Predicting the future of policy making

Get ready because the second dip will occur. It will be nasty: unemployment will be higher and stocks will go lower than in 2009. I am convinced that it is politically unacceptable to have the government propping up the economy as [Richard] Koo suggests it should. The question now is one of timing: when will the government stop propping up the economy? The more robust the recovery, the quicker the prop ends and the sooner we get a second leg down.

So to recap:

  1. A depression was borne out of high levels of private sector debt, the unsustainability of which became apparent after a financial crisis.
  2. The effects of this depression have been lessened by economic stimulus and government support.
  3. Government intervention led to a reduction in asset price declines, which led to stock market increases, which led to asset price stabilization and more stock market increases and eventually to asset price increases. This has led to a false sense that green shoots are leading to a sustainable recovery.
  4. In reality, the problems of high debt levels in the private sector and an undercapitalized financial system are still lurking, waiting for the government to withdraw its economic support to become realized
  5. Because large scale government deficit spending is politically impossible, expect a second economic dip within three to four years at the latest.

Credit Writedowns, Oct 2009

I really don’t like being a doomsayer but I think this train of events accurately describes what has happened in the two years since I wrote these paragraphs. Predicting the future of policy making has been and will continue to be key to understanding where this economy is headed – and by extension what your investment portfolio will do.

The last 2 1/2 years have been a stimulus-induced interregnum in a global depression the likes of which we have not witnessed in three-quarters of a century. Policy makers went at it guns blazing after Lehman’s collapse. The result: in April 2009, we got “The Fake Recovery”. As I wrote then, “you should be under no illusion that the coming rebound is permanent. Much of it is not. What we are seeing is the makings of a cyclical recovery”.

So, the governments went in guns blazing. Great. Nonetheless, the scale of the overextended credit was massive; it was just too much to bear and eventually, bailout and deficit fatigue took over. You have to see a lot more writedowns and debt forgiveness before this plays out. Moreover the leveraging up of public balance sheets meant politically that the origins of this next crisis were always going to be a result of deflationary economic policy.

everyone is fixated on [paying down public and private sector debts via accumulated savings]. I do not believe this private sector balance sheet recession can be successfully tackled via collective public sector deficit spending balanced by a private sector deleveraging. The sovereign debt crisis in Greece tells you that.  More likely, the western world’s collective public sectors will attempt to pull this off. But, at some point debt revulsion will force a public sector deleveraging as well.

And unfortunately, a collective debt reduction across a wide swathe of countries cannot occur indefinitely under smooth glide-path scenarios. This is an outcome which lowers incomes, which lowers GDP, which lowers the ability to repay. We will have a sovereign debt crisis. The weakest debtors will default and haircuts will be taken.  The question still up for debate is regarding systemic risk, contagion, and  economic nationalism because when the first large sovereign default occurs, that’s when systemic risk will re-emerge globally.

That’s where we are now. So, by October 2011, I was telling you that “with the stimulative measures that supported recovery over, the end of the fake recovery is at hand.” That’s what austerity means.

Here’s Keynesian scholar Robert Skidelsky very much on point on this today. He calls the policy response “The Wages of Economic Ignorance”:

When we ask politicians to explain these deplorable results, they reply in unison: “It’s not our fault.” Recovery, goes the refrain, has been “derailed” by the eurozone crisis. But this is to turn the matter on its head. The eurozone crisis did not derail recovery; it is the result of a lack of recovery. It is the natural, predictable, and (by many) predicted result of the main European countries’ deliberate policy of repressing aggregate demand.

That policy was destined to produce a financial crisis, because it was bound to leave governments and banks with depleted assets and larger debts. Despite austerity, the forecast of this year’s UK structural deficit has increased from 6.5% to 8% – requiring an extra £22 billion ($34.6 billion) in cuts a year. Prime Minister David Cameron and Chancellor George Osborne blame the eurozone crisis; in fact, their own economic illiteracy is to blame.

Unfortunately for all of us, the explanation bears repeating nowadays. Depressions, recessions, contractions – call them what you will – occur because the private-sector spends less than it did previously. This means that its income falls, because spending by one firm or household is income for another.

In this situation, government deficits rise naturally, as tax revenues decline and spending on unemployment insurance and other benefits rises. These “automatic stabilizers” plug part of the private-sector spending gap.

