Believing in Gold

Since gold has been skyrocketing for a while, there is hardly any day where financial columnists ignore the topic. Warren Buffet does not like gold, he thinks it is an unproductive asset, not yielding any interest or dividends. That is of course true and if you want to support overall economic growth, you should not withdraw your wealth from the economy and store it in unproductive gold. If you happen to be as rich as Mr. Buffet your individual actions might indeed make a difference, but most of us are more concerned to preserve or increase our personal wealth.

There are three main sectors creating demand for gold: investment, jewelry, and industry. The latter two are to a certain extent predictable. Gold is more or less a normal commodity like any other. If prices go up, demand will decrease. The interesting part is gold as an investment tool. So why are people investing in gold after all? Mostly because they believe that it will preserve its value during difficult times. The trust in gold as a crisis hedge has historic reasons and not too long ago paper money had to be backed by gold reserves (the so called gold standard). Whether gold lives up to its promise, taken the other two demand sources aside, is pure market psychology. If people stop believing that gold has any lasting value, its price will collapse. With the same justification, investors could decide that diamonds will preserve wealth better and start investing in it at a grand scale. Having said that, it should to be made clear that a complete shift of investors’ perception of gold is highly unlikely at this point.

Why are gold prices going through the roof right now? The story with people needing to believe in the value of their investment can be applied to another (un)common investment: money. If people do not believe in the value of money anymore, it will not be worth anything. Hyperinflation and currency reforms are historical facts and investors know that all too well. However, there is one big difference between gold and money. Gold is scarce. Its circulating amount cannot be arbitrarily increased.

As long as central banks and politicians are gradually undermining people’s trust in the value of paper money, they will keep looking for alternatives. Quantitative easing (a euphemism for printing money) and state households increasingly getting out of control will only further nourish that sentiment. With central banks shifting to the buyer’s side and investors just starting to re-discover gold as an investment tool, the prospects for the yellow metal could remain bullish for years to come. Unless investors stop believing in it….

Will cheap dollars create the next crisis?

It is astonishing how quickly times can change. A country like Brazil, long dependent on foreign capital injections, introduces measures to prevent excessive inflow of capital. It seems quite counter-intuitive that countries would hinder investment. The question is why are countries such as Brazil and potentially other Asian economies doing it?

An obvious reason is that they fear that the cheap money creates uncontrollable asset bubbles and triggers yet another crisis. The Federal Reserve has been upholding its historically loose monetary policy for an extended period of time and has shown no intent to stop any time soon. Lots of American investors seem to realize that the U.S. economy is not recovering quickly let alone strongly. Hence, they look elsewhere for growth opportunities. This is so far a normal economic allocation process but the past (or should I say current) financial crisis has added another layer to the situation. Emerging economies have painfully experienced how quickly foreign money can be withdrawn. Higher growth prospects are luring investors into emerging markets. However, once risk aversion increases owing to a looming crisis most investors flee back into the dollar. Such a sudden capital withdrawal leaves a country quite helpless, in particular if a domestic crisis has already started to unfold. Capital flight makes it often all but inevitable that the affected country has to ask for foreign assistance. Aid comes mostly in forms of IMF money, but is always attached to some form of interference with a state’s sovereignty.

In general, I believe that the number of economic problems in a capitalist economy is limited and the same problems occur again and again. The exact circumstances and the severity of the problem might not be the same, but in principal the world has seen capital controls before in order to fight certain economic woes. In addition, it seems that if a certain area is “over-liberalized” as I may call it, politicians that usually are eager to do something, re-discover such a field and start re-regulating. Capital controls have been virtually non-existent in most parts of the globalized world. It seems to be destined to change in the future.

What are possible consequences? It seems quite unlikely that capital controls can prevent the influx of money effectively enough. As a result, economies that are picking up speed partly lose their ability to slow down the economy through limiting credit supply. Almost inevitably, this will create asset bubbles of some sort. However, it is quite difficult to predict when and how quickly bubbles burst. Contrary to popular believe there have been many economists warning of the recent credit crisis. The timing and the exact unfolding of events was almost impossible to foresee. Personally, I feel it is not very likely that any of those asset markets is in danger to collapse in the near future. Cheap money will be available for quite some time and officials of potential candidates such as Brazil or China (the real estate market in Hong Kong seems to be increasingly running hot) seem wary of the situation. Usually it requires a lot more blind optimism for markets to turn. Cheap dollar supply is clearly an interesting issue that might occupy market participants for some time to come. It does not, however, pose an immediate threat to asset markets in emerging markets.

