The Politics and the Economics of the Global Financial Crisis
The purpose of this Commentary is to share some thoughts on the complicated political and economic situation that faces all of us, in different ways, throughout the world.
I intend to first set the larger overall political context in which we find ourselves, explain why this financial crisis is so deep and long lasting, offer some thoughts about the specific situation in the United States, Europe, and China, and finally draw a few lessons from the crisis.
We are now in the middle of a global economic and political crisis, the intensity of which is unprecedented in the post–World War II era. The strains from this crisis, which takes different forms in different countries, have spread throughout the world. Many governments have already fallen, and more will do so in the years ahead because of persistent unemployment and popular anger and distrust. Last year in China there were 189,000 riots and mass incidents due to local grievances and broader issues. Unemployment, inflation, and painful budgetary dilemmas have made the management of politics extremely difficult for leaders all over the world. And we are now only at the middle, not the end, of this painful protracted period of economic distress and popular discontent.
First, let me make a general point about political instability. Two-thousand five-hundred years ago, Plato in his Republic and Dialogues, gave us an intellectual framework for what can happen to forms of government over time. Plato writes that democracy is not a permanent condition, but only a stage in a broader political cycle that begins with tyranny, evolves into oligarchy, shifts into democracy, falls into anarchy, and then returns again to tyranny.
Plato describes this process. He writes that when tyrants like Mao and Stalin pass away, a collective leadership process, which he calls an oligarchy, often replaces it. Initially the people welcome the new oligarchy because it is such an improvement over the bloody tyrant, and people often view the new oligarchs as patriotic servants of the country. Over time, however, Plato writes that the oligarchs become corrupted and lose their prestige, which appears to be happening today in China and elsewhere. Pressures then build to broaden the base of the oligarchy until a democracy evolves. This democracy, Plato asserts, can eventually fall into anarchy after politicians promise election benefits to the people that exceed the ability of the state to afford. Plato says that eventually the drones in the hive outnumber the worker bees, and the hive itself becomes unsustainable. Shortages, inflation, and various destabilizing social phenomena appear, as happened in the final days of the Yeltsin period in Russia. This produces popular anger and eventually a brief period of anarchy. Anarchy never lasts very long, however, and often a new tyrant emerges from this anarchy, who brutally establishes his vision of order.
The challenge Plato’s thesis offers us today is to preserve our precious democracies by managing our current economic problems intelligently and not letting them deteriorate to the point that demagogues from the political world are given space to return to power, as happened in the l930s.
But as we think about Plato’s political cycles, it is important to remember that history suggests that such cycles tend to run clockwise, not counterclockwise. In other words, democracies usually emerge from decayed authoritarian regimes. They seldom evolve from angry, confused, and violent mobs in the streets. A new tyrant is far more likely to emerge from such conditions. We are all hoping that the Arab Spring will prove to be an exception to this pattern.
So this Platonic cycle is the larger political framework that I would like to ask you to bear in mind as we move forward to address the very difficult, painful, and multifaceted global economic crisis we now face.
Credit and Asset Bubbles
The second general point I would like to make has to do with the ultimate roots of this crisis and the reason why it is lasting so long and is so hard to deal with. This is not an ordinary recession.
The Austrian school of economists believes that excessively loose monetary policies, which generate credit and asset bubbles, need to be avoided at almost all costs. That is because bubbles lead to busts, which saddle economies with massive losses, heavy debts, protracted unemployment, and dangerous politics.
Excessively easy money is what caused the Japanese financial crisis, which began in l990 and continues to do this day. Easy money combined with open capital markets triggered the Asian financial crisis in l997 with the big real estate credit booms in Thailand and elsewhere.
Easy money fueled the “dotcom” bubble and the subsequent real estate bubbles in the United States, Spain, and elsewhere. In today’s world of open capital markets, this easy money can also originate from the low interest rates of a large neighbor’s monetary policies.