But if the government starts reducing its own deficit before private-sector spending recovers, the net result will be a further decline in total spending, and hence in total income, causing the government’s deficit to widen, rather than narrow. True, if governments stop spending altogether, deficits will eventually fall to zero. People will starve to death in the interim, but the budget will be balanced.

That is the crazy logic of current economic policy in much of Europe (and elsewhere).

Got it? Let me translate that into the way I write. Lord Skidelsky is saying that any fool could see that the private sector was getting killed by a retrenchment of consumers and businesses. Without the government filling in the gap via “automatic stabilizers”, we would already have been in depression globally as they are in Greece, Spain and Ireland. Now, the economic ignorance of our policy making elite is telling us to fight private sector retrenchment with public sector retrenchment as if that will make things better. No it will make things worse, considerably so. But, hey, that’s what people are saying we should do.

The question is why are they saying this? I think economic ignorance is probably right here. But, there is also a sense among many that even if this policy leads to depression, it is better to take the bitter pill now than throwing money at the problem and making the credit bubble worse down the line. I have a lot of sympathy for that line of thinking. This site is named Credit Writedowns for a reason and this is it.

The real problem/question is how to prevent the deflating of the credit bubble and the attendant deflationary spiral from leading to civil unrest, nationalism, and geopolitical tension. My answer is that you have to fight against austerity. Let the automatic stabilisers be robust and let them do their job until the writedowns have all been taken. That way we get a sharp break and reboot without everyone becoming destitute.

The problem is allowing the credit bubble to deflate… and then piling on by deflating the public sector at the same time. Tell government: If you want to do anything, invest in infrastructure. But on the whole, don’t intervene pro- or anti-cyclically. Don’t cut spending, don’t cut rates, don’t do QE, and don’t do cash for clunkers or that kind of palaver. Let the credit bubble deflate. But be damn sure you have robust enough of a social safety net before you do. That’s my solution: one part Austrian, one part Keynesian.

Of course that’s not how it will play out. Skidelsky has the mindset pegged right:

Of course, [austerity] will not be carried through to the bitter end. Too much will crack along the way – the banks, the monetary system, social cohesion, the legitimacy of the political regime. Our leaders may be intellectually challenged, but they are not suicidal. Deficit reduction eventually will be put into cold storage, either openly, as I would prefer, or surreptitiously, as is politicians’ way. In the United Kingdom, there is already talk of Plan A +.


If nothing works, it will be time to sprinkle the country with what Milton Friedman called “helicopter money” – that is, put purchasing power directly into people’s pockets, by giving every household a spending voucher with an expiration date. This would at least keep the economy afloat pending the development of the longer-term investment program.

It would be better if such schemes could be agreed upon by all by G-20 countries, as was briefly the case in the coordinated stimulus of April 2009. If not, groups of countries should pursue them on their own.

That’s exactly right, both in prediction and tone. So, as Christopher Wood predicted a year and a half ago “the endgame will be a systemic government debt crisis in the western world”. And you can forget about Skidelsky’s ideas of renewed coordinated policy stimulus a la April 2009 fake recovery mode as a response. The helicopter drop of which Skidelsky speaks is probably how this eventually gets resolved. Brodsky and Quantaince talked about just such a plan to stabilize the global monetary system last year. I don’t see any of this happening before we try the deflationary route first.

And while I have called the Age of the Fiat Currency a 38-year (and now 40-year) experiment in (credit) inflation, I recognise that the deflationary route leads to chaos and military confrontation. Policy makers will panic when they see the economic ills their policies create for voters who will revolt in protest. I call it the Scylla and Charybdis of inflationary and deflationary forces in which policy stimulus is removed and then only after everything collapses, do policy makers press the red button; and then they act super-aggressively, leading to wild swings in asset prices, cyclical inflation, currency wars and the like.

Ominously, “this kind of volatility will induce a wave of populist sentiment, leading to an unpredictable and violent geopolitical climate and the likelihood of more muscular forms of government.” And we are beginning to see this now. It will continue.

P.S – since this post is a bit over-the-top Armageddonish, I would really appreciate push back. Don’t feel like you have to agree with me here. But I warn you; I’ve run through this thing a million times and have responses ready! Frankly, I just don’t see where the coordinated policy response is going to come from in a world of bailout and deficit fatigue and nationalistic recrimination. April 2009 was the last chance for that. I seriously think Angela Merkel is trying to bridge this thing. But the gulf between the Barrossos and the Juergen Starks of the world is pretty large. You don’t bridge that gap in a deflationary environment.


Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.