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Epic Recession: Prelude to Global Depression
Part one of a three-part series explaining the financial crisis
In the depths of the economic crisis, in early 2009, ten leading economists attending the annual American Economics Association conference in San Francisco were interviewed on "PBS Newshour." PBS reporter Paul Solman asked each economist, in turn, how the severest economic crisis since the depression of the 1930s could have happened and, "Why didn't you, the economics profession, warn us?" Their respective replies reveal why nearly all the approximately 10,000 economists in the U.S. got it wrong and why they continue to misread the fundamental character of the current crisis.
Why 10,000 Economists Got It Wrong
One set of replies was provided by economists Alan Blinder of Princeton University, Caroline Hoxby of Stanford, and Zvi Body of Boston University. According to Blinder, the "number of things that have gone wrong and the ferocity with which they have gone wrong, I think, was beyond the imagination of almost everyone." For Hoxby, the crisis was too complex to understand how all the elements of the crisis were interacting and "how all the dominoes are going to hit one another." For Body, it was simply that we can't foresee deep crises and that, "Disasters can happen at any time. In fact, what makes them disasters is we're not expecting them. If we were expecting them, they wouldn't turn into disasters."
But not all those interviewed by PBS's Solman admitted their inability to comprehend the crisis. Frank Levy of MIT, for example, replied the economic profession's general failure to explain and forewarn was due to a lack of information: the banks withheld the necessary information, thus preventing the profession from predicting and warning of the explosion. According to Levy, if the banks hadn't hidden their risky loans the Federal Reserve would have stepped in and done something about it. The problem with this view, however, is that the Fed did know. So did many government regulators, at the state level in particular. Many of the latter had been warning about banks setting up a virtual second set of books in which they dumped their riskiest speculative investments, derivatives in particular. The Fed chair at the time, Alan Greenspan, also knew what was going on, as did Greenspan's successor, Ben Bernanke. The data was there. The Fed, the regulators, and economists either looked in the wrong place, didn't bother to look at all, or chose to ignore the facts—often at the Bush administration's direct request.
A third group responding to Solman's challenge attributed the crisis to one of several single causes or, worse, attempted to explain it away by resorting to a variety of metaphors. My favorite among the single causal explanations is that the banks did it. Banks and the financial system are certainly an important element of the crisis but they cannot fundamentally explain it. The banks did it argument comes in various forms, most of which inevitably reduce to the explanation that it was greedy CEOs and managers pursuing super-bonuses that was the primary cause of the crisis. In other words, it was the behavior of certain individuals, a perspective that conveniently removes all discussion of institutions and any endogenous forces intrinsic to the economic system itself as responsible for the crisis. A popular variant of this explanation was provided by Stanford's Kenneth Arrow, one of the deans of the economics profession, who replied that he and his fellow economists erroneously assumed the banks would act rationally and correct their growing abuses and the problem. "We took it for granted these people protect themselves. We were wrong."
Individualist explanations of the crisis also took the form of blaming all of "us"—consumers, unemployed, homeowners facing foreclosures, small businesses facing default. We are as much at fault as bankers, government regulators, speculators, corporate CEOs, and the like. We were all collectively "overconfident," according to Yale economist Robert Shiller; too "trusting" and not careful enough, according to Nobel laureate George Akerlof of the University of California.
Explaining the crisis by means of metaphor was offered by economists Andrew Lo of MIT and Laura Tyson of the University of California, Berkeley. According to Lo, the crisis resulted from people falling into a kind of "drug induced stupor" when engaged in investing and making money. Recent neuroscience discoveries reveal, according to Lo, "financial gain triggers the exact same reward circuitry in the brain that cocaine does." It can even produce a financial hallucinogenic experience, where you don't worry about or "even see the risks," thereby leading to a "situation where you walk off a 30-story building because you think you can fly." Presumably this approach to analysis means Lehman Brothers Investment Bank CEO Dick Fuld, somehow got addicted to subprimes, while Bear Stearns CEO Jimmy Caynes became a derivatives junkie, and Charles Prince of Citigroup hallucinated on credit default swaps and stepped out of a 30 story window. Similarly, first-time homeowners with a subprime loan became spaced out on all the free money. But how is their behavior different from banks today getting loans from the Federal Reserve at less than zero interest rates? Isn't that free money? Why is it drug-like economic behavior for homeowners to take out a nothing down subprime loan, and not addictive for bankers today to be paid interest by the Fed to take a no cost loan? How is the former a problem of addiction and thus a cause of the crisis, while the latter purports to be a rational solution to the crisis?
