being equal, that  booms and busts, without  significant reform, will be more violent than in the past. In view of the huge amounts of money spent by governments worldwide dealing with these crises, the absence of proper bank reform would be particularly devastating. Where would the funds come from to sort out another banking crisis?

The world faces financial, economic, and political uncertainties unlike those seen for some time, and they  are likely to be enduring  in the short to medium term. Economically, this means for  many countries a continuation of large deficits, heavy public debt, and stubbornly high unemployment. The unwillingness of governments worldwide  to put in train proper reform, which I fear may be the case, will be reflected in higher than necessary unemployment, with all its attendant social, economic, financial, and political implications. In that regard many bankers, policymakers, and economists have forgotten one of John Maynard Keynes’s  key insights –  the fact that “radical” or “irreducible” uncertainty is the root cause of economic instability. This uncertainty, cannot be eliminated by insurance (such as with the flawed US giant insurer AIG), fancy derivative work, or crafty securitisation, but will unfortunately be magnified and made more enduring by the understanding of many people worldwide that their governments  have not dealt with the real underlying issues  that led to the Great Recession (and all its related crises), and are afraid of, or very reluctant to,  face down interests, such as the finance industry, permanent current-account surplus countries, and in many cases, public sector trade unions, to effect  full and proper reform. In those circumstances, as happened in Japan, many will continue to save, focus on reducing their borrowings and building up their pension investments, in the expectation that their governments will not “look after them” or take proper action. This reduction in consumption and continuation of savings in the broadest sense makes sense individually, but in broader economic terms becomes a self-fulfilling negative prophecy of economic stagnation and social dislocation.

It does not have to be this way.

In the past significant crises and wars, have led to significant reform and subsequent sustained economic development. I strongly believe that most citizens in the Western  democracies would accept significant reform, once they understood the purpose and considered it broadly fair. I am saddened to hear repeatedly  the supposed attractions of non-democratic states such as China, and their ability to get things done. Confidence in democracy has been shaken as well as respect for the political class in many countries. This truly may be a once-in-a -generational  opportunity to bury the misgivings that threaten the freedoms we have begun to take for granted. Many countries in the world, and particularly Ireland, are I believe at a turning point today. We can continue to apply the failed policies of the past or agree significant, democratically-designed, reforms that make our country and world a better place to live in. The choice is ours.

But we also need to look at ourselves. Human nature does not change dramatically over time. There have been many bubbles, booms and busts in the past, and yet we do not learn. To some extent we blame others to avoid looking inside. Behavioural economists do not assume that the world is populated by “economic men and women” but by human beings who carry three very human traits, that explain clearly why we repeat these mistakes. Those three traits are  difficulty in dealing with complexity, limited self-control, and our willingness to allow our  intellect or reason to be overridden by the “herd instinct”. So while we may look to better and stronger regulation and wiser government action, human nature is likely to continue to be a problem in itself in dealing with these matters. As Johan Norberg a knowledgeable Swede  reminds us (coming from a country that went through some of these issues in the last decade),  politicians and bureaucrats are not immune from the “short -termism” that plagues private firms, nor I might add are we. [ Financial Fiasco: How America’s Infatuation with Home Ownership and Easy Money Created the Economic Crisis, by Johan Norberg, Cato Institute, 2009.]

6. Recommendations


A. In considering what action to take to deal with the various crises facing us, the fact that there are four or more very different crises in many countries should be borne in mind and the reasons for each  understood before remedial action is planned or undertaken.

B. The US and the other members of the G20 should make a concentrated effort to have the role of the US dollar reduced as an international currency by building up the role of the Euro, the  Chinese currency the renminbi, and IMF  SDRs over the medium term.

C. The role of the IMF needs to be developed as quickly as possible, following reform (which has now started) of the membership of the fund to reflect the changing importance of countries such as China, India and Brazil, to help address the global imbalances analysed here, particularly those created by states with significant permanent current-account surpluses or deficits.

Internationally/In Ireland

D. Proper bank reform and regulation, the nature and extent of which is well understood, should be put in place as soon as possible in the US and worldwide. As part of this it should be very clear that jail terms and significant financial penalties will be imposed where the new legally backed regulations are not complied with.

In Ireland

E. The first step in the necessary and agreed reform process in the public sector should be to remove the current guaranteed job for life of all public sector workers. Based on my direct experience, no reform in the public sector will succeed without this first key step.

F. As soon as possible a process of full benchmarking should be completed in Ireland for the public sector. This should put the appropriate value, based on international norms, on the reformed pension benefits of that sector and on  any remaining greater job security held by it compared to the private sector, on average. The benchmarking process should be against appropriate positions in the private sector in Ireland, in the private sector abroad (particularly in the countries which compete with Irish  exports), and crucially against  the public sector elsewhere in the EU and internationally. The latter comparisons should carefully consider both  the cost of the comparable positions and the output generated by them, compared to the position in Ireland.

G. Once that exercise is completed and implemented, all future wage and salary movements in the public sector should be tied in exactly to the movement in the average pay in the private sector. This will help eliminate the current conflict between both sectors, as in done in some Asian countries .

H. The entire social partnership process in Ireland should be fundamentally re-evaluated. Has it corrupted our political process? Is it worsening the normal problem of democracy – the power of vested interests? How do we re- empower our legislators and make them feel responsible for their actions? How can we help the taxpayer/citizen believe the system  is responsive to them?

See also:

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