The Origins of the Next Crisis

William White, the former chief economist at the Bank of International Settlements (BIS) gave an important speech at George Soros’ Inaugural Institute of New Economic Thinking (INET) conference in Cambridge.  While everyone is casting about for the one magic bullet solution which would have prevented this and future crises, he placed the blame for the credit crisis on short-termism, pointing the finger most notably at economists and their models. White said that the models almost all economists use are ‘flow’ models which leave no room for ‘stocks’ and thus completely miss unsustainable secular trends.

In essence, White was saying: "it’s the debt, stupid."  When aggregate debt levels build up across business cycles, economists focused on managing within business cycles miss the key ingredient that leads to systemic crisis. It should be expected that politicians or private sector participants worried about the day-to-day exhibit short-termism. But White says it is particularly troubling that economists and their models exhibit the same tendency because it means there is no long-term oriented systemic counterweight guiding the economy.

This short-termism that White refers to is what I call the asset-based economic model. And, quite frankly, it works – especially when interest rates are declining as they have over the past quarter century. The problem, however, is that you reach a critical state when the accumulation of debt and the misallocation of resources is so large that the same old policies just don’t work anymore. And that’s when the next crisis occurs.

Let me take you through my thinking on this step by step. This is a pretty long post because I want to cover a lot of topics. But they should fit together from the economic models to the likely outcome.

The topics are:

  • The concentration of economic models on flow and the failure to model debt stocks
  • The empirical evidence that debt stocks have been increasing across a broad swathe of private sector dimensions
  • The doom loop of ever lower interest rates that allows debt stocks to increase
  • The effect that a secular decrease in interest rates has on an economy’s ability to increase debt loads
  • The evidence that monetary stimulus is no longer effective in allowing debt levels to increase
  • The likely outcome of a balance sheet recession and a secular decrease in debt

The concentration of economic models on flow

First, from a post called "Why economists failed to anticipate the financial crisis," I echoed White’s sentiments when reviewing a widely read piece by Paul Krugman on why economist’s failed to anticipate the crisis:

Paul Krugman is a Keynesian. So, his prescription is fiscal stimulus. Have the government pump money into the economy and it will alleviate some of the pressure for the private sector. There is some merit to this argument on stimulus. Many Freshwater economists say monetary stimulus is what is needed. If the Federal Reserve increases the supply of money, eventually the economy will respond. This is what Ben Bernanke was saying in his famous 2002 Helicopter speech at the National Economists Club.

Yet, I couldn’t help but notice that Krugman mentioned the word debt only twice in 6,000 words. In fact, it is in the very passage above where Krugman uses the term for the only time in the entire article. And here Krugman refers to government debt; no mention of private sector debt whatsoever.  I have a problem with that….

This economic Ponzi scheme is what I have labeled the asset-based economy. As with all things Ponzi, it must come to a spectacularly bad end. One can only Inflate asset prices to perpetuate a debt-fuelled consumption binge so far. At some point, the Ponzi scheme collapses. And we are nearing that point.  We still have zero rates, massive amounts of liquidity, manipulation of short-term rates, manipulation of long-term rates, and bailouts galore a full 15 months after Lehman Brothers collapsed. This is pure insanity.

The reason economists failed to anticipate the crisis is because they were fixated on avoiding downturns and driving the economy to unsustainable growth rates by using debt to consume today what will be earned in the future. Debt is the central problem. When debt to income or debt to GDP doubles, triples and quadruples, it says you have doubled, tripled and quadrupled the amount of future earnings you are consuming in the present (see the charts here and here). That necessarily means you will have less to spend in the future. It’s not rocket science.

Private sector debt stocks have been increasing

The second post of charts I referenced above (A brief look at the Asset-Based Economy at economic turns) gives you a visual of the massive leveraging in the U.S. economy we have witnessed over the past generation. The charts demonstrate that debt has been increasing on a secular basis across the entire private sector despite numerous downturns.

Debt levels at the end of Q2 2009 are 357% of GDP, a massive increase from the 160% that prevailed in 1982. The data clearly demonstrate that since 1982 the U.S. has relied on an increase in debt, even during recession, to avoid downturns…

debt-us-total

Government Debt

This chart is fairly benign when you look at aggregate levels as a percentage of GDP.  Pundits forecasting an imminent increase in U.S. interest rates because of too much government debt have obviously not looked at these data. However, what is striking is the huge and unprecedented surge in debt as a percentage of GDP since the latest downturn hit.  This discrepancy to nominal GDP cannot go on indefinitely…

debt-government-total

Household Debt

…the increase in debt levels in the household sector are pretty astonishing. In 1952, it began at 24% of GDP, rising to around 40% by 1960, where it remained through the Ford presidency. Afterwards, it shot up again to its present 97%, four times the level a half-century ago…

debt-household

Mortgage Debt

This pattern is largely the same as the previous one.