An even less convincing explanation was offered by economist Laura Tyson, one-time Clinton administration economic adviser. For Tyson, the cause of the crisis was just "a kind of Greek tragedy," explainable by deep human failings. Like all Greek tragedies, the main characters simply cannot help themselves. In Tyson's case the tragic protagonist is us. It is, according to Tyson, "all about us as people." Once again, the cause of the crisis lies with the individual—not the institutions or nature of the economic system itself.
Single cause explanations of the crisis may also take the form of single nations as the cause. In this case, all of us becomes all of them. Thus, Shiller replied to Solman that population growth in China and India created the false impression that prices would continue to rise, feeding the boom phase that resulted in the financial bust. Other contemporary versions of they did it include the view that the offshore global savings glut was responsible for the excessive investment in U.S. housing markets. Still others are that China's continuing refusal to revalue its currency are causing imbalances in the global economy that in turn is causing more financial instability. New York Times liberal economist Paul Krugman has recently emerged as a major proponent of this view that it is them, not us, who are the ultimate culprits.
To sum up, the stars of mainstream economics leave us with a series of individualist or single cause explanations. The crisis occurred because people were too trusting, too overconfident, stoned on the prospect of money making, tripping on the possibility of super profit realization, or were simply expressing their inherently flawed human nature.
Limits of Descriptive-Narration
In the past two-and-a-half years there have been thousands of articles and hundreds of books written describing immediate events relating to one or more aspects of the financial crisis and the near collapse of the economy in the U.S. and globally. Scores of books have been written on the subprime mortgage problem; on specific bank defaults, like Bear Stearns, Lehman Brothers, and others; on the CEOs of the big banks; on the nature and danger of financial derivatives; the failure or success of Federal Reserve policies; or the failure of markets and theories of markets behavior. But all such essentially econo-journalistic accounts are essentially descriptive narratives of the present crisis or else the very recent past. Few have bothered to explain the crisis from a deeper historical perspective. Indeed, few bother with any historical analysis whatsoever. Fewer still attempt to provide a theoretical framework for understanding the origin and evolution of the crisis, without which any predictions of the future direction of the crisis are not possible.
Fundamental crises require fundamental solutions. And neither the economics profession nor journalists associated with major media are inclined to tread there, lest they appear too radical in either their analyses or their proposals. What follows in the remainder of this article, therefore, is an excerpt of a preliminary theoretical framework for explaining the current crisis. A subsequent article, Part 2, will address historical examples in the U.S. that represent similar crises in U.S. economic history—crises that have been neither normal recessions nor classic depressions. A third article in the series, Part 3, will then provide a detailed set of proposals and programs necessary for confronting the current crisis.
A Preliminary Theoretical Framework
One of the great failures of contemporary efforts to explain the current crisis is the inability to distinguish between causes that are fundamental versus those that are contributing or precipitating—as well as the dynamic interactions in turn between the three. Fundamental causes are those without which an epic recession could not occur. Enabling are causes that accelerate the evolution and development of the crisis event, as well as exacerbate the rate of spread and depth of it. Contributing are personal and policy factors that influence the outcome without determining its inevitable course or pace of development.
