Vivek Kaul
Graham Greene’s fascinating book The End of an Affair starts with these lines: “A story has no beginning or end: arbitrarily one chooses that moment of experience from which to look back or from which to look ahead.”
If the current financial crisis were a story (which it is) its beginning would be on September 15, 2008, when Lehman Brothers, the smallest of the big investment banks on Wall Street, went bust. It was the largest bankruptcy in the history of the world. Lehman Brothers started a crisis, from which the world is still trying to recover.
While the American government and the Federal Reserve(the American central bank) let Lehman Brothers go under, the got together to save AIG, one of the largest insurance companies in the world, a day later. This was followed by a spate of other rescues in the United States as well as Europe. These rescues cost the governments around the world a lot of money. As Mark Blyth writes in Austerity – The History of a Dangerous Idea “The cost of bailing, recapitalizing, and otherwise saving the global banking system has been depending on…how you count it, between 3 and 13 trillion dollars. Most of that has ended up on the balance sheets of governments as they absorb the costs of the bust.”
It’s been five years since Lehman Brothers went bust. Hence, enough time has elapsed since the financial criss started, to analyse, if any lessons have been learnt. One of the major reasons for the financial crisis was the fact that governments across the Western world ran easy money policies, starting from the turn of the century. Loans were available at low interest rates.
People went on a borrowing binge to build and buy homes and this led to huge real estate bubbles in different parts of the world. Take the case of Spain. Spain ended up building many more homes than it could sell. Estimates suggest that even though Spain forms only 12 percent of the GDP of the European Union (EU) it built nearly 30 percent of all the homes in the EU since 2000. The country has as many unsold homes as the United States of America which is many times bigger than Spain.
Along similar lines, by the time the Irish finished with buying and selling houses to each other, the home ownership in the country had gone up to 87%, which was the highest anywhere in the world. A similar thing happened in the United States, though not on a similar scale.
Housing prices in America had already started to fall before Lehman Brothers went bust. After that the fall accelerated. As per the Case-Shiller Composite-20 City Home Price Index, housing prices in America had risen by 76% between mid of 2001 and mid of 2006. The first time the real estate prices came down was in January 2007, when the Case-Shiller Composite-20 City Home Price Index suggested that housing prices had fallen by a minuscule 0.05% between January 2006 and January 2007. This fall came nearly two and half years after the Federal Reserve started raising interest rates to control the rise in price of real estate.
The fall gradually accentuated and by the end of December 2007, housing prices had fallen by 9.1% over a one year period. The fall continued. And by December 2008, a couple of months after Lehman went bust, housing prices, had fallen by 25.5%, over a period of three years. The real estate bubble had burst and the massacre had started. Similar stories were repeated in other parts of the Western world. Soon, western economies entered into a recession.
Governments around the world started tackling this by throwing money at the problem. The hope was that by printing money and putting it into the financial system, the interest rates would continue to remain low. At lower interest rates people would borrow and spend more, and this in turn would lead to economic growth coming back.
Hence, the idea was to cure a problem, which primarily happened on account of excess borrowing, by encouraging more borrowing. The question is where did this thinking come from? In order to understand this we need to go back a little in history.
As Nobel Prize winning economist Robert Lucas said in a speech he gave in January 2003, as the president of the American Economic Association: “Macroeconomics was born as a distinct field in the 1940s, as a part of the intellectual response to the Great Depression. The term then referred to the body of knowledge and expertise that we hoped would prevent the recurrence of economic disaster.”
Given this, the economic thinking on the Great Depression has had a great impact on American economists as well as central bankers. This is also true about economists across Europe to some extent.
In 1963, Milton Friedman along with Anna J. Schwartz, wrote A Monetary History of United States, 1867-1960, which also had a revisionist history of the Great Depression. What Friedman and Schwartz basically argued was that the Federal Reserve System ensured that what was just a stock market crash in October 1929, became the Great Depression.
Between 1929 and 1933, more than 7,500 banks with deposits amounting to nearly $5.7 billion went bankrupt. This according to Friedman and Schwartz led to the total amount of currency in circulation and demand deposits at banks, plunging by a one third.
With banks going bankrupt, the depositors money was either stuck or totally gone. Under this situation, they cut down on their expenditure further, to try and build their savings again. This converted what was basically a stock market crash, into the Great Depression.
If the Federal Reserve had pumped more money into the banking system at that point of time, enough confidence would have been created among the depositors who had lost their money and the Great Depression could have been avoided.