debt-mortgage

Consumer Credit Debt

Consumer Credit seems to be much more volatile than mortgage credit.  You can see the fluctuations in comparison to nominal GDP are greater.  And the absolute amounts are much less than in the mortgage market. The conclusion I draw from this is that,to the degree household debt levels have increased unsustainably, it is mortgage debt which is to blame.

debt-consumer-credit

Non-Financial Business Debt

There is a lot more volatility in capital spending as reflected in non-financial business debt levels as well.  Nevertheless, there has been a secular increase in debt levels of the business sector, from 30% in 1952 to the present 78%…

debt-business

State and Local Government Debt

Since the 1960s, state and local government debt levels have been basically flat as a percentage of GDP…

debt-government-state-and-local

Federal Government Debt

This chart looks basically the same with the total government debt charts as Federal Government debt dominates.  What you should notice is that debt levels are lower now than they were in the 1950s and have just passed the post 1950’s high-water mark in 1993 of 49%…

debt-government-federal

Financial Services Debt

…Not only do Financial Sector debt levels rise from negligible to percentages well over 100% of GDP, but the entire post-1982 period sees zero decline compared to nominal GDP until last quarter.

What conclusions can one draw here?

  1. The financial services sector is six times more important than in 1982 when its debt is measured as a percentage of GDP.
  2. The financial sector protected the American economy since 1982 by increasing its debt burden relative to nominal GDP even during recession.
  3. The financial services sector contracted in Q2 relative to GDP for the first time since 1982.  If this is a rear-view mirror view, that means recovery could continue. However, if this is a canary in the coalmine, that is negative for the U.S. economy. This number bears watching.

debt-financial-services

Foreign Debt

debt-foreign

 

The Doom Loop of ever lower rates and increased leverage

These are not just increases in relative debt loads. We are talking about debt increasing at a rate out of all proportion to the underlying rate of economic growth. This increase in relative debt burdens is quite unhealthy and has created an ever-lower interest rates to prevent economic calamity followed by an ever-increasing severity of financial crisis, the Doom Loop.

What is the doom loop?

It is the unstable, crash-prone boom-bust lifestyle we have now been living for some 40 years, where a cycle of cheap financing and lax regulation leads to excess risk and credit growth followed by huge losses and bailouts. With interest rates near zero everywhere, the doom loop seems to have hit a terminal state where debt deflation and depression are the only end game unless serious reform measures are taken.

doom-loop-2.jpg

Source: The doomsday cycle, Peter Boone and Simon Johnson

Because these measures themselves are deflationary and depressionary (with a small-d), in my view, they will not be taken.

Make Markets Be Markets: The Doom Loop

Low interest rates make a debt-servicing mentality seductive

Why has this debt build up has been allowed to continue? I owe these changes to the debt-servicing mentality enabled by a secular decline in interest rates.

The debt service mentality

During the boom and bubble which led up to the financial crisis, many in the financial community looked to debt service costs in the private sector as the only relevant metric to gauge whether debt levels were sustainable – both for individuals and in the aggregate. This was bubble mentality which I must take to task now now that we are seeing it crop up in discussions about public sector debts as well. If not, we will likely see some major sovereign bankruptcies in the not too distant future.

The debt service mentality goes a bit like this: Bob and Shirley are looking for a new house. They make $6,000 per month. So they can legitimately afford to pay $2,000 per month for their mortgage. With a 7% interest rate on a 30-year fixed mortgage, that means they can afford to borrow $300,000 – or just over four times income. So, if Bob and Shirley put 10% down on the purchase of a home, they can afford one that costs $330,000.

The problem is when this is the only constraint on borrowing.  What happens to house affordability when Bob and Shirley’s 30-year rate drops to 5%? Suddenly, they can ‘afford’ a $375,000 loan. What if they get a 4% rate? Now, they can afford $425,000 in debt – a loan  more than 40% larger than at 7% and a massive 5.9 times income. Anyone who has a mortgage recognizes this math as integral to the home buying process.

The lower interest rates go, the more affordable any debt load becomes when debt servicing costs are the only constraint. As rates drop toward zero percent, theoretically Bob and Shirley could afford to buy any house no matter how expensive.  But, of course, interest rates don’t move in one direction.  If rates were to move up significantly when Bob and Shirley wanted to move house, they would face a serious problem. In this sense, artificially low interest rates are toxic. And therefore pointing to debt servicing costs as the only metric of affordability and debt constraints is bubble finance plain and simple.

Here I am talking about bubble finance, not Ponzi finance. In the Ponzi finance schemes in the U.S., we saw fixed rates substituted with lower but unsustainable adjustable rates. Eventually affordability became passé as no-doc, zero-percent down, ninja loans became the norm. In the end, the Ponzi debt scheme collapsed in a heap – as it always must. That’s what we saw in the blow-off stage of the bubble after Greenspan lowered rates early this decade.  But, the debt servicing mentality is what preceded it.

