Speech to the New Zealand Business Roundtable (Auckland), 8 September 2011
The last four years have been turbulent for the world economy. What started with a seemingly minor problem of securitisation of some American subprime mortgages in early 2007 soon reached bigger banks. In the, UK Northern Rock collapsed in 2007; then in 2008 US investment bank Lehman Brothers follow suit. Royal Bank of Scotland had to be saved by the British government; HBOS had to be merged with Lloyds TSB; in Germany HypoRealEstate was bailed out by the taxpayer for more than 100bn Euros. And these were, of course, only the biggest casualties of the financial crisis.
The crisis then spread to other sectors of the economy. The US car industry almost went under in 2008/09. General Motors went through an insolvency restructuring; world trade collapsed for a few months. Governments around the world frantically tried to stabilise their economies by stimulus spending, while central banks provided monetary stimulus like never before.
When it just looked as if we were going to see some green shoots of recovery, the crisis escalated to the next level. Now we were no longer talking about banks or car companies (or at least not predominantly anymore) but about whole countries becoming insolvent.
In the US and the UK, fiscal deficits reached staggering heights with borrowing above 10 percent of GDP. Greece admitted it had manipulated its debt statistics and had to be saved by other European countries after it had virtually been shut out of capital markets. But by then the crisis had already spread to Ireland and Portugal, and it looks as if Italy and Spain are next.
Meanwhile, America just narrowly avoided an immediate default, but just by lifting its debt ceiling to the unimaginable sum of $16 trillion. The Federal Reserve has already engaged in two rounds of money printing, now called ‘quantitative easing’. US interest rates are going to be zero for the next two years, which also means that real interest rates remain solidly negative.
On the other side of the Atlantic, the European Central Bank has in its panic started to purchase government bonds of besieged countries on the secondary market. Meanwhile, there are good reasons to believe that despite all of these efforts Europe’s common currency will collapse, which would also trigger a banking crisis of Europe’s woefully undercapitalised banks.
On the other hand, the US dollar does not look reassuring, either. And if you thought that China can continue to bail us all out, ask yourself whether high Chinese inflation is sustainable and what a worsening demography will mean for China’s long-term growth potential.
We are living in tough economic times. What I have just described sounds like the plot of a horror story, something like ‘A nightmare on Wall Street’. In fact, these were just a few of the highlights of an economic rollercoaster ride we have all been on for the past four years.
I sometimes think that the human mind is not capable of making sense of all of these events any more as they happen in a seemingly never-ending fashion. What has happened in the global economy in the short space of just four years has been extraordinary, and even that is an understatement. We have seen stock markets going up and down ten percent sometimes even within a single day. We have seen major shifts in exchange rates. We have seen household names disappear in banking and manufacturing.
With all of this economic chaos happening around us, it is little wonder that there is a sense of ‘crisis fatigue’ setting in. I don’t know about you but I have certainly had quite a few moments recently where I just wished to skip the business pages and go straight to the sports news; or rather watch the umpteenth repeat of old movies rather than news from the latest crisis summit of European leaders.
‘Crisis fatigue’ is one psychological consequence of the economic turmoil we’re in. But there is another problem. With all the simultaneous crisis events happening, it is difficult to really make sense of it all. There are too many trees and not enough wood, so to speak. What this means is that many commentators, analysts and economists are getting confused about the root causes of the economic difficulty we’re in.
This is the reason why we have now heard so many different explanations of the crisis. People have blamed it on deregulation, Neoliberalism, greed, privatisation, securitisation, ratings agencies, tripartite banking regulation, regulatory capture, non-recourse mortgages, trade imbalances, currency manipulations, short-selling, hedge funds, speculation, and financial derivatives. To my mind, the only thing the global economic crisis has not been blamed on yet are the Catholic Church and an attack from Mars. All other potential explanations of economic turmoil have been debated.
Of course, there are grains of truth in some of the allegations I just mentioned. However, I would argue that all of this chatter has really obscured the fact that in the end you can really reduce all crisis symptoms to two basic causes:
A monetary system that favours the creation of vast amounts of debt, both public and private.
Western governments regularly spending more than they earn, particularly on redistribution through the welfare state.