Fundamental causes include the forces behind the massive accumulation of excess global liquidity in recent decades, as well as the network of speculator-investors, shadow banks and institutions, and the new speculative instruments and markets they have spawned. The new institutional network serves, in turn, as the conduit for a speculative investment shift that has been expanding in relative weight and influence compared to non-speculative forms of investing in recent decades. Together, these investors, institutions, and the new financial instruments and markets constitute what is called the "global money parade," which controls a flow of about $20 trillion at minimum worldwide that now sloshes around from one speculative investment opportunity to another—from currencies and real estate, to global stock markets, emerging market funds, commodities futures of various kinds, and the ever-proliferating list of derivatives and other forms of financial asset securities.
Capable of generating far more profit in a much shorter period of time, the shift to speculative investing not only diverts increasing amounts of capital to financial asset creation, but does so at the expense of potential real, non-financial asset creation that produces jobs and income for the general workforce and the economy at large. Capital thus flows into an ever narrowing funnel, benefiting a smaller proportion of the populace at a growing rate, at the expense of a growing proportion of the remainder of the economy. The consequence is not only increasing income inequality but a decline in consumption and real investment, while financial instability grows proportionately.
The explosion in global liquidity available to the global money parade has various sources. One obvious source is central bank (i.e. Federal Reserve) policy. However, today's revolution in credit and new forms of credit creation is at least a source that lies increasingly beyond the control of central banks. Shadow banks and other speculative investing institutions arise and multiply in order to exploit the exploding liquidity made possible by unrestricted credit creation. New financial instruments and markets are created by the growing number of financial institutions dedicated increasingly toward speculative forms of investing. As other sources have noted, in 2007 these institutions' total assets available for investment in the U.S. at $10.5 trillion exceeded assets available to the traditional, commercial banking system at around $10 trillion. And that's only U.S. totals, or about 40 percent of the global total, which is estimated conservatively at around $20 trillion.
The global money parade of speculators, institutions, their products, new markets, and the speculative investment shift they create are all fundamental causes of epic crises. They produce increasingly frequent and severe cycles of financial instability, booms and busts. They lead to excessive financial debt accumulation and asset price inflation during the run-up to crises and, in turn, drive extraordinary debt unwinding and asset price deflation in the downturn.
Debt accumulation and financial asset inflation in the boom phase also creates a condition of financial fragility. Financial fragility occurs when institutions' debt rises as their available cash and liquid assets on hand to make rising debt payments declines. Banks, shadow banks, and other financial institutions become fragile in the sense that debt loads and debt repayments cannot be covered, or serviced, during the contraction phase. In severe cases, the unwinding of excess debt leads to financial asset collapse which, in turn, leads to financial defaults—i.e., bank suspensions, bank failures and reorganizations, mass withdrawals from and closure of hedge funds, and the like. Asset collapse and defaults by banks and other shadow bank financial institutions leads to a severe contraction of loans and bank credit to non-bank companies which then become financially fragile and begin to default as well. The prospect of imminent default leads companies to sell remaining assets at firesale prices and/or to take on additional debt to service existing debt. A process of interacting debt-deflation-default begins to occur, not only in the case of financial institutions but eventually non-bank businesses as well. Absent in normal recessions, there is consequently a dynamic in epic recessions that involves feedback effects between debt, deflation, and defaults. A vicious, downward spiral occurs in which all three feed upon and exacerbate each other.
The unwinding of debt following an initial financial crisis starts the process. Deflation follows, first with prices of financial assets, then spills over to product price deflation and wage deflation (i.e., layoffs, wage cutting, benefit cutting, hours cutting, etc.). Defaults thereafter spill out from banks and financial institutions to non-bank companies and to consumer households and workers. The defaults exacerbate the deflation, and the deflation in turn exacerbates debt repayment further in a series of multiple feedback effects.
This process of debt-deflation-default is also a fundamental causal factor of epic contractions, set in motion in the bust phase by the unwinding of the boom phase excesses and instability created by speculative investing. The speculative investment shift is thus the linkage between the global money parade and debt-deflation-default on the other. But the process of debt-deflation-default serves as a linkage as well—i.e., between the global money parade and the speculative investment shift, on the one hand, and conditions of financial fragility and consumption fragility on the other.