On the sovereign debt crisis and the debt servicing cost mentality

Another economic boom?

So, you have economists using flow models that completely disregard debt. This gives intellectual cover to the asymmetric monetary policy of flooding the system with money every time the economy hits a rough patch. As a result, private sector agents increase debt levels dramatically across the board. All of this continues for a generation because of a secular decline in interest rates which allows the servicing of ever greater debt burdens.

And don’t think for a second, this can’t continue through another cycle.

This dynamic can continue for a very, very long time. In the United States, by virtue of America’s possession of the world’s reserve currency, an increase in aggregate debt levels has been successfully financed for well over twenty-five years. Mind you, there have been a number of landmines along the way. But, time and again, these pitfalls have been avoided through asymmetric monetary policy and counter-cyclical fiscal expansion.

So, poor quality growth can continue for very long indeed. And it is this fact which allows the narrative of easy money and overconsumption to gain sway.

The boy who cried wolf

A soothsayer who counsels against this type of economic policy, but who warns of impending collapse will surely be seen as the boy who cries wolf. Think back to 2001 or 2002. Did we not witness then the same spectacle whereby the bears and doomsdayers were let out of their holes to warn of impending doom from reckless economic policy? By 2004, unless these individuals changed their tune, they were long forgotten or even laughed at – only to resurface in 2007 and 2008 with their new tales of woe….

The fact is: low quality growth does not lead to immediate economic calamity. It can continue through many business cycles. Even today, it is wholly conceivable that we could experience a multi-year economic expansion on the back of renewed monetary and fiscal expansion.

printing money works.  It does goose the economy as intended and it can induce a cyclical recovery.

Nevertheless, the recovery is likely to be of poor quality due to significant malinvestment. Debt levels will rise and capital investment will be directed toward riskier enterprises. Look at what’s happening in China.  Are you telling me stimulus is not working? It most certainly is.

In the west, stimulus is also working. It is designed to stop people from hoarding cash and to consume. It is also designed to get people out of savings accounts and into riskier asset classes. it is doing just that.

The critical state

But, at some point, all of this must come to an end. In this cycle, we have already reached a critical state in which monetary policy is ineffective. As in Japan for the past decade or more, everywhere we hear that the demand for money has decreased with large business building up significant amounts of cash on balance sheets. Meanwhile small business is starved for capital.

A quote from Paul Samuelson’s 1948 textbook bears noting.

Today few economists regard Federal Reserve monetary policy as a panacea for controlling the business cycle. Purely monetary factors are considered to be as much symptoms as causes, albeit symptoms with aggravating effects that should not be completely neglected.

By increasing the volume of their government securities and loans and by lowering Member Bank legal reserve requirements, the Reserve Banks can encourage an increase in the supply of money and bank deposits. They can encourage but, without taking drastic action, they cannot compel. For in the middle of a deep depression just when we want Reserve policy to be most effective, the Member Banks are likely to be timid about buying new investments or making loans. If the Reserve authorities buy government bonds in the open market and thereby swell bank reserves, the banks will not put these funds to work but will simply hold reserves. Result: no 5 for 1, “no nothing,” simply a substitution on the bank’s balance sheet of idle cash for old government bonds.

Obama forgot Samuelson when he told fat cats to start lending

The reason this crisis is different is that we have reached the lower bound of monetary policy, zero rates.  We simply can’t lower rates anymore. In fact, because of the ineffectiveness of monetary policy, policy makers have taken to other unorthodox methods of policy to get credit growth back. None of this has yet had enough stimulative effect to increase credit. So, where are we headed?

Balance sheet recession

Recovery or not, weak consumer spending will last for years. I happen to think that we are in the midst of a weak cyclical upturn (predicated on the last shot of stimulus we could provide). But, once this particular cycle starts to fade, we are going to be in a different world, the world Japan is now in.

Listen to Richard Koo tell you about what we can anticipate going forward and why normal policy measures won’t work. He makes a very compelling argument.

 

Koo has suggested that Japan’s enormous public sector debt burden owes to the balance sheet recession Japan is suffering and sees a similar dynamic likely to hit the western world. This means the private sector is in a secular deleveraging trend. I outlined some of my thinking based on Koo’s model in the consumer spending post linked above. 

But, the flaw in Koo’s remedy is that it relies on fiscal stimulus, which has been used to maintain the status quo ante, resulting in a misallocation of resources and continued overcapacity and economic malaise (see Revisiting the sectoral balances model in Japan).