Lisbon Treaty

Just a short note on current political events. I consider it a historic event that the Lisbon Treaty can finally go into effect (See the NY-Times article for more details). The delay caused by Mr. Klaus will now become a historical footnote. There have been endless discussions on whether the process of ratifying the treaty was democratic or not. Some of them were partly justified some not. However, I hope those concerns will gradually subside and everybody can see the vision a unified Europe offers. Closer cooperation in most areas of politics, economics, and society will be for the benefit of all.

Keynesian versus neo-classical policies - A never ending struggle?

I find it both entertaining and fruitful how prestigious economists have gotten into fierce fights about the right approach on how to handle the economy. If you have a lot of time, you can read through Krugman’s How did economists get it so wrong and if you are still interested afterwards read through Levin’s open letter response. What is the whole struggle all about? Mr. Krugman claims that markets do not function without heavy government intervention and current models based on rational behavior are basically worthless. This questions the merits of a whole generation of economists and fierce criticism will inevitably follow such statements.

So who is right and who is wrong? It seems that, all the progress in technical modeling aside, economics will always be divided into two opposing views. One, based on the insight of Keynes of the 1930s, will propose state intervention in order to mitigate the amplitude of business cycles. The other, often called “neo-classical” school, will advocate a minimal role of the government that interferes as little as possible with the economy. There are a plethora of approaches somewhere in between imaginable and for the most part economic policy will not opt for one of the extremes. Although scholars have coined the term “neoclassical synthesis”, which means combining both views into one single approach, such a synthesis in the Hegelian tradition is a far cry.

The changes of political sentiment towards one of the two options seems to be almost as cyclical as the economy itself. After the Keynesian revolution, many economists believed they had solved the riddle of business cycles and could control them from now on. Stagflation in the 1970s gave rise to the opposing view again, successfully put into practice by Ronald Reagan and Margaret Thatcher. This movement is closely connected with Milton Friedman and is often described as monetarism. Monetarism proposes that the role of the state should be reduced to providing a stable monetary policy in order to ensure price stability. Now the pendulum is about to swing into the other direction and politicians are again following the Keynesian stimulus promise. To make it clear, Keynes was never out of the picture. The Federal Reserve intervened heavily and tried to steer the economy by contracting and expanding money supply anti-cyclically.

What seems to have happened in the current crisis is that we have gotten into something economics students learn in their introductory macro courses: The liquidity trap. In short, this phenomenon describes a situation where monetary policy cannot stimulate the economy further because interest rates are already close to zero and there are no negative interest rates (well, Sweden actually thinks there are, their banks have to pay now to deposit money at the central bank). According to Keynesian theories we would need, as the only remaining option, anti-cyclical government spending or nowadays more often tossed as a “stimulus package”. This involves much more political troubles as the public takes much more notice of such actions (they feel it affects them more directly in forms of higher taxes later, although theoretically expansive monetary policy can have the same wealth effect through inflation). In addition, the central bank is politically independent and can make its policies without approval of any parliament, whereas stimulus money needs the consent of democratic representations.

Personally, I think the truth lies somewhere in the middle. Both approaches have helped economies in different periods. It is and will stay a constant struggle between the two. Thinking a bit into the future, over-regulation and heavy government intervention seem to be down the road. This already paves the way for deregulation once governments realize the growth potentials of the economy have substantially shrunken. And the pendulum swings back again….

Are there economies of scale in banking?