Of course, many other necessary enabling elements were required to build and prolong these assert bubbles: failures by regulators, strong pressures from financial markets to let the wild parties continue, assurances from rating agencies and others that markets remained safe and sound, individual investors who were increasingly blind to the risks, the herd instincts of bankers, and all the rest.
But William McChesney Martin, the longest-serving chairman of the U.S. Federal Reserve Bank, got it exactly right when he said that a key responsibility of a central banker is to take away the punch bowl, just when the party is really getting going.
My good friend, Jean Claude Trichet, addressed the problem of credit and asset bubbles in a remarkable speech he delivered to the Jackson Hole Central Bank conference in August 2009. This speech, entitled “Credible Alertness Revisited,” is available on the website of the European Central Bank (ECB) in Frankfurt (http://www.ecb.int/press/key/date/2009/html/sp090822.en.html), and I commend it to you. In it, he attacks the thesis that asset bubbles cannot be identified as they develop and that the way to address them is to wait until they finally burst—and then attempt to stabilize the shaken financial markets with aggressive monetary easing and injections of liquidity.
No one has successfully challenged Trichet’s 2009 analysis demonstrating exactly how asset bubbles can be identified before they become a major threat to market stability and in extreme cases to the financial system itself. This speech should be required reading for every newly appointed central banker and finance minister.
Why Recessions Caused by Asset Bubbles Are So Protracted
A credit bubble that fuels soaring real estate, equity, and commodity price inflation can generate immense short-term wealth for major sectors of the economies involved. Newly affluent consumers and investors create broad new demand and growth in the economy. This surging demand triggers increased capital investment in the sectors influenced by the growth spurt that results. But since credit bubble demand is ultimately unsustainable, this new capital investment and the enhanced growth that accompanies it, in effect, is borrowing growth from the future. When the bubble bursts, demand flags, and the economy is burdened by excess capacity and supply. Thus one of the potential drivers of future growth, capital investment, is crippled. If the excess capacity involves real estate and retail investment in an economy heavily dependent on those sectors, as in the United States, this excess capacity becomes a major obstacle for new growth.
Credit bubbles, by definition, involve interest rates where risk is not fully priced into the cost of money. As low interest rates fall even further in the middle of the bubble era, banks, pension funds, and individual investors who manage money are driven increasingly into higher-risk investments, sometimes heavily leveraged. This increases vulnerabilities when the inevitable day comes that risk belatedly returns to the cost of money and refinancing becomes increasingly problematic. As markets grow more nervous, creditors move to the shorter end of the market, in the belief that they can extract themselves more easily from ultra-short-term risk exposure. This leaves banks and other institutions increasingly dependent on ever-shorter-term liquidity. Should markets suddenly grow more nervous, the banks can find that they themselves are unable to refinance, and a Lehman Brothers situation can rapidly evolve, impacting all connected markets and institutions.
Those who have invested heavily at the peak of the credit and asset bubbles are faced with enormous losses and subsequent debt. This triggers defaults, which weakens banks still further and cripples them as providers of credit for the economy until they and their indebted customers can repair their ravaged balance sheets.
Finally confidence suffers at all levels of the economy, and borrowing and risk is avoided.
The generation of my grandparents who lived through the Great Depression subsequently avoided debt, considered stock markets to be dangerous gambling dens manipulated by insiders, and became extremely conservative in the management of their personal finances. Politicians passed laws like the Glass-Steagall Act to make speculation and asset bubbles more difficult to engineer.
Central bankers tended to be like the cautious William Martin.
Eventually, however, that generation died off, and with it their historical memories of the roaring ‘20s and its painful aftermath. Sixty years later, risky old patterns in finance resurfaced, gradually at first, and then with greater and greater momentum. Those who presided over the feast were given God-like status, only to be cast down like the Wizard of Oz when the party crashed.
The problem now is that it takes years after the credit bubble bursts for the excess capacity and debts associated with it to be liquidated at all levels of the economy—from the consumer, to the banks, to the governments. During this time, high unemployment persists, driving governments into countercyclical Keynesian spending and central banks into more experiments with unconventional monetary policies.
