Friday, November 28, 2014

The Failure of Free-Market Finance

LONDON – Five years after the collapse of the US investment bank Lehman Brothers, the world has still not addressed the fundamental cause of the subsequent financial crisis – an excess of debt. And that is why economic recovery has progressed much more slowly than anyone expected (in some countries, it has not come at all).

Most economists, central bankers, and regulators not only failed to foresee the crisis, but also believed that financial stability was assured so long as inflation was low and stable. And, once the immediate crisis had been contained, we failed to foresee how painful its consequences would be.

Official forecasts in the spring of 2009 anticipated neither a slow recovery nor that the initial crisis, which was essentially confined to the United States and the United Kingdom, would soon fuel a knock-on crisis in the eurozone. And market forces did not come close to predicting near-zero interest rates for five years (and counting).

One reason for this lack of foresight was uncritical admiration of financial innovation; another was the inherently flawed structure of the eurozone. But the fundamental reason was the failure to understand that high debt burdens, relentlessly rising for several decades – in the private sector even more than in the public sector – were a major threat to economic stability.

In 1960, UK household debt amounted to less than 15% of GDP; by 2008, the ratio was over 90%. In the US, total private credit grew from around 70% of GDP in 1945 to well over 200% in 2008. As long as the debt was in the private sector, most policymakers assumed that its impact was either neutral or benign. Indeed, as former Bank of England Governor Mervyn King has noted, “money, credit, and banks play no meaningful role” in much of modern macroeconomics.

That assumption was dangerous, because debt contracts have important implications for economic stability. They are often created in excess, because in the upswing of economic cycles, risky loans look risk-free. And, once created, they introduce the rigidities of default and bankruptcy processes, with their potential for fire sales and business disruptions.

Moreover, debt can drive cycles of over-investment, as described by Friedrich von Hayek. The Irish and Spanish property booms are prime examples of this. And debt can drive booms and busts in the price of existing assets: the UK housing market over the past few decades is a case in point.

When times are good, rising leverage can make underlying problems seem to disappear. Indeed, subprime mortgage lending delivered illusory wealth increases to Americans at a time when they were suffering from stagnant or falling real wages.

But in the post-crisis downswing, accumulated debts have a powerful depressive effect, because over-leveraged businesses and consumers cut investment and consumption in an attempt to pay down their debts. Japan’s lost decades after 1990 were the direct and inevitable consequence of the excessive leverage built up in the 1980’s.

Faced with depressed private investment and consumption, rising fiscal deficits can play a useful role, offsetting the deflationary effects. But that simply shifts leverage to the public sector, with any reduction in the ratio of private debt to GDP more than matched by an increase in the public-debt ratio: witness the Irish and Spanish governments’ high and rising debt burdens.

Private leverage levels, as much as the public-debt burden, must therefore be treated as crucial economic variables. Ignoring them before the crisis was a profound failure of economic science and policy, one for which many countries’ citizens have suffered dearly.

Two questions follow. The first is how to navigate out of the current overhang of both private and public debt. There are no easy options. Paying down private and public debt simultaneously depresses growth. Rapid fiscal consolidation thus can be self-defeating. But offsetting fiscal austerity with ultra-easy monetary policies risks fueling a resurgence of private leverage in advanced economies and already has produced the dangerous spillover of rising leverage in emerging economies.

Both realism and imaginative policy are required. It is obvious that Greece cannot pay back all of its debt. But it should also be obvious that Japan will never be able to generate a primary fiscal surplus large enough to repay its government debt in the normal sense of the word “repay.” Some combination of debt restructuring and permanent debt monetization (quantitative easing that is never reversed) will in some countries be unavoidable and appropriate.

The second question is how to constrain leveraged growth in the future. Achieving this goal requires reforms with a different focus from those pursued so far. Fixing the “too big to fail” problem is certainly important, but the direct taxpayer costs of bank rescues were small change compared to the damage wreaked by the financial crisis. And a banking system that never received a taxpayer subsidy could still support excessive private-sector leverage.

What is required is a wide-ranging policy response that combines more powerful countercyclical capital tools than currently planned under Basel 3, the restoration of quantitative reserve requirements to advanced-country central banks’ policy toolkits, and direct borrower constraints, such as maximum loan-to-income or loan-to-value limits, in residential and commercial real-estate lending.

These policies would amount to a rejection of the pre-crisis orthodoxy that free markets are as valuable in finance as they are in other economic sectors. That orthodoxy failed. If we do not address the fundamental fact that free financial markets can generate harmful levels of private-sector leverage, we will not have learned the most important lesson of the 2008 crisis.