Moreover, I see the increase in public sector debt in a balance sheet recession as a socialization of losses.  If you look at any economy that has suffered steep declines in GDP, what we have seen are a reduction in tax revenue, an increase in government spending and bailouts. This is true in Ireland, the UK, and the U.S. in particular. In effect, what is occurring is a transfer of the risk borne by particular agents in the private sector onto the public writ-large.  The magnitude of this risk transfer via annual double digit increases in debt-to-GDP is breathtaking.

Finally, these debt levels are unsustainable for the world as a whole.  Japan has been able to run up public sector debt to 200% of GDP because it alone was in a balance sheet recession and its private sector was willing to fund this debt. But, things are vastly different now. Sovereign defaults are likely. The debt crisis in Greece is a preview of what is to come.  Those debtors which attempt to most increase the risk transfer onto the public will soon find debt revulsion a very real problem.  And what will invariably happen is that a systemic crisis will ensue. Fiscal stimulus is warranted, but deficit spending as far as the eye can see risks a catastrophic outcome. This is a very different world than we lived in during the asset based economy. But it also a different world than Japan has lived in over the last two decades.

There are four ways to reduce real debt burdens:

  1. by paying down debts via accumulated savings.
  2. by inflating away the value of money.
  3. by reneging in part or full on the promise to repay by defaulting
  4. by reneging in part on the promise to repay through debt forgiveness

Right now, everyone is fixated on the first path to reducing (both public and private sector) debt. I do not believe this private sector balance sheet recession can be successfully tackled via collective public sector deficit spending balanced by a private sector deleveraging. The sovereign debt crisis in Greece tells you that.  More likely, the western world’s collective public sectors will attempt to pull this off. But, at some point debt revulsion will force a public sector deleveraging as well.

And unfortunately, a collective debt reduction across a wide swathe of countries cannot occur indefinitely under smooth glide-path scenarios. This is an outcome which lowers incomes, which lowers GDP, which lowers the ability to repay. We will have a sovereign debt crisis. The weakest debtors will default and haircuts will be taken.  The question still up for debate is in regards to systemic risk, contagion, and  economic nationalism because when the first large sovereign default occurs, that’s when systemic risk will re-emerge globally.

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About Edward Harrison

I am a banking and finance specialist at the economic consultancy Global Macro Advisors. Previously, I worked at Deutsche Bank, Bain, the Corporate Executive Board and Yahoo. I have a BA in Economics from Dartmouth College and an MBA in Finance from Columbia University. As to ideology, I would call myself a libertarian realist - believer in the primacy of markets over a statist approach. However, I am no ideologue who believes that markets can solve all problems. Having lived in a lot of different places, I tend to take a global approach to economics and politics. I started my career as a diplomat in the foreign service and speak German, Dutch, Swedish, Spanish and French as well as English and can read a number of other European languages. I enjoy a good debate on these issues and I hope you enjoy my blogs. Please do sign up for the Email and RSS feeds on my blog pages. Cheers. Edward http://www.creditwritedowns.com

47 comments

      1. Skippy

        Naw…soft mostly white bankster backsides will one day experience the term *nailed it*

        —–

        Great post edgy lady, yep all looking for Crack III when they should be detoxifying on a 10 step plan.

        Skippy…hope the hot water was plentiful, scum can be hard to wash off.

    1. alex

      LeeAnne: “wake me up when these fellas start talking fraud”

      You want drama? Watch a movie.

      While I don’t doubt that extensive fraud occurred and should be vigorously prosecuted (see William K. Black), there are other issues. Ed Harrison is talking about how problems can occur even without fraud. In other words, the dull but all important issues of policy and macroeconomics.

      1. MyLessThanPrimeBeef

        Issues of policy and macroeconomics are indeed dull, but that’s not the problem.

        The problem is watching a fictional drama diverts attention from the real world human psychological elements of the crisis of money, or of the Federal Reserve notes which are backed not only by the full credit of the US government alone (the dull part), but also by the full faith of the US government – in other words, the psychological elements.

        And it’s hard to for people to have faith if we don’t talk fraud.

  1. Glenn Condell

    Yes, fraud (or greed) is the elephant in the room.

    ‘White said that the models almost all economists use are ‘flow’ models which leave no room for ’stocks’ and thus completely miss unsustainable secular trends… In essence, White was saying: “it’s the debt, stupid.”‘

    I don’t know how long White has held this view but Australian economist Steve Keen has been saying precisely this for most of this decade. From a perusal this afternoon of the speakers at INET White is not the only one who seems to be channelling Keen. Rigorously applying to economics the dynamic systems analysis central to the hard sciences is an idea whose time has come.

    It would be nice to think that prosecuting control fraud and market manipulation at the source is another, but I’m not going overboard here.

    1. alex

      Glenn Condell: “I don’t know how long White has held this view but Australian economist Steve Keen has been saying precisely this for most of this decade.”

