Beyond the Age of Leverage: Alternative Cures for the Global Financial Crisis
It began as a sub-prime surprise, then became a credit crunch and is now a global financial crisis. At last week's World Economic Forum at Davos there was much retrospective finger-pointing--Russia and China blamed America, everyone blamed the bankers, the bankers blamed everyone--but little in the way of forward-looking ideas. From where I was sitting, the majority of attendees were still stuck in the Great Repression: deeply anxious, but fundamentally in denial about the nature and magnitude of the problem.
There were the people calling the bottom of the recession by the middle of this year. There were the people claiming India and China would be the engines of recovery. There were the people more worried about inflation than deflation. And, above all, there were the people trusting that Keynes would save us. I heard almost no criticism of the $819 billion stimulus package currently making its way through Congress (and mutating as it does so into something more like a pork barrel). The general assumption seemed to be that practically any kind of government expenditure would be beneficial, provided it was financed by a really big deficit.
There is something desperate about the way people on both sides of the Atlantic are clinging to their dog-eared copies of John Maynard Keynes's General Theory. Uneasily aware that their discipline almost entirely failed to anticipate the current crisis, economists seemed to be regressing to macroeconomic childhood, clutching the multiplier like an old teddy bear.
The harsh reality that is being repressed is this: the Western world is suffering a crisis of excessive indebtedness. Many governments are too highly leveraged, as are many corporations. More importantly, households are groaning under unprecedented debt burdens. Average household sector debt has reached 141 per cent of disposable income in the United States and 177 per cent in the United Kingdom. Worst of all are the banks. Some of the best-known names in American and European finance have balance sheets forty, sixty or even a hundred times the size of their capital. Average U.S. investment bank leverage was above 25 to 1 at the end of 2008. Eurozone bank leverage was more than 30 to 1. British bank balance sheets are equal to a staggering 440 per cent of gross domestic product
The delusion that a crisis of excess debt can be solved by creating more debt is at the heart of the Great Repression. Yet that is precisely what most governments currently propose to do.
The United States could end up running a deficit of more than 10 per cent of GDP this year (adding the cost of the stimulus package to the Congressional Budget's optimistic 8.3 per cent forecast). Nor is that all. Even before Barack Obama entered the White House, his predecessor's administration had already committed $7.8 trillion in the form of loans, investments and guarantees. Now the talk is of a new "Bad Bank" to buy the toxic assets from the banks which, despite the $700 billion Troubled Asset Relief Programme, are still in deep trouble. No one seems to have noticed that there is already a Bad Bank. It is called the Federal Reserve System, and its balance sheet has grown by 150 per cent--from just over $900 billion to more than $2 trillion--since this crisis began, partly as a result of purchases of undisclosed assets from banks.
Just how much more toxic waste is out there? Nouriel Roubini puts U.S. banks' projected losses at $1.8 trillion. Even if that estimate is 40 per cent too high, the banks' capital will still be wiped out. A Bad Bank could therefore represent another hole in U.S. public finances more than twice the size of the TARP. And all this is before any account is taken of the unfunded liabilities of the Medicare and Social Security systems, the net present value of which is estimated at around $60-70 trillion. With the economy contracting at a rate (excluding inventory accumulation) of minus 5 per cent, we are on the eve of a public debt explosion which the CBO's forecast--$4 trillion over the next ten years, but peaking at just 54 per cent of GDP--surely understates. The fact that so many other countries are adopting comparable measures means that a flood of new issuance is about to hit national and international bond markets.
The born-again Keynesians seem to have forgotten that their prescription stood the best chance of working in a more or less closed economy. But this is a globalized world, where uncoordinated profligacy by national governments is more likely to generate bond market and currency market volatility than a return to growth. After all, a rising proportion of U.S. public and private borrowing since 2000 has been financed from foreign sources, as a result of negligible domestic saving. The dramatic contraction of world trade means the end of the process of Asian and Middle Eastern reserve accumulation that previously funded American deficits. Already foreign investors are net sellers of long-term U.S. securities. Soon it is going to become painfully clear that new debt is not the solution, but could in fact make matters worse by driving up long-term rates, or pushing down the dollar to the point that Europe and Japan can justly accuse the Americans of "currency manipulation."
There is a better way to go, but is in the opposite direction. The aim must be not to increase debt, but to reduce it. In past debt crises--which usually affected emerging market sovereign debt--this tended to happen in one of two ways. If, say, Argentina had an excessively large domestic debt, denominated in Argentine currency, it could be inflated away. If it was an external debt, then the government simply defaulted on payments and forced the creditors to accept a rescheduling of debt and principal payments.
Today, Argentina is us. Former investment banks and German universal banks are Argentina. American households are Argentina. But it will not be so easy for us to inflate away our debts. The deflationary pressures unleashed by the financial crisis are too strong (consumer prices in the U.S. have now been falling for three consecutive months; the annualized rate of decline for the last quarter of 2008 was minus 12.7 per cent.)
