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
- 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. 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.
- 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.
- Tight coupling within the global financial system led to financial crisis in 2007 with large scale losses in mortgage-related derivatives markets.
- 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/or not feasible due to flawed institutional architecture for common currency in Europe so leaders committed policy error in Britain and the euro zone of simultaneous private and public sector deleveraging during a debt deflationary crisis beginning in 2011 (see prediction from “The origins of the next crisis“, April 2010)
- This has been followed in 2012 by yet more contagion to Spain because of effect of 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.
- 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
- Policy makers are loath to make very large changes in policy positions because it means losing face and being seen as inconsistent and unreliable
- 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 this scale will also be politically unacceptable in the US, Canada and Australia until depression deepens there as well.
- 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.
- The ECB will eventually offer more explicit backstops for Spain and Italy
- The euro zone will eventually accede to Eurobonds
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.
This post originally appeared at Credit Writedowns and is posted with permission.
11 Responses to “Macro Outline of Causes and Effects of and Predictions for the Global Financial Crisis”
Good reflections and in my opinion you outline the macro causes of current global slowdown. Root causes are definitely well spotted, as for resulting predictions I am personally more concerned and staying on negative side. Main criterion in shaping EZ's future will be the battle between France and Germany, as the two oppose each other politically. Merkel may lose ground at home and for sure that's not what she favours. Hollande will try to persuade Germans on Eurobonds. Whatever it takes, political will and stance of decision makers most probably will shape the prospects of Europe and the globe.
Please consider also that possible additional root cause: wrong x-rate floating regimes between western economies and emerging contries (i.e.: China almost fixed currency rate after 10 years in WTO. It has been too much time which caused debt bubble in order to face/solve current accounts deficit in the US). In general if a country enters WTO it should accept a x-rate free floating regime soon.
I think there are some deeper roots. Technology is making people potentially more productive. Communication and transportation have made large improvements. Container ships and better telecommunication made it possible to use China as a manufacturing center. This made the owners of the designs very wealthy and the owners of the Chinese plants very wealthy, but the labor force in the US and Europe very vulnerable. Vast sums of money were generated and concentrated in the hands of a few. These people saw an opportunity to make even more money by playing "financial games". In order to better play their games and to improve their industrial position these people used their money to get laws changed. In order to get the population on board they used their ownership of the media to get their laws passed and to stop people from effectively blowing the whistle on things like liar loans.
Technology allowed the construction industry to build houses cheaply as another example and so people could have McMansions at a cheaper price. And everybody loves a big house and the media loved to push what everybody loves.
Technology allows everyone to get onto blogs like this and speak their peace but they don't really talk back and forth, just making speeches. So the information age has become the gossip age. The issues have become more complex, the public is perhaps slightly better educated, but it is not how well educated you are in an absolute sense, but how well your education stacks up against the problem.
In summary technology has made us potentially more productive. People have not gotten morally worse or better, but technology has allowed the old tendency for greed to become more destructive.
Our current market place has a structure created by people. Technology is allowing productivity in every industry to improve dramatically. But the market place is not structured to harmonize these individual industries. The result is the whole is much less than the sum of the parts. I call this the Frankenstein culture. Good arms, nice legs, great eyes, etc, but Yuck what a monster.
So I don't disagree with your narrative but I think what I am saying is more the root of the problem.
Another way to look at this is that technology allow the "smart people" to do get the dumb people to do some very dumb things. Now the "smart people" are saying to the dumb people, you signed the contract so pay up. And now the "smart people" are trying all sorts of financial schemes to get the dumb people to pay up without knowing that they are paying up.
And the dumb people are so dumb that they may do it. Which will prove that the smart people are right the dumb people are dumb. But the whole system may fall apart in the process proving that we are all dumb.
“Minsky claimed that in prosperous times, when corporate cash flow rises beyond what is needed to pay off debt, a speculative euphoria develops, and soon thereafter debts exceed what borrowers can pay off from their incoming revenues, which in turn produces a financial crisis. As a result of such speculative borrowing bubbles, banks and lenders tighten credit availability, even to companies that can afford loans, and the economy subsequently contracts.” — Wikipedia
Wages did not match productivity growth, debt replaced income. Deregulation and desupervision allowed financial corporate debt to grow, 1980 – 2010, from 20% of GDP to 120% of GDP in the U.S. (I looked this up a Flow of Funds Report, March 2012, Table D.3) I like the word "desupervision", but I like criminal negligence better. I prefer former Fed Chairman Marriner Eccles account of the origins of the Great Depression, owners took such a big share of the productive wealth that they deprived themselves of customers. The interface of low-income emerging countries (BRIC) with developed industrial nations also contributed. This was a train wreck foreseen well in advance. The greed of the top-earners should also have been foreseen. The international billionaires club of 1226 billionaires own on average $3.7 billion each one, and that is equal to working 37 years with $100 million of income each year. My best year did not come anywhere close to $100 million. Credit Suisse bank's World Wealth Report states that 0.5% of the planets adults own 38% of everything, 9% own 82%. What countervailing force will pry loose that capital resource to invest in humanity's needs? Profit is the only investment lure presently, and collective action from government is scorned as totalitarian inefficient waste of resources. Humans have to confront either bludgeoning from the wealthy or collective action from the many. My blog is http://benL8.blogspot.com
in the effects/responses section I would include consumer sentiment, as returning to growth will require a change in the mindset of consumers/investors away from the fear factor at the moment
Ben Leet seems to have part of the crux of the situation. Yes, there were mistakes and unwarranted euphoria on the parts of many people. Yes, there was a flawed structure for the EZ to begin with. In the end, however, the entire situation comes down to the question, "What is fair and good for society?" When that question ceases to underpin the economic relationships of people–where organized labor, corporations, or private businesses are involved–society suffers from the unbridled greed and shameless opportunism.
Edward are you including the securitisation of debt as part of the first two points? There was already too much debt in 2000 causing the subsequent recession, but then securitisation started to flourish with the low interest rate environment in 2003. This I think was the baloney reason for the boom until 2007, thus making a big debt problem become what we have globally today.
Excellent thesis presented!
I agree with your points but I am a little more optimistic in the short term.
1) On a macro level I do think G20 leaders are able to manage economic activity and find ways to mitigate a drop in business activity and deflationary spirals. World leaders understand the lessons of the Great Depression. Still a repeat(s) of the 2008-9 drop is a reasonable probability.
2) Worldwide growth is the key factor in my opinion and it is going to be at a lower rate looking forward than in our past. If you think about the past 100 years Corporate business activity has grown from 10% to 85% todays economy. So growth is going to come from population increases and incremental growth in business activity. Perhaps 2% for the next decade?
An article by Jeremy Grantham last year was insightful as he asked (paraphrase from memory) What kind of growth can a world expect long term? Compounding over a 1000 years even 1% was not possible. The exercise may be crude but does help place a perspective.
3) The biggest threat and pressure comes from the number of worldwide jobs. Last I read from the ILS we are 50+ MM short of the 2007 peak. The political impact of people without jobs and or declining real wages is the long pole in the tent.