      I also felt like I was reading Keen (that’s praise, not complaint). From the comments at Keen’s blog, specifically http://www.debtdeflation.com/blogs/2009/07/15/no-one-saw-this-coming-balderdash/

      patfla: I think William White, former chief economist for the BIS, deserves more than an honorable mention:
      http://www.spiegel.de/international/business/0,1518,635051,00.html

      Steve Keen: Absolutely! I mention Bill’s work at every opportunity, and I’ll bring it to Bezemer’s attention.

  2. Edward Harrison Post author

    I have been asking the same thing for months now (rhetorically of course):

    http://www.creditwritedowns.com/2009/03/where-are-the-perp-walks.html

    http://www.creditwritedowns.com/2010/03/fbi-warns-of-mortgage-fraud-epidemic-seeks-to-head-off-next-sl-crisis.html

    http://www.creditwritedowns.com/2010/03/chanos-where-are-the-perp-walks.html

    You know as well as I do that there aren’t going to be any perp walks. We have the heads of Citi and WaMu going down to DC for their ritual public flogging and then its back to business as usual. You can’t expect real change when the agents of change are the very same people who caused the crisis.

  3. edwardo

    This piece is impressive, but…

    “But White says it is particularly troubling that economists and their models exhibit the same tendency because it means there is no long-term oriented systemic counterweight guiding the economy.”

    The economists who hold sway in the public sphere are those whose models comport with the dominant mode of socio-economic organization in our society. In our case, it is The Mussolini Fascist business model, or if one prefers something a bit more crude, corporatism run amok.

    So, by all means, rake the chosen economists over the coals for their irresponsible and misbegotten contributions over these many years of building imbalances, distortions, and worse, but be mindful that the particular batch of misguided ivory tower myopics in question are the servants of pathologically motivated corporate miscreants and their bought and paid for handmaidens in government.

    1. Kevin de Bruxelles

      You make a very important point.

      I’m sure there are plenty of other economists with equally flawed models, but that fail in the other direction (transferring wealth downwards) but for some strange reason these people never got promoted up to positions where their failed models could be implemented.

  4. Bates

    Excellent post Mr Harrison…

    This: “Moreover, I see the increase in public sector debt in a balance sheet recession as a socialization of losses. If you look at any economy that has suffered steep declines in GDP, what we have seen are a reduction in tax revenue, an increase in government spending and bailouts. This is true in Ireland, the UK, and the U.S. in particular. In effect, what is occurring is a transfer of the risk borne by particular agents in the private sector onto the public writ-large. The magnitude of this risk transfer via annual double digit increases in debt-to-GDP is breathtaking.”

    And This: “And unfortunately, a collective debt reduction across a wide swathe of countries cannot occur indefinitely under smooth glide-path scenarios. This is an outcome which lowers incomes, which lowers GDP, which lowers the ability to repay. We will have a sovereign debt crisis. The weakest debtors will default and haircuts will be taken. The question still up for debate is in regards to systemic risk, contagion, and economic nationalism because when the first large sovereign default occurs, that’s when systemic risk will re-emerge globally.”

    All that central banks are accomplishing by private to public losses of large (and now semi) private FIRE sector businesses is eliminating moral hazard and encouraging more risk taking for those that have brought the world financial system to the verge of collapse. It is enlightening (in a frightening way) to see just how far CBs are going toward a total melt down of world finance to keep Wall St and the CBs from losing their grip on control of debt/credit. Von Mises must be amused, wherever he is. Observing this historic drama unfold is certainly more interesting and entertaining than any other bread and circus offered up for mass consumption, but I don’t think we will enjoy what emerges from the smoldering heap. Looking on the bright side, peak oil, along with peak everything else, may be put of for some considerable length of time!

  5. billwilson

    Amen!

    Of course the inability of our models to handle “stocks” vs. flows” also gives us environmental destruction and the ignoring of externalities. The argument of course is that stocks are too hard to value on a consistent basis, while flows are easy to value (we have transactions). But that is a pretty stupid argument – akin to accountants working on historical cost while inflation rages (you get pretty wonky – and wrong – results).

    My simple example is that if I drive to the grocery store that is better for the economy than if I walk. Clearly stupid, yet that is what our models spit out.

    Unfortunately “what gets measured, gets done” and if we want “GDP growth” we will do everything to get it, even if it is an ultimately flawed measure. The solution is to work for a better “goal”. Anything less is insane.

  6. fresno dan

    “Debt is the central problem. When debt to income or debt to GDP doubles, triples and quadruples, it says you have doubled, tripled and quadrupled the amount of future earnings you are consuming in the present (see the charts here and here). That necessarily means you will have less to spend in the future. It’s not rocket science.”

    Uh, well, thats perfect – can’t be said better.

  7. LeeAnne

    thank you edwardo

    that’s what I meant to say

    “The economists who hold sway in the public sphere are those whose models comport with the dominant mode of socio-economic organization in our society. In our case, it is The Mussolini Fascist business model, or if one prefers something a bit more crude, corporatism run amok.

