The 2008 Economic Crisis: Consequences And Fix (Guest Voice Part II)
This is the second of three special Guest Voice posts on the present Wall Street economic meltdown by Mikkel Fishman, a TMV reader and frequent writer in our comments section who is also an author and computer scientist.
The 2008 Economic Crisis: Consequences And Fix (Part I of III)
by Mikkel Fishman
In my previous post, I discussed what I believe is the root cause of this current mess on a very abstract and theoretical level that focused primarily on debt as it related to productivity. This post will focus more on the concrete reason, which is that there is too little money to support so much debt and then talk about the ways to try and fix this and the consequences of each. Sorry it’s really long but I hope it’s interesting.
All modern economies use fractional reserve banking. This means that banks keep only a small portion of their deposits and lend out the rest at a higher interest rate than they borrowed it for. The more dollars they loan out proportional to the amount of capital they keep on the books, the more “leveraged” they are said to be. The average US bank is leveraged 12-15x (this is the maximum allowed by regulatory agencies) which means that their loans are only backed by less than 10% of the money that they are obligated to pay on demand.
This has a very interesting side effect, and that is that banks create “money” out of nothing. This Wikipedia link (http://en.wikipedia.org/wiki/Fractional-reserve_banking#Money_creation) shows how $100 turns into $500 with 20% reserve, but like I mentioned, the actual reserves are closer to 8% or slightly below. This means that the vast bulk of “money” in the world is actually debt to banks.
I put “money” in quotes because for all intents and purposes, credit acts like money in the real world and economic modeling. The vast majority of the time people don’t care whether you pay them in cash or through debt (i.e. a credit card) so the total amount of debt available in the world affects inflation and return rates on investment. Even the Federal Reserve mentions, “Referred to as the fractional reserve system, it permits the banking system to “create” money.”
Debt isn’t money. Debt is debt. The Federal Reserve explanation should say “it permits the banking system to expand the monetary supply through issuance of debt,” but they want to act like it is as good as money. So the key question becomes: when is debt as good as money and when isn’t it?
Of course it’s as good as money when the debt is repaid, and if the debt isn’t repaid then it isn’t as good as money. Upon default, the monetary supply contracts and a corresponding amount of real money must be set aside to help maintain deposit requirements now that the income stream is gone. Banks are always worried about default, so they require collateral in most instances. If someone defaults and the collateral is worth as much as the loan then the bank doesn’t lose, and could even gain if the collateral is worth more.
Hence the trick to make sure that debt is as good as money is to keep asset values rising. Here is where I’m going to tie in back to my previous post. Asset values can rise very sharply in bubbles, but that rise will be backed by unsustainable debt if there isn’t a corresponding increase in productivity or the fruits of that increase aren’t distributed widely. This is precisely what we’ve seen and why asset values are falling sharply.
The irony is that asset value is used as collateral to pretend like debt is as good as money, but when it falls it is normally due to “downturns” (I’d say it’s actually reverting back to historical values) which increases the number of defaults. Moreover, the decrease in asset value makes people more likely to default as well. So our entire economic system is built on a wink and nod that it doesn’t make sense logically.
Of course most of the time the fluctuations are small enough that we can work through it and our favorite method is to issue even more debt, which exacerbates the problem later on. However we are in a “once in a century” event with asset values crashing that weren’t supposed to crash. Everyone knows the stock market can go down a lot, so they don’t let you have much leverage and it doesn’t have the same impact as housing which is leveraged to the hilt.
The very abrupt events we saw in the last week are due to everyone realizing that a vast amount of “money” in the world isn’t actually money and so people are scrambling to grab as much cash as they can. The slowness of banks to accept this has made the problem worse, as hundreds of billions of credit lines were tapped earlier this year by businesses and individuals and simply stored in CDs and money markets, which reduced bank options even further. This is why on the surface it looks like there are many liquidity problems and the government has been trying to treat it as such. However that is just a symptom of the underlying insolvency disease.
We must deleverage the system and there are really only two ways forward: prop up asset prices by increasing the monetary supply or deleverage the system by letting debt go bad. We’re hardly in a new position here as the same problem has plagued civilizations time immemorial.