Perhaps these two root causes of the financial crisis are really just one single cause: The world has lost its anchor. Nothing could stop the creation of debt; nothing could stop the profligacy of governments. Because for a while, we have artificially severed the ties of our political, economic and monetary system to reality.
In basic economics, it is simple: You can only spend every dollar once. And you can only spend what you earn. The funds government wants to spend, government first needs to appropriate. For an economy to grow, entrepreneurs need to invest. In order to fund investment, you need savings. In a closed economy therefore the total sum of investment equals the total sum of savings. You can only ever save for tomorrow what you don’t consume today.
It sounds pretty straightforward and sensible. And it is.
Economics can be so simple, and in basic economics these axioms are absolutely correct. It is what we teach undergraduate students in Econ 101 classes.
What Western governments have done over the past decades, however, can be described as an attempt to suspend these iron laws of economics. They were trying to show us that you can spend a dollar several times through a fabled ‘multiplier effect’. That to fund government, you do not have to rely exclusively on taxpayers. You can always spend more than you earn either by borrowing or by printing money. Or you just engage in creative accounting like Greece.
Western governments and their economists in academia also told us that an economy can grow if governments only stimulate it enough. That in order to fund investment you don’t really need savings but just lower interest rates. And that therefore the total sum of investments can in principle exceed the real amount of savings. And that saving for tomorrow and consuming wealth today is not a contradiction in terms.
This strange kind of ‘Alice in Wonderland’ economics is what students of economics learn these days in their graduate courses. Of course, the issues are never really spelt out as clearly as I presented them to you just then. They are usually wrapped in dense economic jargon and rendered almost incomprehensible by complex mathematical equations. But if you unmask a lot of conventional, mainstream, Keynesian economics this is really what it boils down to.
The original sin in all of this has been the departure from commodity backed monetary system. For centuries, well actually for millennia, money was linked to something in the real world. Money had an anchor. This anchor could have been copper, diamonds, silver or gold. These goods became money because they were the most marketable goods. It was easy to exchange and trade them because they had an inherent value. And so they became money not because some king or emperor said so, but because the market came up with this solution.
For centuries, a system of gold and silver based currencies worked very well. There was low or non-existing inflation, limited government spending, healthy public finances and none of the boom-bust cycles we are experiencing today.
The big change occurred when governments all over the world saw the potential to take money as something they could manipulate. Instead of relying on gold, they simply printed paper notes and declared them to be money. In effect, they nationalized money.
It made it much easier for them to finance wars and welfare programmes because now they did not need to collect taxes to spend money. The effects of such policies would only be felt later, especially in the form of inflation, currency crises and economic cycles.
Very few economists actually criticised this new monetary order. I would say that is because most economists did not really understand the nature of money. They treated it as something neutral, as if it did not matter whether people agree to conduct their businesses with a stack of paper notes or a few gold coins.
Only very few economists actually saw through the destructive potential of paper money that could easily be printed. One of them was Friedrich August von Hayek. Hayek, who won the Nobel Prize in Economics in 1974, once wrote:
“The past instability of the market economy is the consequence of the exclusion of the most important regulator of the market mechanism, money, from itself being regulated by the market process.”
And he went on to warn:
“I still believe that, so long as the management of money is in the hands of government, the gold standard, with all its imperfections, is the only tolerably safe system, but it is better to take money completely out of the control of government.”
Hayek went even further:
“The only way to … save civilization will be to deprive governments of the power over the supply of money.”
Pretty stark words – “to save civilization”. And yet, when you are looking at the world today you won’t get the impression that Hayek exaggerated.
A few days ago we celebrated the 40th anniversary of the departure from the last remnants of the old gold standard. It happened in 1971 when US President Nixon unilaterally declared that the United States would no longer back the dollar with gold reserves. He did so because the link to gold inhibited the Americans’ ability to pay for the war in Vietnam. For the US government, getting rid of the gold standard provided them with the softer currency they wanted.
What we have seen in the forty years since is a complete transformation of the global financial system. We have seen the rise of big financial institutions which would not have been possible outside a paper-money system.
But we have also seen more frequent and more pronounced financial crises than in the past. We had the Mexican crisis in 1994, the Asian crisis in 1997, the Russian crisis in 1998, the Brazilian crisis in 1999, the end of the Dot-Com boom in 2001, the Argentine crisis in 2002, and then of course the Global Financial Crisis from 2007.