But central banks discover that however much liquidity they provide to retail banks, the credit worthy demand for money is so muted that the desired monetary expansion fails to materialize. The liquidity does produce short-term impacts on equity and commodity markets. This liquidity also flows like a river to other open economies with higher interest rates. This complicates the management of monetary, currency, and trade policies elsewhere. In extreme cases, it results in capital controls of various types and protectionism.
Central banks do have the ability to provide liquidity to banks under strain, and this is important. Central banks do not, however, have the unlimited ability to eliminate balance sheet problems for consumers, deep structural competitiveness obstacles to growth, or unsustainable fiscal problems. Attempts by desperate central banks to exceed their limits could easily create further and deeper problems for the impacted economy, including inflation.
Overly ambitious monetary policies from central banks that trigger unsustainable credit and asset bubbles leave fearsome legacies. Once these bubbles burst, governments have no easy short-term solution to the disastrous follow-on consequences. The bigger the bubble, the longer it takes to recover from its consequences, and the more political radicalism from the right and the left can begin to seep into the political space.
Post-Crash Policy Options
There is no one-size-fits-all solution to the global financial, economic, and banking crisis that now exists. Conditions vary with each country and region. Each is in a somewhat different stage of the process.
The IMF in its latest World Economic Outlook addresses many of these individual issues, and I commend this report to those of you interested in a deeper perspective. For now, I am going to make just a few relevant observations.
In the real world, politics is the art of the possible. A theoretical solution to a major economic downturn such as the one we now find ourselves in is of limited value if there is no practical way of implementing it in the real world. Transfers of wealth are involved here by taxes and inflation. The apportionment of losses, the pain of pension reductions, and the erosion of other existing benefits come into play. Leaders who fail to retain a critical mass of political support soon find themselves writing op-ed articles in newspapers instead of running governments. Only by understanding the real world of local politics can one understand what political leadership can or cannot extract from parliaments and the electorate. But policy options and dilemmas do exist, and painful decisions must be made and marketed, or events, including sudden massive market or political pressures, will drive policy.
In the current crisis, we have the example of the Baltic countries, which took their budgetary lumps early, accepted lowered growth rates and living standards, and created a solid basis for future growth, with the help of the IMF and others.
In the case of Japan, a very different approach was used. The Japanese government tried to spread out the pain and losses over more than a decade. There were reasons for this different approach. The Japanese asset and credit bubble was simply titanic. At the peak of the real estate bubble in Japan, the tiny island in the center of Tokyo where the emperor has his palace, was considered to be worth more than the entire state of California, with all of its farms, homes, and productive facilities. Japanese banks, with the support of the government, encouraged individuals and companies who owned land in Japan to use this land as collateral and borrow vast sums of money for speculative purposes. Since money was essentially free, and the process blessed by the authorities, speculation grew rampant. All asset classes in Japan soared, including the Nikkei, which rose to five times its current level.
When the bubble eventually burst, trillions of dollars of collateral vanished. Immense losses occurred to banks, companies, and individuals. The economy faced utter ruin.
Part of the Japanese government’s solution was to borrow immense sums from the people’s remaining private savings and spend them on infrastructure and consumption. One after another of Japan’s famous banks collapsed or was merged into the few remaining stronger institutions. The central bank experimented, under intense foreign pressure, with various palliative measures. This massive debt accumulation has gone on for two decades.
The problem is that the longer this Keynesian policy of borrow and spend continued, the higher the public debt grew, until debt service charges in Japan have become nearly a quarter of the entire fiscal budget, even as interest rates were depressed to unprecedented levels. Eventually this debt grew to exceed 238 percent of GNP. The Japanese government is now trapped into a long-term ultra low interest rate policy, distorting capital markets in the process.
Addressing the necessary adjustment caused by the bursting of an asset bubble will normally fall somewhere between the quick, sharp, painful Baltic model, and the Japanese model of a very long-term sustained exercise in Keynesianism. This process of postponing adjustment is also called “kicking the can down the road,” and available domestic savings in Japan to finance this policy are running out.