I had the pleasure to listen to a quite inspiring lecture by Amar Bhidé who argues for more personal relationships in finance and banking. The lack of the latter and their replacement by mechanical, engineering-like, one-fits-all approaches, might indeed have contributed a fair share to the immense credit losses of the recent past. Mortgages have not been given according to individual judgment in a case by case decision, but based on corporate guidelines. “Bankers” selling such credit were actually salespeople that encouraged (over)-stretching those rules as they were not responsible for credit quality, but profited from a high sales record. The proposal of bringing back personal relationships into banking and finance means we have to turn back time, say about thirty years.

Credit ratings based on volatility measures and standard criteria are to be replaced by personal judgment again. Taking this idea a step further might indicate that a change in the regulatory framework and an increase in capital requirements, as it is on the table right now, will not eliminate the systemic risk in finance. This would mean politics is aiming for the wrong trade-off. Higher capital requirements for financial institution will in one way or another decrease growth potentials in the real economy. This is seen as a trade-off against a more secure financial system. If the argument of a lack of personal relationship holds, higher capital requirements and stricter regulation come at a cost that is not offset by the desired gains. The trade-off should be to scale back or reverse the central decision making in banking. True, this would reduce the overall efficiency of banks, but so would the current plans of stricter regulation. All in all, it seems economies of scale are limited in banking and they have been overly exploited at significant long run costs, far outweighing the initial efficiency gains.

So back to the old days where you went to a bank and had to convince a person and not a form that you should get a loan. Doing this would probably help to keep the numbers of employed bankers from declining even further. The jobs, however, will not be the fly-high, get-rich immediately ones, they will be boring, average-pay banker jobs – as we remember them from some time ago.

A Chinese view on international credit flows

It is a well known phenomenon that the Chinese economy buys a significant amount of U.S. Dollar denominated debt every month, partly offsetting Chinese trade surpluses with the U.S. Thereby China supports the status quo of the exchange rate of its, as many argue, undervalued currency. This creates a situation of mutual independence as a necessary adjustment of the exchange rate would hurt both countries. A sharp depreciation of the U.S. Dollar would cause trouble for the U.S. economy in many forms such as increased costs for energy imports and higher finance costs as a result of waning trust in the dollar. For China the problem is simple: their huge dollar reserves (around 2 trillion U.S. Dollar) would decline in value. So far this dilemma is well-known.

However, there is another layer which presents itself taking a Chinese perspective. The bonds Chinese private households, the government, and firms put their money in, yield relatively low interest rates. This is mostly due to the still dominant position of the dollar and the U.S. economy. On the other hand, U.S. companies pour their dollars back into the Chinese economy in forms of investments. Those investments are by no means low-profit investments and generate significantly higher profits. To put it short and sweet, the Chinese lend money to the U.S. at a low interest rate and U.S. firms and investors come back and invest getting a high return on their investment.

Naturally, one might think: Why not leave the money in the country from the start? That is, of course, what Chinese economists try to suggest and shift the investment flows towards domestic investments rather than investing abroad. This will not happen overnight, but in general Chinese economists seem to be often better heard in their country than elsewhere. Some even suggest to try to make the Renminbi the dominant currency, that is to say most debt should be denominated in Chinese currency. That is a far cry from now, but considering the population ratios and the current troubles of the U.S. economy, not impossible in the very long run.