Nor is default quite the same for banks and households as it is for governments. Bankruptcy can be a complicated business. Understandably, monetary authorities are anxious to avoid mass bankruptcies of banks and households, not least because of the knock-on effects on asset prices of distressed sales of assets.
The solution to the debt crisis is not more debt but less debt. Two things must happen. First, banks that are de facto insolvent need to be restructured--a word that is preferable to the old-fashioned "nationalization." Existing shareholders will have face that they have lost their money. Too bad; they should have kept a more vigilant eye on the people running their banks. Government will take control in return for a substantial recapitalization after losses have meaningfully been written down. Bondholders may have to accept either a debt-for-equity swap or a 20 per cent "haircut"--a disappointment, no doubt, but nothing compared with the losses suffered when Lehman Brothers went under.
There are precedents for such drastic action, notably the response to the Swedish banking crisis of the early 1990s. The critical point is to avoid the nightmare of a state-dominated financial sector. The last thing America needs is to have all its banks run like Amtrak or, worse, the Internal Revenue Service. State life-support for moribund dinosaur banks is an expedient designed to avert the disaster of a generalized banking extinction, not a belated victory for socialism in North America. It should not and must not impede the formation of new banks by the private sector. Financial history is, after all, an evolutionary process. When old banks die, new banks swiftly take their place. It is therefore vital that state control does not give the old banks an unfair advantage. So recapitalization must be a once-only event, with no enduring government guarantees or subsidies. And there should be a clear timetable for "re-privatization" within, say, ten years.
The second step we need to take is a generalized conversion of American mortgages to lower-interest rates and longer maturities. Currently around 2.3 million U.S. households face foreclosure. That number is certain to rise. For example, $97 billion of $200 billion of option adjustable-rate mortgages will reset in the next two years. The average monthly payment will increase by more than 60 per cent. As a result, up to 8 million households could be driven into foreclosure, driving down home prices even further. Few of those affected have any realistic prospect of refinancing at more affordable rates. So, once again, what is needed is state intervention.
The idea of modifying mortgages appalls legal purists as a violation of the sanctity of contract. But, as with the principle of eminent domain, there are times when the public interest requires us to honor the rule of law in the breach. Repeatedly in the course of the nineteenth century, governments changed the terms of bonds that they issued through a process known as "conversion." A bond with a five per cent coupon would simply be exchanged for one with a three per cent coupon, to take account of falling market rates and prices. Such procedures were seldom stigmatized as default. Today, in the same way, we need an orderly conversion of adjustable rate mortgages to take account of the fundamentally altered financial environment.
Another objection to such a procedure is that it would reward the imprudent. But moral hazard only really matters if bad behaviour is likely to be repeated. I do not foresee anyone asking for or being given an option adjustable-rate mortgage for many, many years. The issue, then, is simply one of fairness. One solution would be for the government-controlled mortgage lenders and guarantors, Fannie Mae and Freddie Mac, to offer all borrowers--including those on fixed rates--the same deal. Permanently lower monthly payments for a majority of U.S. households would almost certainly do more to stimulate consumer confidence than all the provisions of the stimulus package, including the tax cuts.
Ever since the New Deal, American politicians have proclaimed their faith in the "property-owning democracy" and the "American dream of home-ownership." For years they have actively encouraged the expansion of the sub-prime market. But the result has been an American nightmare. With housing prices still falling precipitously--the latest Case-Shiller index put the annual rate of decline at minus 18 per cent--there is an urgent need for action.
No doubt those who lose by such measures will not suffer in silence. But the benefits of macroeconomic stabilization will surely outweigh the costs to bank shareholders, bank bondholders and the owners of mortgage-backed securities.
Americans, Churchill once remarked, will always do the right thing--after they have exhausted all the other alternatives. But if we are still waiting for Keynes to save us when Davos comes around next year, it may well be too late. Only a Great Restructuring can end the Great Repression. It needs to happen soon.
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It makes no sense to say the whole world is too indebted. It's impossible. Every debt someone owes is also a debt that's owed to someone, equal and opposite. The total debt is always zero.
The US is too indebted to China (among others), but that just means that we will have to work more and/or consume less when the Chinese start taking payment instead of continuing to lend us more than the interest on what we already owe. It doesn't mean that no one can get a job because no one can afford to buy anything because no one can get a job because no one can ..., the way things are now.
It does make sense to say that the mechanisms by which we manage financial risk are absolutely FUBAR. We may have created a system of risk management so watertight that nothing could go wrong unless everything went wrong -- guaranteeing, of course, that everything would go wrong. The metaphor I like to use is the alliances before World War I.