This thinking on the Great Depression came to dominate the American economic establishment over the years. Friedman believed that the Great Depression had happened because the American government and the Federal Reserve system of the day had let the banks fail and that had led to a massive contraction in money supply, which in turn had led to an environment of falling prices and finally, the Great Depression.
Hence, it was no surprise that when the Dow Jones Industrial Average, America’s premier stock market index, had a freak crash in October 1987, and fell by 22.6% in a single day, Alan Greenspan, who had just taken over as the Chairman of the Federal Reserve of United States, flooded the financial system with money.
After this, he kept flooding the system with money by cutting interest rates, at the slightest hint of trouble. This led to a situation where investors started to believe that come what may, Greenspan and the Federal Reserve would come to the rescue. This increased their appetite for risk, finally led to the dotcom and the real estate bubbles in the United States.
In fact, such has been Friedman’s influence on the prevailing economic thinking that Ben Bernanke, who would take over as the Chairman of the Federal Reserve, after Greenspan, said the following at a conference to mark the ninetieth birthday celebrations of Friedman in 2002. “I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”
At that point of time, Bernanke was a member of the board of governors of the Federal Reserve System and hence, the use of the word “we”. What Bernanke was effectively saying was that in the days and years to come, at the slightest sign of trouble, the Federal Reserve of United States would flood the financial system with money.
And that is precisely what Bernanke and the American government did once the financial crisis broke out in September 2008. The Bank of England, the British central bank, followed. And so did the European Central Bank in the time to come. Recently, the Bank of Japan decided to join them as well.
Central banks around the world have been on a money printing spree since the start of the financial crisis in late 2008. Between then and early February 2013, the Federal Reserve of United States has expanded its balance sheet by 220%. The Bank of England has done even better at 350%. The European Central Bank came to the money printing party a little late in the day and has expanded its balance sheet by around 98%. The Bank of Japan has been rather subdued in its money printing efforts and has expanded its balance sheet only by 30% over the four year period. But during the course of 2013, the Bank of Japan has made it clear that it will print as much money as will be required to get the Japanese economy up and running again.
The trouble is that people in the Western world are not interested in borrowing money again. Hence, the little economic recovery that has happened has been very slow. The Japanese economist Richard Koo calls the current state of affairs in the United States as well as Europe as a balance sheet recession. The situation is very similar to as it was in Japan in 1990 when the stock market bubble as well as the real estate bubble burst.
Hence, Koo concludes that the Western economies including the United States may well be headed towards a Japan like lost decade. In a balance sheet recession a large portion of the private sector, which includes both individuals and businesses, minimise their debt. When a bubble that has been financed by raising more and more debt collapses, the asset prices collapse but the liabilities do not change.
In the American and the European context what this means is that people had taken on huge loans to buy homes in the hope that prices would continue to go up for perpetuity. But that was not to be. Once the bubble burst, the housing prices crashed. This meant that the asset (i.e. homes) that people had bought by taking on loans lost value, but the value of the loans continued to remain the same.
Hence, people needed to repair their individual balance sheets by increasing savings and paying down debt. This act of deleveraging or reducing debt has brought down aggregate demand and throws the economy in a balance sheet recession.
While the citizens may not be borrowing, this hasn’t stopped the financial institutions and the speculators from borrowing at close to zero percent interest rates and investing that money in various parts of the world. And that, in turn, has led to other asset bubbles all over the world.
These bubbles have benefited the rich. As The Economist points out “THE recovery belongs to the rich. It seemed ominous in 2007 when the share of national income flowing to America’s top 1% of earners reached 18.3%: the highest since just before the crash of 1929. But whereas the Depression kicked off a long era of even income growth the rich have done much better this time round. New data assembled by Emmanuel Saez, of the University of California, Berkeley, and Thomas Piketty, of the Paris School of Economics, reveal that the top 1% enjoyed real income growth of 31% between 2009 and 2012, compared with growth of less than 1% for the bottom 99%. Income actually shrank for the bottom 90% of earner.”
Once these bubbles start to burst, the world will go through another round of pain. Satyajit Das explains the situation beautifully in a recent column for the Financial Times, where he quotes the Irish author Samuel Beckett “Ever tried. Ever failed. No matter. Try Again. Fail again. Fail better.”
To conclude, there are many lessons that history offers us. But its up to us whether we learn from it or not. As the German philosopher Georg Engel once said “What experience and history teach is this – that nations and governments have never learned anything from history, or acted on principles deduced from it”. And why should this time be any different?
The article originally appeared on www.firstpost.com on September 16, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)