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    1. CommentedRalph Musgrave

      Turner needs to study Keynes and Modern Monetary Theory. Government debt is a complete and total non-problem. As Keynes put it: “Look after unemployment and the budget looks after itself”. MMTers have been screaming the same message from the rooftops for the last four years, but to little avail.

      For anyone interested in why national debts are a total and complete non-problem, see:

    2. CommentedAdam Green

      This article is as bewildering and lost in the clouds of finance as the reasons for the crisis itself. Debt leveraging, countercyclical capital tools, blah blah blah.

      Seriously I hoped for more than this. the current economic model is totally flawed and adding pathetic new reforms, regulations and legislation on top of it will not help. Usury should be a crime, it's that simple.

      How is it OK, for example, for banks to borrow money from the world bank at 0% interest and then lend it out at a fixed interest rate and then basically cream profits for money than wasn't theirs in the first place? And then gamble that money on food prices thereby out-pricing millions of people in poor countries who need to eat?

      And stock markets and hedge funds. What the hell is going on. Most people, including myself, don't have a clue what all this financial gibberish is all about and, frankly, we aren't interested. It doesn't work, so why waste effort learning about it. Take your petty visions of the world's financial future and piss off.

    3. CommentedPer Kurowski

      “Excess of debt” is not a sufficient explanation.

      Yes there was excess of debt to what was perceived, by regulators as “absolutely safe”, like to infallible sovereigns, housing and the AAAristocracy, but, there is no way we can talk about excess debt for those perceived as “risky”, like the medium and small businesses, the entrepreneurs and start-ups.

      What “Failure of free market finance” do you refer to?

      Regulators by allowing for different capital requirements based on ex ante perceived risks, introduced the mother of all financial distortions which made it impossible for banks to allocate credit efficiently in the real economy.

      And Lord Turner knows about this, but prefers to keep silence.

      And you, who identify yourselves as progressives, should be ashamed of yourselves, for not protesting the regulatory favoring of "The Infallible" and which results de facto in an odious discrimination against "The Risky".

    4. Commentedde Lafayette

      {the world has still not addressed the fundamental cause of the subsequent financial crisis – an excess of debt.}

      I beg to differ.

      There was certainly excessive debt in the financial system. But debt was simply the external manifestation of a far more human attribute. Greed. Not of just a few, but far too many.

      The entire free-market system, from the builder to the buyer to the mortgagor/mortgagee to the seller and next buyer, fostered a bubble condition based upon rapacious expectations (for profit). How was it possible to believe that a house bought at one price could resell in a period of a few months with a net profit worth three years of the average median salary in America (about $150K)?

      Our notions of “worth” became discombobulated, topsy-turvy - whacko.

      Real worth in any market system is the Holy Grail. It our appreciation of market value based upon worth that makes for the fundamental reality in which we live. A house that appreciates in resold value in a short period of time with enormous appreciation distorts our reality.

      Distort that reality and you do so at your peril.

      The process engenders a frenzy and since the “natural value” is replaced by a “virtual value”, inevitably the bubble must burst. It MUST burst as it enters into the final cycle of continually diminishing expectations. In that manner we return to reality – and thus to real worth.

      And when the entire credit mechanism is seized and stops, because of the Debt Mountain created by the constant revaluations, then the damages are brutal, widespread and debilitating. Which is why it has taken us so long to exit from the Great Recession's torpor.

      We distorted reality and we are now paying the consequences, based upon the fact that we (collectively as a nation) have not conquered our fear that the ground tomorrow could open below our feet.

      In time we heel, depending upon good policy judgments that convince us that the worst has passed, which are increasingly rare.

      Moreover, we have done too little to prevent that bubble-frenzy from repeating itself. So, it will do so ...

    5. CommentedTomas Kurian

      The key is to understand, that debt is essential to functioning of todays capitalistic economy. Without debt ( private or government), there cannot be neither private savings nor entrepreneur´s profits.

      You cannot get rid of debt without cancelling private savings, either Cyprus style or through classical inflation
      ( as in USA in 70ties till 1983)

      Read more in my work:

      Aggregate demand ( buying power) distributed in the form of wages is always lower than aggergate supply, consisting from wages + profit.

      Therefore, the difference has to be supplemented from some different source. If it is private debt, it is always short lived and eventually comes to an end in the form of crash.

      To avoid these kind of recessions, we need an upgrade of current financial framework, which would enable recycling of "dead-unused capital" to come back into economy and boost aggregate demand, but not in the form of loans, but wage supplements.

      This is the only way how to get rid of cyclical downturns and megarecessions, which threaten to engulf the entire world.

      Describes the mechanics amd benefits of new economic model, which can cure current problems.

