You may not agree with Chris’ views—on the state of US banks; on which reforms of the system of financial regulation and supervision are appropriate; on the risks that large monetized fiscal deficit imply in terms of future inflation and risks of a crash of the US dollar—but he is always thought provoking, well versed in the details of financial history and a master of lateral and contrarian thinking that challenges the conventional wisdom. You may believe – like I do – that the greatest short-term risk facing the US is currently deflation as a slack in goods and labor markets implies seriously strong deflationary forces. But Chris correctly points out that large and monetized fiscal deficits eventually may cause in the medium term a rise in expected and actual inflation as they did after the Civil War and WWII. Indeed the temptation to use a moderate and unexpected inflation tax to wipe out the real value of public debt and avoid the debt deflation of the private sector is powerful and history may repeat itself even if the short-term maturity of US liabilities, the risk of a crash of the US dollar and an associated runaway rising inflation, and the related risk that US foreign creditors may pull the plug on the financing of the US twin deficit, may constrain these inflationary biases.
Similarly, Chris stresses the role of poor fiscal and monetary policies and botched regulatory policies in triggering recent and past financial crises. But financial crises existed well before there was a central bank causing moral hazard distortions through its lender of last resort role, before misguided regulation and supervision of banks and well before there was a significant role of federal fiscal policy in the US. Indeed, my recently published book, Crisis Economics, shows that financial crises and economic crises driven by irrational exuberance of the financial system and the private sector – unrelated to public policies – existed for centuries before fiscal deviant sovereign and central banks distorted private sector incentives. Markets do fail and they fail regularly in irrationally exuberant market economies; that is the source of the role of central banks and governments in preventing self-fulfilling and destructive bank runs and collapses of economic activity via Keynesian fiscal stimulus in response to collapse in private demand. The fact that these monetary policies and fiscal policies may eventually become misguided – creating moral hazard and creating large fiscal deficits and debt – does not deny the fact that private market failures, independent of misguided policies, triggered asset and credit bubbles, which triggered a public rescue response. Market solutions to market failures don’t work because in periods of panic and irrational depression markets fail given collective action problems in private sector decisions. Still, there is a long standing debate on whether bubbles and the ensuing crises are due to poor government policies (the traditional conservative and Austrian view) or due to market failure requiring policy reaction (the liberal and Keynesian view). Chris takes the Austrian view, but the Great Depression experience shows that too much Schumpeterian “creative destruction” leads to uncreative destructive depression. On the other hand, the Japanese experience of the 1990s also suggests that keeping alive zombie banks and companies can lead to persistent near depression.
The most fascinating parts of this great book are about the historical similarities in US financial history: cycles of asset and credit booms and bubbles followed by crashes and busts; the fiscal recklessness of US states that leads to state and local government defaults; the temptation to socialize those state and local government losses as well as the losses of the private sector (households and banks) via federal government bailouts; the recurrent history of high inflation as the solution to high public deficit and debt problems and private debt problems both after wars (Civil War, WWI, Vietnam and possibly now following budget busting wars in Iraq and Afghanistan) and in the aftermath of asset and credit bubbles gone bust; the historical resistance of US state, local and federal governments to raise enough taxes to finance an increasing public demand for public services and entitlements that cause these large fiscal deficits, and the schizophrenia of an American public that hates high taxes but also wants public and social services; the trouble being that you cannot have simultaneously public spending like in the social welfare states of Europe and low tax rates as under Reagan. Europeans, at least, are willing to bear high taxes for the public services that they demand instead of living in the delusional bubble that both the government and the household sectors can live beyond their means piling more private and public debt.
The recurrence of financial crises – especially in the last 30 years (three big bubbles gone painfully bust since the 1980s) after a lengthy 50 year period of relative financial calm following the reforms of the Great Depression – leads to the question of why these crises keep on occurring despite attempts after each crisis to better regulate and supervise the financial system. Here I would like to develop a point that is only half fleshed out in Chris’ analysis of US households and governments living beyond their means and piling public debt on top of private debts; it is the role of rising income and wealth inequality in these financial crises.
Indeed, in the last 30 years there has been a large increase in income and wealth inequality in advanced economies. This rise is due to many factors: winner take all effects of an information society; trade integration of China, India and other EMs in the global economy; knowledge and skill-biased technological innovation; a rise in finance and increased rent-seeking and oligopoly in financial markets.
This increase in inequality led to a “keeping up with the Jones’s effect”: households in the US and Europe could not maintain their living standards, spending and lifestyle goals as wages and labor incomes rose less than productivity with a rising share of income going to capital and to the wealthy.