It also makes sense to say that we have a vast amount of paper wealth that doesn't correspond to owning means of production, either directly or via intermediaries. Rather, we owe each other money: the gross amount of debt and the gross amount of assets are out of touch with reality, so we're vulnerable to relatively small discrepancies. But that doesn't mean we're insolvent overall.
This is a very important article. Thanks for writing it. Continue to address this to people.
Indebtedness is the problem. Time to press the reset button. The government and banks have failed us. Absolve all debt. Put everybody into the black. Pay back all debt up to $200,000. Above that pay back all debt at 50% of the dollar above 200,000 up to ten million. Above ten million, pay back all debt at 10% of the dollar up to a billion. Above a billion, pay back debt at 5%.
It's all in the derivatives, baby.
What's your evidence that government debt has anything to do with this crisis? Because as it is, you seem to conflate government and private debt as though the things were the same. As far as I can tell this crisis has been caused almost exclusively by problems of private debt (both bad debt and overleveraging that debt). Again, as I understand it, public (government) debt affects the rate of inflation; but that seems not to be a problem at all.
Inflation will be a problem if we can't keep our spending here using the things we mine, the things we drill, the wind that drives our windmills, the geothermal power that exists from Yellowstone-- the biggest active volcano in the world, the things we make, and the education of people who create the jobs we need. Spending needs to be designed in a way that keeps our money at home.
The world economy can just borrow from another rich planet looking for an investment.
LOL!
I agree with the first part , it is simply not possible for a govenment to print and spent a trillon dollars to motivate companies to start hiring more people or to start new companies. If it was we should spend 10 trillion. If our debt goes to high we will have to raise interest rates , the dollar will decrease, inflation will increase and we will be right back in a recession.
After all the political games and stimulus packages are passed the economy will only start to recover when the excess supply of housing has been reduced and the companies that have survived work off thier inventories.
Forcing lenders to reduce rates or principal will demotivate lenders and make loans harder to get and the recovery will take longer. Who would loan money if they though the government force you to take a loss.
In the long run its better to let the economic system work. We can't guarantee that everybody in this country will have their own house.
In the early eighties unemoyment was near 10% , there wasn't any stimulus package and we recovered and a long expansion started.
A mix of debt forgiveness and debt restructuring. I'm all for the idea. Then we can start the madness all over again!!!
Reminds me of a book titled: ALL I REALLY NEED TO KNOW I LEARNED IN KINDERGARTEN.
Can anyone say 'Do-Over'?
For my money, your whole article hits the sweet spot, Mr. Ferguson. It's one of very few such explanations - out of the many and varied descriptions, prescriptions, analyses, big picture and small - I've read that seems to cover all the bases, and propose a logical way forward OUT of the mess. And I gather that most of those who are (only or primarily) advocating massive amounts of new debt-financed government spending are basically HOPING that such spending is the right approach, with no definitive proof that it is.
The 'too much debt' diagnosis lines up with my own inexpert personal assessment of the economy's excesses, and your proposed solution(s) account for that and work quickly to ameliorate its toxicity. Yes, clearly we continue to benefit from historic lows in interest rates, when it comes to financing our ballooning federal deficits and debt. But what happens when that unsustainable scenario ceases, as you foreshadow? Hard times, indeed, for all those Washington politicians who want nothing more than to postpone the inevitable - and unavoidable - pain for another few months, or years.
May Chris Dodd, Barney Frank, Max Baucus, Kent Conrad and their Republican counterparts, et al, read your ideas, and take them to heart. At the very least, they should be holding hearings on your proposals, ASAP. After all, it stands to reason that if most of the world's economists failed to forecast this financial storm, most of the world's economists may now be prescribing the wrong medicine
This is a truly bizarre column. The first half is spent bashing Keynes with no apparent understanding of Keynesian economics. Ferguson declares debt to be bad, without addressing the basic notion that spending in conditions such as the present ones pays dividends well in excess of the debt undertaken. Next, he fails to acknowledge that there is a difference between an over-leveraged bank, and a government
Next come the proposed solutions, which call, very reasonably, for a restructuring of consumer debt and reorganization (nationalization) of banks. With not a word about the government spending that is the heart of the Keynesian approach! Perhaps Ferguson has not yet recovered from the rarefied air in Davos.
You have know idea what your saying!
As a member of the Federal Reseve, after reviewing all the evidence worldwide, about the current global economic catastrophe due to excessive indebtedness, and global insolvency, I've concluded that there are only two ways for governments, and central bankers to save the global economic system, and restore it to economic growth:
1. Forgive all debt of all kinds worldwide, and let everybody keep what they have free. That way everybody starts over, and the people owed money won't lose because they won't have to pay the people they owe--all the way up the debt chain. In addition, extract written affidavits from everybody in the world promising to never engage in that type of irresponsible financial behavior again. Banks worldwide could have "toxic mortgage" burning parties, freeing up capital to lend.