Most people prefer that we figure out how to prop up asset prices. This is because when prices fall it creates a “deflationary spiral” which means that a drop in asset prices leads to more defaults, which leads to contraction which leads to less economic growth, which leads to more defaults…etc. In a deflationary spiral, millions of people will lose their jobs and net worth (especially because so many people have it stored in housing and the stock market) and see their wages decline. This is what happened in the Great Depression. The cycle only stops when the amount of leverage becomes sustainable in proportion to the amount of production, but this is hard to guess because production is falling in that environment as well. This is why Keynes suggested that at some point the government has to come in and start ramping up production itself. However his ideas have been twisted into thinking that the government should always stop contraction, when I would argue that it should only be considered when the amount of debt is far lower than the amount of dormant productivity, and issuing the debt will decrease the Debt to GDP ratio.
The deflationary spiral is what economists and politicians think we need to stop at all costs. The only way to prop up asset prices is to increase the money supply, either through direct printing or debt issuance. Direct printing should be out of the question, as there is only about $7 trillion of real money in the world and we’d need to print several trillion, the dollar would instantly collapse and everyone that had real money would see its worth drop immensely. This is why Zimbabwe and the Weimar Republic saw 100 million percent inflation. So we’re going for debt issuance.
Debt issuance can either be through banks through loans or the Federal Government through bonds. Until this point I’ve treated all debt the same, but now I am going to mention some differences. The banks can’t issue more debt because they have too many bad loans, so it’s up to the Federal Government to issue it through bond sales. We need several trillion dollars worth initially to try to prop up values, and the government doesn’t want to issue all that because we already have a $10 trillion debt (hey I guess deficits did matter!) and it’s unclear whether foreigner creditors will want much more. So they are trying to thread the needle and issue enough government debt that they can “buy” stuff from the banks and then the banks can lend more and increase the money supply further.
If it’s successful, then enough money will be in the system that asset prices will be saved.
Well what’s the problem? To understand the problem is the whole point of my first post. Productivity is the problem. If the monetary supply grows significantly faster than productivity (it must in order for this to work) then each unit of money becomes worth less, and so there is inflation. The only way to enjoy the low levels of inflation that we’ve seen the last couple decades would be to have massive productivity increases. If we could magically have all cheap renewable energy sources tomorrow then we would see enough productivity increase that we would be able to get away with increasing the monetary base, but I don’t think that’s likely.
In fact, we are going to see both absolute and relative price increases. Absolute inflation comes from there being more money in the world and each unit is worth less, and what I call relative price increases (although I’ve never seen this discussed explicitly so if anyone knows if it is actually called something else please tell me) comes from repricing goods and services based on their new relative value. For instance, let’s say that a house is worth $100 and a bunch of food is worth $10 and that is the historical average of 10:1. If there is a bubble and the house is deemed to be worth $300 while the food is still only worth $10 then the ratio is now 30:1. After the bubble pops, then the house would probably fall back to $100 (assuming there was no change in the monetary base). However, if the house is held at $300 by some means, then the food has to increase 300% as well to regain the historical relationship. This means that goods from bubbles that aren’t allowed to decrease will cause price increases in goods and services that weren’t in bubbles, regardless of the effects of inflation due to the monetary base.
Yes, a good deal of increase in oil, food and other basic necessities over the past year was probably due to the realization that they were undervalued compared to housing. In my prior post I mentioned that bubbles tended to form in things that are historically undervalued, so once asset values stopped rising in housing, the excess liquidity in the world got out of that bubble and formed a new one in gas and food. Commodities had fallen enormously in recent months because people recognized that we were entering a deflationary spiral, which would cause everything to fall in value, but since the proposal, they have spiked up again, with oil up 20% in less than a week.
The best case scenario if we inflate is that the price increases lead to commensurate increases in wages. The 70s was pretty close to this situation. This scenario would mean that people that worked would not see a huge decrease in standard of living and businesses could past on most of their increased costs. The people that would be hurt are those that have lots of savings or don’t work for whatever reason.
However, this is not very likely for a couple of reasons. First of all, it’s been determined that wage inflation is “bad” because it leads to price inflation. Over the last 30 years there has been a concerted effort to keep “wage pressures” down, and through outsourcing and other measures I don’t see this changing any time soon. Also, if you look back at the graph in my first post you’ll see that Debt to GDP actually didn’t change much during the 70s. This is because most of the price increases in the 70s were caused by external factors and productivity increases stayed high enough to offset the increase in the money supply. In fact, government debt as a percentage of GDP actually decreased throughout the decade.
Starting in the 80s, with a gigantic increase in government debt, and the last 20 years that has seen gigantic increases in debt by individuals and businesses, we have not been able to keep up productivity increases. This means that it is highly unlikely that wages will be able to keep up with price gains and everyone will have a significant decrease in standard of living.