Similarly, consumption fragility involves households, consumers, and workers, whereas financial fragility involves banks and businesses. The two forms of fragility are similar, however, in that they can be expressed as ratios of debt load and debt payment levels, in relationship to available liquid assets that might be used to pay debt. For banks and businesses, it is a ratio of debt servicing (i.e., debt repayment) to available cash flow. For households-workers, it is expressed as a ratio of debt servicing to available real disposable income. For either banks-businesses or households-workers, if debt servicing requirements rise, fragility grows. If disposal income-cash flow falls, fragility also grows. If the former rises and the latter falls, then fragility—whether financial or consumption—grows even more severe. Epic recessions are characterized by high levels of both financial and consumption fragility.
It is the dynamic interplay and causal interdependencies between these various fundamental forces that differentiates epic from normal recessions. When debt-deflation-defaults are allowed to continue to deepen and their feedback effects allowed to worsen, both financial and consumption fragility deteriorate further. It is possible to have more than one fracturing of financial and/or consumption fragility. For example, it is possible to have a banking crisis followed by a second and third banking crisis. That represents multiple fracturing of financial fragility. Similarly consumption fragility may experience several fracturing events over an extended economic downturn. Put another way, a possible downward spiral of debt-deflation-default can lead to a continuing deterioration of financial-consumption fragility.
When the downward spiral of debt-deflation-default accelerates, and multiple fracturing of forms of fragility occurs, an epic recession transitions to a bona fide classic depression. When this happens, it can be called a Type II epic recession, in contrast to a Type I epic recession. In Type II, the dynamic processes are not checked and contained, and lead to depression. In Type I, the spiral of debt-deflation-default levels off and multiple fracturing of fragility does not occur. The outcome is an extended period of economic stagnation—neither further decline nor sustained long run recovery of the economy either. As will be described in Part 2 of this article, Type I occurred following the financial panic of 1907 and led to a prolonged period of relative economic stagnation. Type II occurred in 1929-1931, and led to the great depression of the 1930s.
Fundamental Forces of Epic Recession
The fundamental forces of epic recessions determine the pace, rate of spread, depth, and trajectory of the economic crisis, both in its financial and real economic aspects. They are quite different from what might be called enabling causes of epic recession, which are often mistaken for fundamental causes.
Typical among these enabling causes, for example, is financial deregulation. It is often argued that financial deregulation since the late 1970s, and in particular the repeal of the Glass-Stegall Act in 1999, is the primary cause of the financial crisis in 2007. But whereas deregulation may have enabled the crisis, it did not fundamentally cause it. Speculative investing and the global money parade typically finds a way around regulatory constraints. The lifting of those restraints may enable an even greater relative shift toward speculative forms of investing. But they would occur in any event.
A similar argument is sometimes made that too liberal Federal Reserve monetary policies since the 1980s led to excessively low interests rates of 1 percent in 2003 that provoked the subprime and housing bust of 2007 that set off the current crisis. But that is inaccurate. The speculative shift and housing bubble began well before the Fed's 1 percent rates, as early as 1998 in fact. Other enabling causes include technologies that have made possible the globalization of finance capital in recent decades. Enabling causes influence the magnitude and rate of spread of financial instability and epic recession, but do not fundamentally set either in motion.
Contributing causes can also play a role in the general evolution of an epic recession. These include the influences of personalities and the decisions they make, or don't make. What Greenspan did or didn't do, what Treasury Secretary Henry Paulson did poorly or negligently, the strategic errors of Fed Chair Ben Bernanke, the 2009 bank bailout proposals of Treasury Secretary Geithner that left bank bad assets essentially unaffected and did little to bail out residential mortgage markets all have some influence. But their actions would not have taken place were it not for the fundamental forces that distinguish and differentiate epic recessions and severe economic contractions from nor
In Part 2 of this series, a brief consideration of the epic recessions of 1907-1913 and 1929-1931 will be undertaken as evidence of the preliminary theoretical framework proposed above.
Jack Rasmus's forthcoming book is Epic Recession: Prelude to Global Depression (which can be preordered from Amazon). His website is www.kyklosproductions.com.
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