    “So, by all means, rake the chosen economists over the coals for their irresponsible and misbegotten contributions over these many years of building imbalances, distortions, and worse, but be mindful that the particular batch of misguided ivory tower myopics in question are the servants of pathologically motivated corporate miscreants and their bought and paid for handmaidens in government.”‘

    And, I might add about ‘ivory tower myopics,’ taught same to young impressionable minds financed by ambitious parents stretched to the limit for tuition who just want the best for their children. ‘Just show me the grades, kid.’

  8. craazyman

    The true crisis is the perception of time as linear, with direction, a Cartesian vector, an arrow of thought, instead of cyclical and endlessly repeating, a circle, the cycle of nature.

    The former enables notions such as “the time value of money”, which produces excessive hoarding, nourishes an arid and shallow belligerence, distorts imagination away from productive craft and underlies all economics and finance.

    This is the underlying imbalance. And all other imbalances teeter on its shaky foundation.

    How were the danishes and coffee by the way? I bet they were top shelf. LOL

    1. AK

      craazyman says:
      >> The true crisis is the perception of time as linear, with direction, a Cartesian vector, an arrow of thought, instead of cyclical and endlessly repeating, a circle, the cycle of nature.

      You are a philosopher. :)

  9. Jamisia

    I (partially) beg to differ. You can’t compare Japan, the US & the UK to Greece. Japan, the US and the UK are sovereign in their currencies. Greece is not. Issuing dollar-denominated debt makes Greece (and Portugal) vulnerable to two currencies they do not control.
    Because Japan, US & UK are sovereign, they need neither taxes nor debt issuance to spend. What they do need is tax liability and something real ‘out there’ to purchase. In that case, a return to full employment would give the private sector move than enough room to pay off debts. (it would also produce some very welcome inflation)
    For the sovereign however, the issue is not paying off debt or default, but to stop issuing debt altogether! That entirely removes the problem of debt (that’s what it was all about, right? we weren’t talking printing money).

    It’s curious that Edward Harrison mentions Australian economist Steve Keen. What I’ve written is my understanding of another Australian economist: Bill Mitchell. That two of the most interesting economists come from Oz, must be something about the place ;)

    1. alex

      Don’t get carried away with the “the government can just print money” line. MMT (Modern Monetary Theory) doesn’t promise a free lunch anymore than traditional monetary theory does – ultimately you’re still inflation constrained.

      1. Jamisia

        Good point! Can I bring in Karl Denninger? Some time ago he wrote / calculated that, had the US not issued a total of some $4.5B (period: 1988 – 2009) but *printed* it instead, the inflation over the entire period would’ve been 2.8%. I’m simply buying KD’s argument here, so: yes, inflation is a constraint, but the point is a) how much inflation? and b) over /what/ period of time? 2.8% over 21 years doesn’t sound like much of a concern to me.

    2. Edward Harrison Post author

      When I talk of sovereign defaults, I am thinking first and foremost of the Eurozone and/or emerging markets that have significant foreign debt obligations.

      From a liquidity perspective, it is definitely a key difference between the Eurozone and the US and UK that the Greeks cannot print money. Greece is beholden to the ECB’s monetary policy on the one hand and is restricted in fiscal policy on the other. That means the deflationary route to longer-term solvency is the only one available to them.

      Given their huge debt load and their already high primary fiscal deficit, they will need to take Herculean efforts to avoid eventual default – aided, of course, by help from the EU and a benign economic environment. I am not optimistic.

      The US and the UK cannot voluntarily be rendered insolvent as their debts are essentially promises to be paid back with more promises (that is what a fiat currency is).

      http://www.creditwritedowns.com/2009/11/if-the-u-s-stopped-issuing-treasuries-would-it-go-broke.html

      The Euro experiment has not been successful. It can only be righted through some serious collaborative efforts. Otherwise, we are likely to see defaults.

  10. Robert Hammer

    Tomorrow at 11:00 AM the President of the Federal Reserve Bank of Richmond is speaking at West Virginia University and taking the students “tough” questions.

    I, as a student at WVU and religious reader of Naked Capitalism, would like to ask the Naked Capitalism community for a list of “tough” questions for Mr. Jeffery Lacker.

    I will be given the opportunity to ask any and all questions. What should I ask him?

    Any questions would be greatly appreciated.

    Thanks ahead of time. Let’s come up with some good stuff.

    1. scott

      Why did we have to bailout AIG but not the monolines insurers, they were both on the wrong side of the doomsday insurance trade?