2. Relax counterfeiting laws and standards, so everybody can print money that could be accepted everywhere. Institute reasonable standards, so people can't just make money in any color they want, or on any kind of paper they want. The money would have to look real for it to have credibility. Allow merchants the discretion to reject any currency that they feel looks too ridiculous or absurd, forcing people to make money of a higher quality. It would drastically reduce the need for credit cards, and banks would be flush with deposits, from people depositing money they make.
This economic self-suffiency would free the Fed of the responsibility of printing money, and let them concentrate on monetary policy.
1. OK, as long as those of us who don't have much stuff because we DIDN'T spend ourselves into debt have a chance to catch up and stock the shelves, get big houses, new cars, etc. before we bail everybody out. Oh, and I want a degree from Harvard to replace my public university ones, too. So please pre-pay that for me, ok? Columbia and Stanford would be ok if Harvard is full.
2. LMAO
Back in the 1980's as the government began subsidizing corporate America to close our factories, break unions, etc., middle to lower-income class families saw a shift in how they earned income. Initially, there was tremendous financial opportunity as balance sheets and annual statements reflected a lower overhead, particularly payroll and cheaper goods and services: Consequently, profits were steadily rising. We "flipped" manufacturing jobs first, then "service industry and the base for our country became "credit" as an "industry.
Nearly twenty years ago, I sat in a luncheon with a corporate CFO and inquired what happens to those workers who build things in this country. He simply responded, "we'll retrain them." Opportunities have been missed to retool those now closed factories and jump on "smart energy or green" manufacturing. Schools were less funded. Credit was doled out like Christmas toys from an inexpensive department store and we are now surprised at this financial abyss?
Opportunity is here again with a Recovery or Stimulus plan geared to improving our future. The past is gone. Education, health care, science, research and development, re-tooling or building energy efficient factories for green energy, infrastructure, etc., at minimal are needed.
So to save the world from a massive avalanche of worthless debt, the solution is more debt.
SAVE THE TAXPAYER, SAVE THE WORLD!
Your idea for mortgage modification stinks. Why should people that rent subsidize homeowners?
There are many that saw the bubble in real estate and made the sound financial decision not to buy a house. We also have the poorest members of our society that cannot afford to buy but are forced to rent.
Your solution forces renters and the poor to pay for homeowners and send wealth upwards. Deflation is good for people that save and we should be rewarding savers. Falling housing prices and falling rents lower the cost of living and improve the quality of life.
The ones that are losing their houses can rent. If we do not bail out the housing market, the rental market should become less and less expensive for some time to come. We should not fight against this lower cost of living but embrace it.
The whole idea of bailing out the financially inept whether they are homebuyers or Wall Street bankers is wrong headed. That $525,000 three bedroom ranch style was never worth more than $205,000 and now that it is apparent to all propping up the value or bailing out the ones who thought they could get in and make a quick 100k is ludicrous. Bailing out the banksters is itself a criminal act.
As a person who turned down a mortgage offer believing the property was way beyond my financial reach, it is disturbing to now have to help subsidize others who did not act wisely.
Also, I know several realtors/investors who are sitting on multiple properties they purchased (million dollar homes) and in this upscale community where I live ... foreclosures are beginning to happen. As well our municipality is in the red because empty houses don't generate significant tax revenue as some of these investors are not able to pay real estate taxes on expensive properties; and there is little to no income generated with utilities, etc. It is not merely about "poor" people who purchase above their income ability.
This economic collapse was a product of the theory and a actions of men like Rubin, Summers and Geithner and don't forget the genious's of wall street like Greenspan or the anti- Regulation Republicans (and one very ant-regulation Democrat- Schumer). Now you think that this mess is going to be fixed by any of these people. This mess is going to last until 2015 - yes - six long and hard years- during which the rich will get richer - maybe in six years the middle class having saved and worked their way back will finally get some relief
I posted comments after Steve Bartin's "PUBLIC PENSION TROUBLES LOOM FOR STATE AND LOCAL GOVERNMENTS" at http://www
Government employees who have pension funds need to think like very smart investors. They need to be thinking of how to increase their dividends and capital gains over time.
The United States of America and many other countries should stop taxing interest from savings accounts, dividends, capital gains, and estates. They should be increasing sales taxes on wealthy people and others.
The United States of America and many other countries should legalize, regulate, and tax the sale of marijuana, heroin, and cocaine for people who are at least 18 years old. This may bring in a lot of revenues for a lot of governments and reduce the numbers of people in prisons.
I recommend people read
"Obama Has the Chance To Be Another FDR - He Can End the Era of Marijuana Prohibition" by Bob Fitrakis and Harvey Wasserman http://www
I ran for United States Senate in 2002.
Sincerely,
Ken Stremsky
I like what you have to say.
Read my comment reply to JeffBarea below
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