Two Fatuous Policy Debates / Displacement Activity

Policy debates are occupying editorial columns in the US and Europe: it's displacement activity.

1. How fast should the US be recovering? Reinhart & Rogoff (slowly) vs Bordo & Haubrich (much quicker than this)
2. Egregious Institutions: The IMF's little 'Fiscal Multiplier Error'

How Fast Should the US Be Recovering?

So is the US recovery post financial crisis exceptionally slow or about normal? On an academic plane, this public debate pitches Reinhart and Rogoff (who's read of economic history suggests slow recovery is, roughly speaking, the norm), versus Bordo and Haubrich (who's read of economic history finds that US bouncebacks from financial crises usually feature periods of very rapid recovery). But this is a full-spectrum argument, being waged not just by rival academic papers, but subsequently by newspaper columnists, because, of course, the verdict bears directly on the Presidential election. If Reinhart and Rogoff's history is correct, President Obama need not apologize for the sluggish recovery. If Bordo and Haubrich are right, his policies are at best ineffective, and at worst they are retarding the recovery.

In the end, the argument comes down to which data-set one uses. But that in itself is interesting, because it reveals that the real argument is about what a financial crisis really is, and that in turn means you cannot escape talking about the structure and role of financial institutions.

And here, I believe, is the real problem. For it seems clear that what happened in 2008 was radically different from any financial crisis I've witnessed before. In fact, I believe that what happened this time wasn't so much a financial crisis as a crisis in financial institutions. Ultimately the systemic financial crisis had surprisingly little to do with saving and investment decisions made by the non-financial sector, but everything to do with the leverage within and between a relatively small number of financial institutions themselves.

The popular narrative of the crisis would have us believe that it was the weight of mortgage and credit card debt which triggered the crisis. Certainly they were the catalyst, but the seizing up of interbank and inter-financial institution credit in 2008 had relatively little to do with that. Rather, what did the damage it was the sudden fear of unfeasibly large contingent liabilities surfacing in the CDS market – which, not incidentally, were discovered to be effectively non-fungible. How much? By mid-2007, outstanding CDSs had a notional value of $62.17 trillion.

The world's financial institutions made the terrible and belated discovery that writing a new CDS to 'offset' an unwanted bilateral position was not the balance sheet equivalent as commercial banks' clearing each others' cheques at the end of the business day. That single simple-minded banking error potentially stood to bankrupt every major player in the CDS market, and an unknowable number of their clients. That was the deadly poison of the 2008/09 financial crisis.

As a result, the normal 'boom and bust' trajectory in the real economy should not be expected. The normal (Austrian-inflected) story of financial crises and business cycles has the following outlines:

1. Excessive leverage results in unwise investments:
2. As returns on those investments slow, so the cashflows to sustain new investment diminishes.
3. Consequently, credit availability dries up, mal-investment is discovered and eventually liquidated.
4. Cashflows are restored as savings are reallocated to more profitable opportunities.

For those of us who watched the 1997/98 Asian crises, this is a profoundly convincing narrative – indeed, with only small adjustments for individual countries, it has been demonstrably true.

But it's a template you'd struggle to fit over the data for this crisis. First, where's the systemic over-investment? By my calculations (based on depreciating all investment over a 10 year period), in 2007 US capital stock was growing at a paltry 5.3%, which is lower than the 7.9% in pre-recession 1999, say, or the 11.5% in pre-recession 1981. Indeed, growth in capital stock of just 5.3%, is 0.6SDs below the average of 6.7% sustained between 1980 and 2007. And yes, that data includes residential investment.

Secondly, so far as the non-financial sector is concerned, the rectification stage of the cycle has been rapidly achieved. My return on capital indicator bottomed out in 2Q99, recovered to 2007 levels by 2Q10, and by 2Q12 was the highest since 1999. And partly in consequence, a 2Q07 private sector savings deficit of 4.6% of GDP was turned into a savings surplus of 9.9% of GDP by 2Q09. And this was very visible: the corporate sector amassed cash, and the household sector fully paid off its 2Q07 $2.214tr net debt to credit markets by 1Q2011.

To summarize: the non-financial sector's initial 'credit-fuelled over-investment' was unspectacular in the run-up to the financial crisis, and its financial reaction to the crisis has been a) in form, as one would expect; b) rapid and c) huge.

If this crisis fit the (Austrian) description, the US would indeed be growing very vigorously by now on the back of rapid and extensive balance-sheet restoration. Soaring ROC would produce hearty investment-spending; banks awash with depositors cash would seek out new financing opportunities; newly-strengthened balance sheets would restore consumer confidence.