  11. Edward Lowe

    Thanks for an interesting post, Edward. While you have done a nice job capturing the macroeconomic dynamics and reviewing these, once again, for our audience here. We still are not really allowing ourselves to grapple fully with the interests and corporate and national cultures that are rewarded in the asset-based phase. If short-termism, or completing “the deal,” is all that is rewarded in every financial transaction from shopping at the mall to sell houses, or to completing major financial derivative deals, no one is going to see the costs of the debt-stocks as they build and fester. Well, that is until they overwhelm everything. At that point, a new set of feed-back processes are inevitable: getting rid of the toxic backlog of crap! I don’t think policy makers, who were installed for their friendliness to those who make “the deal” (hello FIRE and Finance sectors) — can have any idea about what to do with the next cycle, i.e., getting rid of the piles of debt and other toxic crap (ahem, malinvestments) that have accumulated over the past 40 years. Indeed, I suppose that with this last hurrah of placating the deal makers, the deleveraging, cleansing cycle to come, will likely be delayed for an uncertain among of time. (though since the crisis is now global, not sure we can drag it out as long as Japan has).

  12. AK

    White vs. Krugman. Who has more prestige in my view? I bet Krugman.

    But would I put my life on Krugman’s teaching. You bet no.

    1. alex

      But why would you bet your life (or at least your prosperity) on Krugman? I admire his stuff too, but I won’t rely entirely on authority. The question is how do their arguments stack up?

      I think White, Harrison, Keen, et al have some good points. I’m still a big believer in Keynesian stimulus, ala Krugman, but it may not be sufficient. I’m actually more worried about private debt than public. All the focus is on the latter, but if everybody is in hock up to their eyeballs, who’s going to spend anything? Ultimately we may need some more private debt repudiation and/or forgiveness.

      Here’s a Keen post with good (scary) plots on the issue:

      http://www.debtdeflation.com/blogs/2010/03/01/debtwatch-no-43-declaring-victory-at-half-time/

      1. AK

        What I obviously meant that they are both wrong in my view but Krugman is less wrong since at least his ideas are more or less ‘scientific’ whereas White’s position is more or less ‘amateurish’ (IMHO of course).

        1. Travis

          That is awesome. The insider is the amateur and the outsider the scientist. So is White akin to an atom and Paul akin to an atomic microscope. Ooops, I forgot Paul does not do micro!

  13. QQQBall

    Great piece Mr. Harrison.

    I’d summarize as “First the Income Statement, then the Balance Sheet”.

    1. People and entities focused on ability to service debt vs ability to repay the loan. When the income stream is disrupted, debt not only cannot be serviced, it certainly cannot be repaid.

    2. Japan’s contraction was dulled by the global expansion. The next coming contraction, or present contraction, may well be a self-perpetuating global decline.

    3. One issue not really addressed is collective arrogance. People are acting like this is a “typical” recession, w/o considering that throwing more debt at already unservicable liabilities will not work.

    Thanks again Mr. Harrison.

  14. dearieme

    “It’s not rocker science”: you can say that again. Rocket scientists are well able to model both stocks and flows. So are Chemical Engineers, Civil Engineers, medical men… and pursuers of just about every numerate discipline bar Economics. Why should that be, I wonder?

  15. Elwood Anderson

    The source of the next crisis will probably be the same as the current crisis: too much capital and too few investment opportunities. Over the last several decades wealth and income has become concentrated in the capital sector while the consuming sector has required debt to sustain its consumption. When the world is awash in investment capital and investors can’t find productive places to invest, they drift toward riskier investments and look for ways to sustain their diminishing returns through the use of leverage and derivatives that expand the money supply and hide risk. This leads to bubbles of fictitious wealth of one kind or another as the price of assets are bid up artificially. These bubbles ultimately burst and the economy freezes up as investors and consumers lose trust in the system. I see no way to avoid such instability unless government is willing to step in and rebalance the wealth and income in the capital investment and consuming sectors through adjustments in the way these sectors are taxed. It doesn’t seem to make any sense to reduce taxes on capital gains when money is piling up in the capital sector, while the consuming sector is using debt to sustain its consumption. At such times it would seem more reasonable to increase capital gains taxes and reduce taxes on the middle class, which make up the largest portion of the consuming sector. Do current economic models account for this wealth distribution effect? The federal reserve is an institution of the capital sector and it has control of monetary policy. Does this lead to wealth and income accumulation in the capital sector at the expense of the consuming sector? GDP growth seems to be the main goal of this institution, while it is a poor measure of the well being of the greater society. It seems to me that government should have more control to prevent bubbles from developing.

  16. sunny129

    As long as EXTEND and PRETEND policy, in the so called ‘new’ normal goes unchallenged every day, in spite of disclosure of accounting scandals/frauds, one bigger than the other, there is NOTHING in horizon for optimism!

    Moral from bailing out Banksters:

    Crime does pay, in fact a lot and yes, you can get away with it!

