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Posted by on Sep 24, 2008 in Economy, Guest Contributor | 12 comments

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.

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Copyright 2008 The Moderate Voice
  • bacalove

    WALL STREET’s RECKONING!
    (Yet, it Took 10 Years to Raise MinWage $1.00)

    http://www.youtube.com/watch?v=S27yitK32ds

    “Rule one: Rush the decision. Time the game to fall in the week before Congress is set to adjourn and just 6 weeks before an historic election so your opponents will be preoccupied, pressured, distracted, and in a hurry.

    Rule two: Disarm the public through fear. Warn that the entire global financial system will collapse and the world will fall into another Great Depression. Control the media enough to ensure that the public will not notice this. Bailout will indebt them for generations, taking from them trillions of dollars they earned and deserve to keep.

    Rule three: Control the playing field and set the rules. Hide from the public and most of the Congress just who is arranging this deal. Communicate with the public through leaks to media insiders. Limit any open congressional hearings. Communicate with Congress via private teleconferencing calls. Heighten political anxiety by contacting each political party separately. Treat Members of Congress condescendingly, telling them that the matter is so complex that they must rely on those few insiders who really do know what’s going on!”

    (FYI: Republicans have blocked voting on bills by Dems for more oversight and regulation.)

  • CStanley

    Wow, just wow.

    My inclination is to ask: do you think there’s any possibility of a hybrid solution that partly boosts assets and partly cleans out the bad debt? I have no idea if that even makes sense, it’s just my natural tendency when two different approaches each have severe downsides, to consider whether a patched approach could get to the needed solution while softening the landing.

    • mikkel

      Sorry for not replying earlier, I was out camping.

      As DLS points out, deflation doesn’t have to be “massive” and points to Japan. This is what people are aiming for replicating here. Japan faced the same basic problem and managed to work it out over time instead of through massive debt destruction. It took them about 12 years to start growing again and the way they did it was to make very cheap money and “ignore” the problem.

      I would argue that we are unlikely to be able to emulate Japan for a number of reasons. First of all, the Japanese had very high savings rates and nest eggs. The average citizen had months if not years of cash stored up and the government had little debt. When people lost their jobs in the crisis they had quite a lot of time to look for new jobs and live off their savings, and the government had lots of leeway to manage the crisis.

      Obviously neither our citizenry nor government has this leeway. However this is what a “hybrid” solution would look like. The point of that would be to let the banks have debt destruction, but then the government would recapitalize them directly. (It costs a lot less to do this than to buy the assets in the first place, because of leverage. So for the government to buy assets at half value it’d still have to pay 5x more than letting all the debt be destroyed and recapitalizing the bank that had 10x leverage). Then also there would need to be greater governmental programs to make sure that individuals were given debt relief and money for expenditures so they would be able to spend money and continue to buy things at relatively high costs.

      Secondly and perhaps more importantly, the bulk of their decline happened while the United States and Europe were experiencing the largest boom in history, and later in the decade (after the Asian currency crisis) Russia, China, etc. joined in as well. Even though Japan was in bad shape domestically, they continued to do very well in exports and their imports were falling in price on a relative level as the 90s saw an unprecedented moderation of inflation, particularly in food prices.

      I think that the current problems are more likely to lead to worldwide recession and thus there would be little inflow of money to stem domestic inflation.

    • mikkel

      CS I just ran across a hybrid plan here that acknowledges the basic problems. You’ll see that implicitly it is calling for deflation by acknowledging that housing prices need to fall, and says that the government shouldn’t support current securities (which will cause a lot of lost capital and debt destruction) but also says that they should be capitalizing in parallel…even through the creation of new banks.

      I think that plan actually looks pretty good and would tentatively support it. Now I’m more pessimistic about whether it would “work.”

      On first glance it seems to actually confront reality and encourage the main goal — continuing lending — that the current treasury plan does not. However, it would only work if there would widespread socioeconomic changes because the current lifestyle that many people leave is unsustainable (indeed, paying off their prior one is) and this plan would not address that.

      Again, everyone points to Japan as a model, but their citizenry was economically cautious by nature and the malinvestments were much more well contained to a small group of people than our overleveraged society. If we adopted a hybrid plan like that one AND had leadership to create lasting changes with how people valued quality of life (including flight back to urban areas and other things to reduce transportation dramatically) then that might work until we could develop new efficiencies.

      I would argue that our underlying assumptions are misguided because they rely on continuing economic “growth” just to function properly. Under the Great Depression, GDP dropped by about 35%, which would take us to about $9.5 trillion, or the level of 1999. It’s kind of weird that this would be catastrophic even though I don’t remember 1999 being a vast wasteland. If you or anyone else is interested I could write a post about that sometime.

  • DLS

    Deflation wouldn’t necessarily be “massive” (even by media-hype standards), but more like what Japan faced — widespread malaise that would rival or surpass what we got to “enjoy” under Carter.

    Deflation associated with public gloominess will persist despite any federal make-work or “stimulus” spending or other programs, or other attemps to force the economy to revive. (Massively increasing the money supply of course makes no sense to do.) Again, see Japan.