But this is not happening because that's not how this crisis was caused, nor how it erupted, and it is not how it will be conquered. I suggest that what we have seen, and are seeing, is less a financial crisis than a crisis in financial institutions. What does this crisis consist of? First, the realization that the institutions are profoundly undercapitalized for the business they wish to pursue. Second, the realization that since every financial institution in the developed world has the same problem, these are no longer national problems: Europe's financial/political crisis is – as well as everything else – a reflection of this. And third, behind all this lies the same unresolved structural crisis that has ultimately been the driver behind everything – the likelihood that the bond bull market which ran so profitably from 1982 to the present day (albeit only on QE life-support) is finished. After all, it was the desperate chase after yield in an otherwise fully-arbitraged bond world that bred the CDS market in the first place.

I could add to this list indefinitely were I to consider the still-unclear political fall-out from the mass failure of the western world's financial institutions.

But for now, the crucial thing to know is that when a financial institution lacks capital, it no longer has the ability to buy or create financial assets. What this means is that the private sector can restore its balance sheets as rapidly as it may – but the dollars it places in the financial institutions aren't going to come back out again in the form of loans or other financial assets. The dollars go there to die.

We can measure this by looking at monetary velocity, which is GDP/M2. Let's first have a look at what happened to Japanese monetary velocity before and after the Bubble burst in 1990.

There is a danger of this being a little abstract. The key point is this: Japanese banks' loan books peaked out in December 1993, at Y525.4 trillion. As of September 2012, they stood at Y397.7 trillion – down by a quarter. And deposits? Up by around 26% during the same period.

Now consider what's happening to monetary velocity in the rest of the world.

And the conclusion? That the US recovery is hobbled, and will be hobbled, by the problems inherited by a set of financial institutions which have failed, but still with us. The recovery will not be aided by financial institutions: it will have to carry them. A new set of institutions will emerge, or will have to be improvised.

This is not, incidentally, a condemnation of any particular set of named institutions, or a slur on the good people who work in them. Rather, the problem is the very form of our financial institutions – commercial banks are forms of commercial activity which were a sensible response to, say, 17^th century European experience. They are geniunely irrational and dangerous in the 21^st century.

I could go on, but the key text is by Jesus Huerta de Soto: “Money, Bank Credit, and Economic Cycles'. New forms of financial institutions are desperately needed, and will, I expect, emerge over the coming years. I would also recommend supplementing it by looking up the work on mutual fund banking by Randall Kroszner, who's been developing his ideas on this since his stint as an intern at John Greenwood's GT in Hong Kong in the late 1980s.  

IMF - Let's Pretend the Fiscal Multiplier is the Error

Meanwhile, Europe is being entertained by the IMF's discovery that it underestimated the fiscal multiplier effect of government spending cuts in Southern Europe, thus sending the wrong policy prescription, and miring Southern Europe in spiralling depression.

The core passage reads: “earlier analysis by the IMF staff suggests that, on average, fiscal multipliers were near 0.5 in advanced economies during the three decades leading up to 2009. If the multipliers underlying the growth forecasts were about 0.5, as this informal evidence suggests, our results indicate that multipliers have actually been in the 0.9 to 1.7 range since the Great Recession.  “

Where does one start? The IMF's mea culpa would be more impressive – no, let me rephrase that – would be less egregious if its implemented policy recommendations for Southern Europe hadn't inexplicably overlooked two much more important problems:

1. Ruling out devaluation out of the Euro (ie, lending its support and our money, to propping up the Euro project)
2. Failing to grasp the different dynamics underpinning the administrative capabilities and relationship between the public and the govenrment in Northern Europe to Southern Europe. (Measured and explained by the World Bank, and precised by me here.)

The IMF's re-working of its fiscal multipliers is no explanation and scant apology for these two obvious and fundamental howlers, but rather an attempt to disguise their disastrous consequences as a mere calculation error by their econometricians. Rather than a contribution to a policy debate, it looks to me like an attempt to dodge responsibility. To argue its merits is to grant the IMF's recommendations a degree of credibility which, frankly, they do not deserve.

Growth or austerity? 'OK, the patient is dead: now, what's the best way to encourage him to tap-dance?'

The second reason for not engaging in the 'policy debate' is this: all major central banks are now committed, one way or another, to 'quantitative easing'. Let's be clear what quantitative easing is: it is the policy of despair; by deliberately over-riding pricing as a mechanism for allocation savings, it is the subversion of economics. Why should one take seriously blitherings about fiscal policy when the real policy is simply to print more money and give it to the banking system to give to the government?