In essence the proposed solution is going to be painful for all of us, and disproportionately on those that saved and were responsible (since the people with massive debt will most likely be able to pay it off and keep the fruits of their bad decisions).
Furthermore, these increases will make the problem much larger and at some point we are going to have to stop increasing debt faster than productivity is rising and hold it there for decades while productivity catches up. The best case scenario would see the next 20-40 years with much lower rates of real growth and many fewer opportunities for entrepreneurs and investors (you can forget about 10% annual gains in the stock market) which will completely destroy all government projections for Social Security, Medicare, etc. Taxes will have to be raised a ton and/or we’ll have to get rid of most government spending.
So what I believe is best is to do what is unthinkable: massive deflation. Basically I am saying that we need to let there be another Great Depression. I am aware this is going to be highly controversial for the three people that had the patience to read to this point but I think I can make my case.
I feel like I should mention that I’m pretty liberal in my sympathies, whereas most people that argue for this would lean more conservative (well libertarian mainly), but I’m convinced over the long run it is a better idea.
If there is massive deflation, the prices of everything will fall precipitously. Wages will fall faster than the price of goods (I’ve looked up the Great Depression and basic goods fell 50% while the average wage fell 70%) so there will still be a huge decrease in standard of living, however people with a lot of savings will see the value of their savings increase tremendously. When I say savings I mean actual cash savings as the stock market will crash, and house prices will drop a lot more (although even worst case scenario we’re probably more than half way through). People with a lot of debt will find it very difficult to pay back and it would be logical for them to default.
Even during the height of the Great Depression, 75% of people kept their jobs, and those that did had an OK time surviving and even started putting themselves in a position to see great increases in standard of living as they eschewed non-essentials and saved money. The real tragedy came from the other 25%.
I believe that much of the great suffering during the Great Depression came from a combination of government incompetence and freak natural occurrences like the Dust Bowl. We have the ability to create far more food than is needed to feed our populace (perhaps enough to feed most the world) and of course more houses than we know what to do with. For a much smaller cost than trying to inflate the problem away, the government could increase programs to distribute food to those that need it, and procure shelter (paying below historical norms) that could be rented to those that have jobs. It would really be inexcusable if many people would suffer on a fundamental level and we would need to maintain vigilance both towards the government and our own habits to ensure this doesn’t happen.
Once most of the bad debt was wiped out of the system, the government could then undertake massive public projects to fix our crumbling physical and digital infrastructure and develop alternative energy. These improvements would lay the groundwork for a revitalization of our national economy by enabling massive and sustainable productivity gains. It would lead to new industries and businesses that operate more efficiently (and hopefully morally and intelligently, haha) than the current climate.
The people that would be most affected over the long term are those that do not have time to share in the revitalization before they are out of the workforce. Anyone over 55 would probably be worse off if we went this route than the first – assuming the first was actually successful, which is debatable whether it would be. Many people’s plans for retirement would be completely destroyed, as most of their life’s assets would be gone. If we went down this path, it would fall onto the younger generation to make some sacrifices to support their elders, whom made very large sacrifices for the chance for future generations to have a higher standard of living.
However, as the United States is still a major power, and uh, I guess the fundamentals of our economy are strong in the way that McCain tried to reposition himself, there is a good chance that the rest of the world would start having their faith renewed in our country. This, combined with increased productivity, would decrease the amount of inflation and make our long term commitments to Social Security and Medicare be OK. As long as our government started being responsible once the next depression was over, and stopped with the hundreds of billions in farm subsidies, bridges to nowhere, wars, etc. there is a very real chance that our balance sheet would look better than it does now.
On the social level we would also see a renewed interest in self responsibility, sacrifice, and all the good old mythical values of the 50s (hopefully without the Red Scare), and get to complain extensively to future generations about how they have it so good. http://www.minyanville.com does an excellent job tying economic situations to social mood, so if you’re interested start reading them.
I hope that this will at least spur discussion. I should confess that I am 25, have no debt, a lot of cash and will have an easy time keeping my job…so my suggestion is pretty self serving. However, I feel confident that I can game the system no matter which direction we take and that will be the subject of my next post – what to do once a direction is decided. I truly feel that most people will be better off in twenty years if we get rid of excess.
On a final note, I have attempted to describe the realistic “best case” scenarios for each. If people are interested I can talk about what I think the worst case scenario is for each plan but they are pretty ugly so I’ll only do it if there is a request.