    6. CommentedWalter Gingery

      Wrong: it wasn't an excess of debt, per se. It was (and is) an excess of risk. The USA has borrowed a prodigious amount, but still pays rock-bottom rates, because it's a good risk. What the financial markets need is a way to manage risk. And an essential part of that is personal liability for losses due to risk. You will evaluate debt much more carefully when you know you could lose your stake. The function of government, then, is to segment the market into more or less risky portions.

        CommentedPer Kurowski

        What "excess risk"? You must mean "excess trust". There was not one single assets ex ante considered as risky that created this crisis. As always it was a consequence of excessive exposures to "absolutely safe" assets which, ex post turned out to be very risky. And in this case by regulators, like Lord Turner, allowing banks to hold minimum capital against these supposedly absolutely safe assets.

        CommentedMoritz G€d1g

        A. Turner is right insofar as it was too much private debt. The cause of this must of cause be that there were other entities able and willing to lend too much. The risk is much harder to quantify than the inequality and imbalance that let to what is history in hindsight and should have been recognized as risk.
        Over all the article is either obvious or wrong.

        CommentedJules Pierre

        Right, the cause was an excess of /bad/ debt. But it also seems likely that a rapid society-wide debt increase has good chances to be made up of bad debt.

        And you'we wrong when you say that “What the financial markets need is a way to manage risk”. You acknowledge it yourself ! What the markets need is a better way to /evaluate/ risk. And that means transparency, readability, and simplicity ; pretty strong constrains on finance actually !

    7. CommentedJohn Sullivn John Sullivan

      The most regulated markets in the world are financial. To claim a failure of a free markets is absurd. It's a failure of banking regulations. Free markets are based on property rights and property laws as the foundation of markets, exchange, and contracts. Banking Laws are in violation of property law and therefore can't be regarded under the category of a free market.

      This type of misleading terminology sets the table for more and more regulations. Mr. Turner is a bureaucrat, a man who lives a life of setting policies and regulations. He can call financial markets what he wants, but they aren't free markets.

    8. CommentedZsolt Hermann

      But how could they address debt when the whole system is built on it?
      The present constant quantitative growth economic system has no natural foundations: it is impossible to thrive for never ending quantitative growth in a closed, finite, natural system with given natural and human resources.
      Such an artificial system can only be maintained if we design artificial conditions around it.
      Thus humanity in order to secure the "never ending growth" and profit accumulation, built an artificial bubble with its subsystems and sub-laws that are separate and mostly opposite to the "outside laws", the principle laws of nature.
      And the fuel of the whole system is credit, debt.
      Simply managing on available assets, resources does not fuel growth, it only allows redistribution, mutual exchange, or a different kind of growth, a qualitative one.
      The best example is the difference between the metabolism of a growing child and an adult.
      The artificial bubble seemingly worked until humanity was still expanding ("growing"), as if living in a "free space, a vacuum", but by now the globalization, saturation of the human system is complete, this is why suddenly as if we find ourselves on a different planet.
      The "outside laws" of nature are encroaching on the artificial bubble as if the clutch has been released and the cogwheels of the human system engaged within the cogwheels of the system of nature.
      The only "way out", solution in such a scenario is the adaptation to the system of nature, taking its laws governing the global, integral, natural system on ourselves.
      The artificial bubble we created dreaming about never ending growth and profit is bursting whether we agree to it or not, the natural system with its laws around us is infinitely larger and stronger than humanity, but we can make the transition to an inevitable natural, resource based human system faster and smoother if we do it proactively, and if we do it in a global, mutual fashion.

        CommentedEdward Ponderer

        The "outside" laws of nature that you refer to would imply the encroachment of a higher system on our lower "bubble" which would come in the form of an entirely new group of interactions in that bubble. -- And this is precisely what has happened! --the evermore strongly coupled nonlinear inter-dependencies across different scale of corporate entities from international cartel and block to local community, business, and individuals -- as well as criss-crossing with nature -- perhaps most notably climatically, animal/agricultural, microbial, and fresh water (or rather, its lack).

        This type of bubble-system-crashing into the large system has happened countless time in natural communities. The immediate result is deterministic chaos in the loose membership community which is match by an altruistic interaction by that community which turns that chaos into communication, homeostasis, and successful higher being. Failing this altruistic gelling, the chaos would flow full scale into Murphy's law and the bubble rather than smoothly evolving, ruptures catastrophically.

        "The artificial bubble we created dreaming about never ending growth and profit is bursting whether we agree to it or not, the natural system with its laws around us is infinitely larger and stronger than humanity, but we can make the transition to an inevitable natural, resource based human system faster and smoother if we do it proactively, and if we do it in a global, mutual fashion."
        --exactly so Mr. Hermann, exactly so.