The global economy is in an economic depression. This post is a brief outline in bullet points of my macro view of that depression and the global financial crisis which caused it. I highlight causes, effects and predictions. My goal here is to help me crystallize what the real issues are and how they are likely to play out. I think framing the problem in macro terms could be a very useful exercise. Please chime in with your comments and criticisms.
In my view, the still ongoing financial crisis has five root causes:
- Excess credit growth and private indebtedness in advanced economies
- Combining of financial deregulation with desupervision (and decriminalisation)
- Tight coupling and undercapitalisation in the global economy and financial system
- Flawed institutional architecture for common currency in Europe
- Inevitable policy errors given the number of fault lines
- Allowing financial deregulation to be combined with desupervision led to financial fragility throughout advanced economies (See "Deregulation as crony capitalism from Aug 2009"). Low interest rates encouraged excess credit growth, creating an unsustainable credit bubble. When the subprime credit bubble in the US popped, excess leverage in the housing sector outside of subprime led to contagion and a full scale national housing downturn beginning in 2006. (See Ludwig von Mises on Austrian Business Cycle Theory for the negative effects of how low interest rates stimulate economic activity).
- Slowing US growth led to slowing global growth in 2007.
- Slower growth combined with excess credit growth and private indebtedness to create mortgage busts beginning in 2007 in countries like Latvia, Denmark, Spain, Britain, and Ireland in particular (see "Irish property dam about to burst" from June 2008).
- Tight coupling within the global financial system led to financial crisis in 2007 with large scale losses in mortgage-related derivatives markets (See Rick Bookstaber’s "Human Complexity and the Strategic Games of Uncertainty" from Mar 2011 for more on tight coupling).
- By the end of 2007, the housing downturn took down the US economy and the tightly coupled financial system began to unwind in 2008 via wholesale lending markets.
- The financial institutions which were most undercapitalised and most exposed to mortgage-related losses came under attack and failed.
- The US committed the inevitable policy error with Lehman by allowing it to fail without adequate preparation for the fallout.
- The financial institutions which were most undercapitalised and most exposed to contagion in tightly coupled system were bailed out in 2008 and 2009.
The policy response
- Large scale lender of last resort liquidity for financial institutions and fiscal stimulus in advanced economies and China in particular arrested the debt deflationary spiral in early to middle 2009. We are now in a technical recovery.
- Another inevitable policy error occurred as excess credit growth and private indebtedness in advanced economies, combining of financial deregulation with desupervision, tight coupling and undercapitalisation in the global financial system, and flawed institutional architecture for common currency in Europe were not addressed or were only partially addressed.
- The euro zone sovereign debt crisis began in late 2009 when investors realised that undercapitalised financial institutions combined with the flawed institutional architecture of the euro area to create unexpectedly high sovereign and bank default risk.
- The flawed institutional architecture of the European common currency, bank undercapitalisation and tight coupling between euro area countries meant that a crisis that began in Greece would quickly spread to the next weakest link in the euro area until sovereigns defaulted, the euro zone broke up, or the ECB provided an unlimited backstop starting in 2010.
- Due to political will to keep the euro intact, Greece was bailed out followed by contagion to Portugal and a bailout, followed by contagion to Ireland and a bailout accompanied by contagion to Spain and Italy and the LTRO backdoor partial ECB backstop in 2010 and 2011.
- Large-scale deficit spending was politically unacceptable outside of euro area and not feasible due to flawed institutional architecture for common currency in Europe. Leaders committed a policy error in Britain and in the euro zone of attempting simultaneous private and public sector deleveraging during a debt deflationary crisis without expecting renewed recession beginning in 2011 (see prediction from "The origins of the next crisis", April 2010).
- This was followed in 2012 by contagion to Spain because of the effect of the policy error of simultaneous private and public sector deleveraging and Spain’s undercapitalised banking system and to Italy because of tight coupling between Italy and Spain.
- Overall predicted outcome: Economic depression mitigated by correct policy responses or exacerbated only by a series of policy mistakes.
- The origins of and cure for leveraging cycles are contentious, making debt deflation via defaults, writedowns and depression more likely when private debt is high.
- Politicians avoid policies not geared to ideological biases of voting constituencies and pro-growth short/medium-term economic outcomes because of election cycles.
- Policy makers are loath to make very large changes in policy positions because it means losing face and being seen as inconsistent and unreliable.
- Euro zone political leaders are genuinely committed to the euro zone.
- The euro zone citizenry generally supports the euro and is afraid of the consequences of a euro breakup.
- Spain and Italy are too large economically and politically to default or be bailed out by any entity other than the a central bank creator of currency.
- Greece, Portugal and Ireland are small enough that euro zone leaders believe they can default and/or be bailed out without significant negative effects.
- Simultaneous deleveraging or cuts in consumption in private and public debt leads to a Fisher debt deflationary spiral when private debt is high.
- Government deficit spending is generally seen as irresponsible and unsustainable because of comparisons to household budget constraints.
- Euro zone policy leaders, afraid of contagion, will do whatever possible to keep the euro zone intact. But policy errors due to excessive adherence to previous policy positions will creep in. Result: Greece departure at a minimum.
- Deficit spending on a large scale will be politically unacceptable in the US, Canada and Australia until depression deepens there.
- The slowing economy will combine with continued simultaneous private and public sector deleveraging to cause a renewed global recession.
- Europe will suspend Maastricht 3/60 hurdles and allow ESM to be accessed by banks (See "[Premium] Euro zone policy may turn to relax 3/60 hurdle and to EuroTARP" from April 2012).
- The ECB will eventually offer more explicit backstops for Spain and Italy.
- The euro zone will eventually accede to Eurobonds.
- Corporatism. The nexus of government and business colluding to benefit private special interests is a big factor in the financial crisis in my view. It’s not clear where I can put this in terms of cause and effect. But when I spoke of "policy failure" in the policy response section, my assumption there was that corporatism was a major factor. Corporatism is also a factor in decriminalisation of control fraud in the financial sector. (See "Corporatism masquerading as Liberty")
- Labor wage arbitrage. A big factor in creating the preconditions for excess credit growth was the labor arbitrage available to global competitors due to the influx of workers from the former Soviet Bloc, China and India into the global economic system. This has depressed wages in the west and been kindling for debt as a substitute. Pro-reform free market ideology is used to promote this wage suppression and is closely linked to corporatism. (See "A populist interpretation of the latest Boom-Bust cycle", an early post here at Credit Writedowns from Mar 2008.)
I am going to leave it there for now as a first cut.
My contention here is that we are in the midst of an economic depression caused by the five antecedents I identified at the outset. This depression could be exacerbated by committing a series of back to back to back policy errors in quick succession in dealing with the depressions root causes as we saw during the Great Depression. However, even if leaders commit policy mistakes, the depression can be mitigated by attacking the crisis root causes with enough strength to overcome the loss of output from the inevitable contraction of credit.
This is my thesis. Although this pulls together a lot of the thinking from previous posts, I have put this together quickly enough that I might move a few points around and add points over the next hours as the framework solidifies. I will try to add links to posts I have written that cover these points in greater detail as well.
Which of these bullet points, if any, are the most controversial? Why? Do you have a different list of crisis root causes? Why? Would changing any of these lead to alternate potential outcomes? Am I too optimistic or too pessimistic? I look forward to incorporating your responses to this article.