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.