The response of central banks to these crises has always been the same: they were issuing even more money. They lowered interest rates, and now they are also engaging in ‘quantitative easing’.
Unfortunately, these medicines have severe side effects. They may work for some time, but they are creating further problems down the track. And in any case, they were treating the symptoms, not the cause.
To understand why cheap money does not solve any problems, let’s take a step back and ask yourself what really happens when the central bank responds to an economic slowdown with cheaper credit.
In a commodity backed monetary system, you can only invest resources that you have previously saved. This limits the total sum of an economy’s investment. It also acts as a rationing mechanism for investment. Only the best investments promising the best prospects and returns will be undertaken.
Once you go into a paper money world, however, no such checks and balances exist. Instead, you can now invest although no-one had previously put aside the capital for this investment. Nor does the investment need to promise good returns. It is sufficient if the returns are above the interest rates that are artificially kept low by the central bank.
In this way, the paper money system leads to widespread misallocations of capital and malinvestment. Back in 1940, the great Austrian economist Ludwig von Mises described what happens in such situations:
“The popularity of inflation and credit expansion, the ultimate source of the repeated attempts to render people prosperous by credit expansion, and thus the cause of the cyclical fluctuations of business, manifests itself clearly in the customary terminology. The boom is called good business, prosperity, and upswing. Its unavoidable aftermath, the readjustment of conditions to the real data of the market, is called crisis, slump, bad business, depression. People rebel against the insight that the disturbing element is to be seen in the malinvestment and the overconsumption of the boom period and that such an artificially induced boom is doomed. They are looking for the philosophers’ stone to make it last.”
Mises was convinced that you cannot make such artificial booms last. Here is another quote:
“Credit expansion cannot increase the supply of real goods. It merely brings about a rearrangement. It diverts capital investment away from the course prescribed by the state of economic wealth and market conditions. It causes production to pursue paths which it would not follow unless the economy were to acquire an increase in material goods. As a result, the upswing lacks a solid base. It is not real prosperity. It is illusory prosperity. It did not develop from an increase in economic wealth. Rather, it arose because the credit expansion created the illusion of such an increase. Sooner or later it must become apparent that this economic situation is built on sand.”
Now, Mises wrote all this decades before the current crisis, but his followers in the Austrian School of Economics had warned years before the Global Financial Crisis that we are heading for precisely such a Misesian scenario. I am afraid they were right.
So here we have the first basic cause of the current crisis: the world’s monetary system. As I said before, it is no longer a system linked to the real economy. It has become an entirely politicised system. Not even the pretence of central banks’ independence is kept these days. Who would seriously believe the Federal Reserve, the Bank of England or the European Central Bank to be independent in their policies?
We have seen it in recent years that they are all doing what their political masters want them to do, namely to prevent the clearing out of bad debt and capital misallocations by providing yet more liquidity. This can only end in tears.
It is quite surprising that the public is not even aware of what is happening in the monetary world. Maybe that is because the monetary system has a reputation of being difficult to understand. It shouldn’t be.
From experience we know that governments are bad at managing businesses. We know how poorly nationalised companies operate. We can still remember how the state-run economies of the Soviet bloc looked. There is really enough evidence to show that the state is a bad manager of economic affairs.
But if we all know this, almost instinctively, then why should we believe that the state is any better at managing our money? Why should the same government bureaucrats, who cannot provide us with decent telecommunication, airlines and rail services when they are state-owned, suddenly turn out to be enlightened bankers?
To ask the question is to answer it. It is folly to believe that government can be any better at managing our monetary affairs than they are anywhere else. It is therefore high time to remove monetary affairs from political influence and give it once again an anchor in some sort of commodity backing. I am not saying that this has to be another gold standard. It could just as well be a mixture of commodities. But we have seen the destructive potential of political fiddling with money – and this has to stop if we want to exit from this crisis and prevent future crises.
This brings me to the second basic cause of the economic crisis: the overspending of Western governments, particularly on the welfare state.
It is no longer a great secret that governments in the US, Europe and Japan have been spending more than the taxes they collected for decades. Incidentally, this massive overspending really began in earnest in the 1970s, so precisely after the end of the gold standard. This is no coincidence.