I have great sympathy for the Japanese dilemma. The l990s asset bubble was so vast, and the resulting losses and debt burdens so great, and the anger of the Japanese people so intense, if the Japanese government had attempted to adopt a version of the Baltic approach to their problems, there could easily have been a social revolution and economic implosion. Given the size of the Japanese credit bubble and its frightening aftermath, a Baltic-type solution would have been both impractical and counterproductive. But the other policy extreme is also proving to be a longer-term disaster for Japan. If unaddressed, Japanese leaders could soon find themselves under pressure to adopt an inflationary policy to reduce the crushing debt. This will further unsettle credit markets, which already are nervous because of recent rating agency downgrades of Japan.
The question now looms: how will Japan craft an exit strategy from its vast public debt without triggering a new crisis. Japan’s fractious and paralyzed politics have thus far greatly limited what the government can do by way of new taxes or reduced spending. The danger is that at some point, Japan will not be able to roll over its vast bond issues without an interest rate increase that triggers a fiscal and national crisis.
The Broader Picture in the United States, Europe, and China
The U.S. economy is still growing at a very modest pace, but the leading indicators, including electricity consumption and the jobs reports, suggest a slowing down later in the year. So while the United States is farther along in its recovery than other parts of the world, there will not be sufficient growth this year for us to serve as much of a locomotive for other economies in difficulty. Moreover we have the challenging task of addressing our own unsustainable fiscal and current account problems and eventually unwinding part of our swollen central bank balance sheet. I am reasonably confident, however, that you will see gradual progress on these matters after our election campaign ends in November. I would not be surprised, however, to see another attempt at quantitative easing later this summer in response to flagging growth and political pressures.
The euro zone faces the prospect of a new recession and all the political strains that will accompany it.
The politics and negotiations that have characterized Europe’s efforts to cope with the region’s multifaceted sovereign debt, banking, and fiscal problems have resembled an extended poker game with gigantic states. The richer northern members of the euro zone are encouraging the more vulnerable debtor countries to follow modified versions of the Baltic austerity model to give markets and their own electorates confidence that there is light at the end of the euro tunnel, and not just vast transfer payments, moral hazard issues, huge contingent liabilities, and eventual inflation for the donor countries.
More Europe, not less Europe, is said to be the solution. But nationalism is rising, not falling, in the euro zone. Questions of legitimacy of the whole elite-driven European project exist in the minds of many ordinary people. Patience with the failure of Greece to follow through on promised reforms is in very short supply.
The more vulnerable economies face painful reductions in public payrolls, pensions, and other benefits. Potentially impacted constituencies would clearly like to shift more of the costs, risks, and contingent liabilities onto the tax bases of other countries and multilateral institutions. The differing expectations of both creditor and debtor countries’ electorates cannot be fully met. Concerns about the possible collapse of the euro currency itself hang over these negotiations.
Greece is obviously the most extreme case of an economy in trouble, and we have just been through an agonizing weekend as the votes were counted on what amounted to a referendum on the euro and the nation’s negotiating tactics. Greece’s economic problems run very deep. When Greece entered the euro zone, its borrowing costs were greatly diminished, and the political class took full advantage of these low borrowing costs to finance a credit-driven boom. The Greek economy promptly doubled its GNP. An engineer driving a locomotive in the Greek-owned railroad receives twice the salary of his German counterpart, and he can retire with a lavish pension at age 53. Militant unions support such generous measures. Many of the Greek people would very much like these benefits to continue, if only funds were available.
The problem is that there is no short-term solution to the partly artificial Greek economy kept alive by years of borrowed money. Any country has only three variables in managing its economy: how efficiently it uses available capital, labor, and resources. Greece has encouraged a whole generation of its people to seek sinecures and government employment rather than jobs in the private sector. It has spent its borrowed money on consumption, rather than investment. It will take at least a decade to adjust that economy in a more sustainable way, and in the meantime, the politics of both Greece and its creditors will be extremely difficult to manage.