    Social Security and Medicare will fail without intervention. Like it or not, that’s reality. Once these programs run deficits, more revenues must be found in order to continue to pay benefits in full. (Of course, benefits can be reduced and perhaps long-term growth can be curtailed, but the beneficiaries and the Democrats will howl.)

    The banks and investment firms and insurance companies? Let them fail; don’t give them money or loans. Same for the Detroit Big Three and other companies ready to clamor for “rescue” of themselves.

    Those at the leading edge (the head) of the Baby Boom cohort, who have benefited the most throughout the cohort’s existence, will continue to do better than the rest. Those at the trailing edge (the tail)) will once again suffer the most. All of our society and economy are likely to suffer in the next 20+ years with population aging, health care cost explosion and disability explosion, asset sell-offs that should dwarf today’s real-estate bubble popping (homes currently _still_ cost too much and _should_ get cheaper than they are now!), and all kinds of economic problems with consumer-producer imbalance and worker-dependent imbalance.

  • kluther

    Wow, this article exactly expresses what I have been thinking is the obvious problem and explains it well. Why is this not out there on the street? Why hasn’t the Obama campaign picked up on it? It is a great fit with his Infrastructure Investment strategy?

    Kathy

    • mikkel

      Kathy the problem is that it would be very hard to design a plan for “restarting” the economy. I kind of glossed over this because I didn’t want to about it for pages and pages but there is no set way of doing it and we’d be groping in the dark.

      It’s also very hard to sit back and watch tens of millions of people suffer. It’s easy to sit here and say what we “should” do from a logical standpoint, but I have a hard time seeing how elected representatives could sell it.

      Still it would be a great fit over all for Obama’s strategies, but I fear he is too much a captive of this moment in history to do much.

      It’s really easy to go down the other path that I think won’t work because it takes much smaller interventions at each step..the problem is that as each step doesn’t work and we take more steps we could find ourselves deep underground without realizing it. I fear Obama is apt to do this, especially since it plays into his natural optimism that smaller changes might be sufficient..

  • pacatrue

    I read the whole think, mikkel, and found it enlightening. I got lost at one point, perhaps due to the inflationary and deflationary options being offered. During the deflationary cycle, you mentioned that people with real money (the responsible folk) would do the best in this situation, because their real money would retain its value. Later, however, you seemed to be saying that people with large savings, particularly those close to retirement who won’t see the end of the Depression tunnel, would suffer the most. Can you straighten me out?

    • mikkel

      Pacatrue I just kind of assumed that most people would not have many real savings, as even more responsible folk have it tied up in assets, especially real estate. Yes, people with a lot in cash (or government bonds) would most likely make do relatively well, I meant that a large chunk of the boomer generation and their elders would not be around long enough for assets to start rising immensely on the other side of the tunnel…or at least not be in the work force to have to earn enough to acquire those assets.

      The people that could make it through deflation and still have lots of cash and buy lots of assets cheaply would see their fortunes rise immensely in 10 years.

  • mikkel

    For everyone:

    I mentioned that I didn’t want to paint a picture of what will happen if the bailout fails at this time, but this summarizes it completely.

  • CStanley

    Thanks, mikkel, those points make sense (especially regarding lifestyle.)

    On your last paragraph, I would think that it’s the precipitous drop that would be a problem, no? Much like tax policy, people talk about whether taxes should be at X level or Y, but really it’s the rate and direction of change that’s important (that’s McCain’s explanation, for example, for voting against the Bush tax cuts initially but later being in favor of extending them, because allowing them to expire is effectively a tax increase for some and he believes that doing so in a bad economy would make things worse.)

    Or another example would be gas prices- if we’d gradually gotten to $4 a gallon gas it wouldn’t have hurt nearlly as much as it has with the quick increase in price. Obama was right about that when he responded that way in an interview, though it was probably politically inept to say it out loud.

    And another point about going back to 1999 level GDP- we wouldn’t go back to the level of federal spending of that year, we’d have much higher expenditures (esp in the case of SS and Medicaid which are rising dramatically, even to the point that we’d be starting to have problems now even if the economic growth rate was good and we had positive GDP change.) That makes a huge difference, doesn’t it?

  • cwyatt

    When the first settlers landed in Jamestown, VA, and started the first American colony, the colonists did not have the same options for survival, as they did in their native homeland. Thus, the only way to survive & flourish was through ‘mutual guarantee’. Of course, as the years passed, and more people sailed for the new land, in hopes of “freedom”, the ego grew. All of a sudden, those original pioneers realized that all of their hard work for so many years now meant that they had to ‘guarantee’ success for even more, which led to the law in the New World of supply & demand, thus propagating our monetary system today. So, the current economic crisis is really not so current…just escalated and compounded! As long as we continue to live through egoistic intentions, the WIIFM (What’s in it for me?), we will continue to see this “trend” in every facet of life. There is a solution. To find out more: http://tinyurl.com/4o6gqd

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