The massive expansion of state activity was only possible because it was debt financed. But debt financing probably could only happen within a paper money system. Central banks were providing liquidity at low interest rates, and commercial banks were using this liquidity to buy government bonds paying slightly higher yields.
For governments this was a very attractive way of financing themselves. They could provide all sorts of services, benefits and entitlements to their populations without having to ask them to pay for it directly.
If you want to see where such policies can lead to, just have a look at Greece. Greece has a ridiculously inflated public service, a crippled private economy, and a debt burden now exceeding 150 percent of its annual economic output.
The addiction to debt has destroyed Greece. But now it also threatening to destroy the banks that had lent to Greece. The same banks that had previously made enormous profits from financing government activities are now on the brink of collapse because this seeming perpetual motion machine is broken. It now turns out that eventually whatever a country spends will need to be paid for.
Again, this realisation should not be a big surprise. We all know from our personal financial affairs that you may well go into debt for some time but you will have to repay it eventually. With whole countries it’s not different at all.
It was Keynesian economics that pretended otherwise. Keynesian economists had claimed that governments can easily use debt financing to smooth over economic fluctuations, stimulate the economy when it’s needed, and keep the economy on track. Debt was never thought to be a problem because it was assumed that it would either be paid back during economic booms, or that economies would simply reduce their debt loads in relative terms by growing fast.
In practice, this never happened. Although Keynesian theory was about balancing the government’s books over the cycle, politicians never played by the rules of economic textbooks. Politicians always cherry-picked the bits of Keynesian economics that they liked. Debt financing was simply too attractive to them to refrain from it, even in economic booms. And as for the second alternative, growing out debt, from a certain level of total debt to GDP this is simply not possible.
Many Western governments now stand at debt levels of around or even above 100 percent of GDP. Even the Germans, who are still seen as the best debtor nation, have to pay around 2.5 percent interest on their borrowing. For countries like Italy it is now between 5 and 6 percent. But Italy is not growing anywhere near 5 or 6 percent. In fact, over the past decade Italy has barely grown at all. So in relative terms Italy’s debt burden is increasing further.
The fiscal adjustment now needed to bring debt back to a sustainable level are now so huge that it is doubtful that it can be achieved. This is certainly true for Japan with more than 200 percent debt to GDP. It is also true for many European countries; it is certainly the case for the US.
There can be no global economic recovery, at least no lasting one, if these debt problems are not solved. And by solved I do not mean the current policies we see. I don’t mean lifting the US debt ceiling without committing to large cuts and, yes, perhaps also tax increases. I don’t think putting a trans-European slush fund like the EFSF or later the ESM in place will cure Europe’s debt addiction. And I don’t think that Japan can bank on its high national savings rate, either.
Eventually, all these heavily indebted governments will need to reduce their spending substantially, which also means they will need to reduce their government activities. This would bring an end to personal and corporate welfare. It would require an end to subsidies to politicians’ pet projects such as renewable energies. The alternative is to keep muddling through the crisis but that won’t prevent the day of reckoning. It will come – and it will be all the more painful the longer you delay the required adjustments.
To get the global economy back on a stable path, the two basic causes of our current economic troubles need to be resolved. We need to return to a sound monetary order, and we need to reduce government debt and ban any future deficit funding of government activity.
New Zealand and Australia can do next to nothing to bring about this global change. Our role in this unfolding global disaster is a minor one. However, we can learn our lessons from this crisis. And we can draw our own conclusions.
First, we need to get our own government finances in order. This would also reduce our vulnerability to events in international capital markets. In order to achieve this we need to limit the size of the state and government spending. We should also ban any future debt financing of government activities. No more budget deficits – ever!
Second, we should consider strengthening our own monetary credibility. Either by underlining the independence of our central banks – which would for example mean that the Australian Treasury Secretary should no longer sit on the board of the Reserve Bank. Or we could even consider the option of moving the Australian and the New Zealand dollar back onto some new system of commodity backing.
There are good reasons to be very concerned about the future of the global economic and monetary order. In Australia and to a lesser degree in New Zealand we are probably in a somewhat better position than most other developed nations. We should use this opportunity to prepare ourselves for the next stages of the Global Financial Crisis.