  17. BJ

    Don’t worry – a new reality will be created any time now to resolve all the pertinent issues you bring up – here’s a quote from Soro’s book: The New Paradigm:

    I had not paid much attention to the postmodern point of view until recently. I did not study it, and I did not fully understand it, but I was willing to dismiss it out of hand because it seemed to conflict with the concept of reflexivity. I treated the postmodern view of the world as an overreaction to the Enlightenment’s excessive faith in reason, namely, the belief that reason is capable of fully comprehending reality. I did not see any direct connection between the postmodern idiom and totalitarian ideologies and closed societies, although I could see that, by being extremely permissive of different points of view, the postmodern position might encourage the rise of totalitarian ideologies. Recently, I changed my views. I now see a direct connection between the postmodern idiom and the Bush administration’s ideology. That insight came from an October 2004 article by Ron Suskind in the New York Times Magazine. This is what he wrote:

    “…In the summer of 2002…I had a meeting with a senior adviser to Bush. He expressed the White House’s displeasure (about a biography of Paul O’Neill, The Price of Loyalty by Ron Suskind), and then he told me something that at the time I didn’t fully comprehend – but which I now believe gets to the very heart of the Bush presidency.

    “The aid said that guys like me were “in what we call the reality-based community”: which he defined as people who “believe that solutions emerge from your judicious study of discernible reality.” I nodded and murmured something about enlightenment principles and empiricism. He cut me off. “That’s not the way the world really works anymore,” he continued. “We’re an empire now, and when we act, we create our own reality. And while you’re studying that reality – judiciously, as you will – we’ll act again, creating other new realities, which you can study too, and that’s how things will sort out. We’re history’s actors…and you, all of you, will be left to just study what we do.”

  18. ray l love

    I agree, an outstanding post and an outstanding conversation.

    The MMT position has however created some lingering confusion for me though. Specifically, Bill Mitchell’s views seem to find there way into threads as if he and his followers have broken the secret code. I went to ‘Billy Blog’ and asked some strait-forward questions but came away not quite sure what to think of it all?

    1. Skippy

      Saw you over there.

      I find bill a “good sort” as they say down here. Full employment is his forte/passion for all the right reasons in my mind, although when one seeks, one may zoom in too far, distorting the wider field, if not blinding ones self from it.

      http://www.billmitchell.org/sport/medal_tally_2008

      Skippy…no offence bill, may the workable middle_find us_some day.

  19. Kevin G

    Help me out here. Governments have all this debt. So do consumers. And companies. My first question is, who do they owe it to? And secondly, do they have any assets, and if so, how do those compare with the appropriately-concolidated net debt?

  20. ndk

    This is exactly right. I suggested in Feb ’09 the same phenomenon at play, and I believe our monetary policy “cures” to recessions are also the cause of the “doom loop”.

    Where I was completely wrong was in thinking that we couldn’t go through the wringer again. We apparently are beginning another cycle right now.

    I plan to sit this one out, because I have no idea when or where it will snap. It took about 5 or 6 years for the last one to snap. This one should be a little shorter — the periodicity seems to be decreasing — but I have no idea how soon.

    Please, please, PLEASE keep pushing this, Edward. I cannot imagine a single more important topic, because it implies that literally all our macroeconomic are all wrong. They lead to an accumulation of wealth in the hands of creditors, and now even the government itself is deeply in hock to them. To the extent money is a proxy for influence…

    1. Edward Harrison Post author

      ndk, I will definitely keep this theme going. I have a related post on Koo up at CW right now on balance sheet recessions and sovereign debt. Still thinking about what it means about the length of this cycle. I’ll probably get this on at NC tomorrow as Yves seems to be in continued light posting mode.

      Further up in the comments, BJ, that’s a great quote from Soros. I may have to use that.

      By the way, one reason I wonder if this cycle has legs has to do with strategic default. I will have a post up tomorrow at CW and maybe at NC about the anecdotal stories I am hearing about the connection between default and consumer spending. This could keep things going for a bit, especially if it leads to job and income growth.

      Cheers.

      1. ndk

        Thank you so much.

        I fear that the combination of no down payment/no payments for XYZ months, along with greater tolerance of defaults, really could launch us into another round. The implications of that could be all over the map depending on how things play out, but my best guess is sovereign default would be the defining event at the end of that era.

  21. Bernard

    Very interesting. Except when you say :
    “When debt to income or debt to GDP doubles, triples and quadruples, it says you have doubled, tripled and quadrupled the amount of future earnings you are consuming in the present (see the charts here and here)”.
    You cannot consume “futur earnings”, if you consider society as a whole.
    I would like an answer to KenG when he asks :”Governments have all this debt. So do consumers. And companies. My first question is, who do they owe it to?”
    Thank you

  22. eurostoxx

    great post! though I think somewhere in that analysis has to be a discussion of free-floating FX rates (or at least un attached to gold). They have allowed currencies and thus debt to become anchored to any ‘stock’ based analysis.

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