In the 1980s, the United States faced a similar debt and adjustment-related problem in Latin America. During this period, Brazil signed 11 letters of intent with the IMF and did not fully honor a single one. But Brazil’s bank loans were rolled over again and again, notwithstanding its IMF problems. But the United States used the time gained to design and market a whole new productivity-based economic model for its interaction with Latin America. It was later called the Washington Consensus, and it worked.
The challenge now facing the euro zone is to use the time gained in its own multiple versions of “kicking the can down the road” to design and market a credible medium-term strategy that offers the realistic prospect of fiscal sustainability, gradual adjustment, and a viable euro and banking system. The competing taunts of the Greek and German soccer fans in Poland recently underscore the problems (e.g., the Greek fans’ “We will never pay you back!”).
Because Greece is imbedded in the European Union, which has a democratic requirement for membership, the odds favor retaining Greek democracy. But it will undoubtedly be threatened from time to time in the years ahead by its angry and disappointed citizens, just as Plato warned.
Fortunately the problems of the other euro zone countries are more manageable. The results of the recent Greek election will give Prime Ministers Mariano Rajoy and Mario Monti more time to implement their own needed adjustments in Spain and Italy. It will also give the rest of the euro zone more time to contemplate additional supportive measures, including likely heavier ECB involvement in the process.
Rallying political support in Germany and elsewhere for additional support measures is a time-consuming and difficult task, made more difficult by Germany’s accumulating public debt and the chaotic politics elsewhere in Europe. This results in last-minute decisions that not only are unsettling to markets, but also greatly increase the cost to all parties of financing the adjustments.
China has its own set of problems. During my last visit to Beijing, top leaders warned me that China faced the threat of stagflation in the years ahead, that China’s current economic model was unsustainable, and that corruption was causing serious issues for the government at many levels. Prime Minister Wen Jiabao went into these matters in greater detail in his March speech to the National People’s Congress (available at http://www.xinhuanet.com/english/special/2012lh/index.htm).
This year there were so many riots and mass demonstrations in China partly because the rule of law is insufficient to cope with corruption and official abuse of the people. This tells me that another eruption like that which occurred in l989 is not impossible in the years ahead. Again, we think of Plato’s cycle of government.
The bad news is that when credit and asset bubbles burst, the pain, debts, and adjustment needs can last for many years, and the political strains on governments and peoples in the impacted countries can pose a mounting threat to political stability.
The good news is that the world has enjoyed a half century of rapid economic growth and rising living standards, driven by technological developments, globalization, peace, and the mass-based education that undergirds this productivity-based long wave.
Millions of people who were working in rice paddies and farms have gone to the cities and taken up higher productive employment. The children of these factory workers are becoming even better educated, and some are already moving into the highest levels of the economy and science all over the world.
This trend is not going to change.
Yes, there will be a slowdown as we all adjust from the credit-driven excesses of the past decade, but it will only be a pause.
Our challenge now is to deal with our needed adjustments with patience and imagination and not turn to those who offer unrealistic solutions that will only further delay the global recovery.
I am confident that we will not make the political mistakes of the first half of the last century, and I look to the future with both hope and optimism.
(This Commentary is based on a speech delivered by Richard McCormack in Budapest, Hungary, on June 19, 2012.)
Ambassador Richard McCormack is a senior adviser at the Center for Strategic and International Studies in Washington, D.C. He served in five U.S. administrations, most recently as under secretary of state for economic affairs, and G-7 sherpa for President George H.W. Bush. Earlier, he was the executive vice chairman of Bank of America.
Commentary is produced by the Center for Strategic and International Studies (CSIS), a private, tax-exempt institution focusing on international public policy issues. Its research is nonpartisan and nonproprietary. CSIS does not take specific policy positions. Accordingly, all views, positions, and conclusions expressed in this publication should be understood to be solely those of the author(s).
© 2012 by the Center for Strategic and International Studies. All rights reserved.