This rising inequality is the root cause of the American household tendency to spend beyond its means that Chris correctly bemoans in his book. Indeed, this inequality led to alternative policy responses in the Anglo-Saxon countries versus the social welfare countries of continental Europe. In the former group (US, UK, Ireland, Spain, Iceland, Australia, New Zealand) the response was one of democratization of credit that allowed households to borrow and spend beyond their means: the boom in mortgage and consumer credit (credit cards, auto loans, student loans, payday loans, subprime loans, etc) then led to a massive increase in private household debt matched by rising leverage of the financial sector (banks and shadow banks). This financial system leverage was abetted by reckless financial deregulation (the repeal of Glass-Steagall, non-regulation of derivatives, explosion of toxic financial innovation, rise of a subprime financial system, explosion of the shadow banking system). Since households and the country were spending more than its income, all of these “anglo-saxon” countries were running large current account deficits financed by over-saving countries (China, emerging markets as well as Germany and Japan) So you had an explosion of private debt and foreign debt that eventually became unsustainable and led to the financial crisis of 2007-2009.
The response in Europe, instead, was more social welfare state: government spent more than their revenues and increased budget deficits and public debts to provide households with “semi-free” public services (education, health care, social pensions, extended unemployment benefits and other massive transfer payments) as the slow growing incomes did not allow private spending to grow fast enough. This increased public debt was absorbed by households (that maintained positive savings rates as the government was dis-saving massively), banks and other financial institutions. So the financial system piled on public sector assets (government debt) rather than claims on the private sector (as in the Anglo Saxon countries).
So in one set of countries you had initially a rise in private debts and leverage while in the other group a rise in public debt and leverage. However, when private liabilities became unsustainable in the Anglo-Saxon countries leading to an economic and financial crisis you eventually had a massive re-leveraging of the public sector for three reasons: automatic stabilizers; counter-cyclical Keynesian fiscal stimulus to prevent the Great Recession from turning into another Great Depression; and socialization of the private losses. This third factor put many of the debts of the private sector (especially banks/financial system but also households and non-financial corporates) on the balance sheet of governments as fiscal costs of bailing out the financial system became very high. So at the end of this cycle the Anglo-Saxon countries also ended up with large budget deficits and stocks of public debt as the democratization of credit and massive releveraging of the private sector (households and banks) became unsustainable.
Therefore, we now have problems of combinations of large stocks of private debts and public debts in most advanced economies: household debts, banks and financial system debts, government debts and foreign debts. That is why crises will continue and we will have an era of Economic and Financial Instability: households will default when their debts are unsustainable; governments will default when their debts are unsustainable; and banks and shadow banks will be insolvent because they are full of bad assets; claims on the private sector in Anglo-Saxon economies; claims on the public sector in the social welfare state economies.
Thus, the problems of Greece and the eurozone are only the tip of an iceberg of large private and public debts and leverage in most advanced economies. This implies a “new normal” of – at best – slow growth in advanced economies for the next few years as households, financial systems and governments need to deleverage by spending less, saving more and reducing their debts. At worst, if these deficit and debt problems are allowed to fester we will get households defaulting en masse, governments going bankrupt, banks and financial institutions going bankrupt as their public and private assets go sour and countries going bankrupt with more economic and financial instability. So the coming financial instability and economic crises and twin risks of deflation followed by inflation will be driven not only by the unwillingness to rein in – via proper regulation and supervision – a financial system run amok. They will also be driven by the deeper economic and social forces that have led to income and wealth inequality and a massive rise in private and public debts given the stresses of rising inequality and globalization of trade and finance.
So we can, unfortunately, say goodbye to the Great Moderation and hello to the Era of Financial Instability/Crises and Economic Insecurity. Chris’ book provides us with a fascinating and deep financial history and road map of how we have gone through repeated cycles of great moderations followed by asset and credit bubbles leading to financial crises driven by excessive debt and leverage of the private sector (households, banks, corporate firms) leading to excessive public sector debt accumulation – via socialization of private losses – that leads to twin risks of outright default (usually by US states) or use of the inflation tax through monetization of fiscal deficits (at the federal level).
The philosopher Santayana once said: “Those who cannot learn from history are doomed to repeat it.” This deep study of US financial history may help policy makers avoid repeating the mistakes of the past, even if – in thoughtful Marxist spirit – one could argue that powerful economic, financial and thus political forces drive these repeated cycles of boom and bust that the study of history alone cannot prevent.
Nouriel Roubini is Professor of Economics at the Stern School of Business at New York University and Chairman of Roubini Global Economics (www.roubini.com)
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