The rise and fall of Wall Street

It is a much discussed issue these days and also Mr. Obama mentions that it is no loss if not every individual with analytical skills is headed for Wall Street. How right he is. There is nothing wrong with working in the financial area and I happen to be interested in it as well. I remember when I was choosing my study subject that I went with my guts, I have had a passion for economic topics early on and I went with it. That’s what many do and I was convinced it is best to choose according to your talents and interests, not where the job prospects are best or the highest salaries are waiting. Others might, of course, opt for the direction where the money is and seldom has the choice been so clear and easy: Finance is where the money is.
Well, it used to be the dot-coms before and I am too young to know what it was before that. However, this time even those who didn’t decide with their briefcase in mind in the first place got a second chance. Either they were lucky enough to be in some natural science field or if not, whatever you did before, you could go to a horrendously expensive business school for your MBA (I always wonder how expensive a year of education can be; if Paul Krugman explains international trade theory to me I might have sort of a headstart, but only to certain extent and I am not sure if I didn’t also get it those days with my old, rather unknown professor – but ok as an economist I should know – it’s just supply and demand). So it was comparatively easy to get into finance and even if it hadn’t been your passion, the prospect of big money was convincing enough. Together with a positive sentiment in society towards those who amounted material riches the smartest and the most ambitious went into finance. The talents helped making banks more and more inventive and exploit every smallest opportunity to make profits. Such talent involved obviously not only those who could crunch numbers, but also well connected political lobbyists that helped soften financial oversight. As a result, the boom in finance was alive for an unusually long time. Economic reasoning would suggest that one sector cannot uphold overly competitive salaries for an extended time because more and more talent will stream into those sectors and drive down wages. This did not happen this time and high-paid jobs remained plentiful.
However, the boom happened in a very sensitive economic sector. Financial institutions always walk on dangerous grounds and a failure of one institutions carries the risk of causing a collapse of the whole system. Exactly that happened and instead of regulating itself by decreasing wages the system fell apart. It is only natural that the people involved in finance want to go back to their old ways. The reason why those employed in finance made so much money is owing to an intrinsic characteristic of banks: they can take on huge risks promising them enormous gains in the case of success but may drive them out of business otherwise. Since nobody owns a bank personally and is only an employee, it is quite natural that too much risk is taken on. If the bets don’t win, the bank fails and the taxpayers needs to come up for the bill and if everything works out the jackpot is waiting. So the upside is on your personal account and the downside on somebody else’s. The problem is called moral hazard. Of course, for somebody in finance this is a good deal and why not continue with it after society paid the bill for the last disaster and pocket some money until we send them the next invoice.
There is nothing wrong with paying high salaries to top executives for that they are achieved leaders carrying lots of responsibility. However, the way to get rich should not be open to any newly graduated that can place some bets and ultimately risk taxpayer money.

Risk aversion and economic growth

The concept of risk aversion is crucial for many basic theories in finance and portfolio theory. To give an example: Stock A has an expected return of 10 % per year with a standard deviation of 15 % and stock B has the same expected return and a standard deviation of 10 %. The term standard deviation expresses the risk of the stock; the higher the standard deviation the higher the risk. As a result, stock B offers the same expected return as stock A, but is less risky. A risk averse person would now prefer stock B over stock A. Depending on the individual risk aversion a person is willing to give up a certain amount of expected return in exchange for lower risk. Generally, people are assumed to be risk averse and few scholars doubt that the vast majority of individuals would opt for stock B in that example. Unfortunately, the world does not always present itself in such a clear, straightforward way. A lot depends on how such a decision problem is presented and how complex it is.

I want to present another, quite hypothetical example. Assume there are two economies A and B. Both have an expected annual growth rate of 3 % (I’m optimistic here). In line with the example from before, economy A has a standard deviation of 2 % and economy B of 4 %. That should express that the growth rate of economy A is in average much closer to the expected, average growth rate than economy B. Which economy would you rather live in? How much growth would you be willing to give up in exchange for a more steady economic growth? Again, the world is not that simple as in that problem and it is not that easy to choose or create economies in the proposed way. There are a multitude of factors that influence how sensitive an economy is to the boom and bust cycles that appear naturally in capitalist economies. Recently one major factor has drawn much attention: regulation and oversight of the financial system.

The world has learned again, the painful way, how important appropriate regulation of the financial system is. There is apparently a clash of the more risk tolerating Anglo-Saxon tradition and the Continental European tradition of more state control and intervention. It does not come as a surprise that all parties are fiercely rallying for their stance on how regulation should be shaped in the future. In the past it was much easier for each country to model its own regulatory framework and decide on how much risk the financial system is allowed to carry. Today, this is not possible anymore. The system falls with its weakest element. The interconnections of global finance and trade are so strong that no single country or block can isolate itself from a financial meltdown as the current one. Most Asian countries have healthy financial systems – still they suffer from the failures in the U.S. and Europe. Therefore, it is logical that those interested in a more conservative and restrictive approach on regulation are concerned that their efforts at home are in vain if other important actors do allow for lax regulations. Ask the German or French governments which have been pushing for stricter regulation long before the crisis started; they could not prevent that their banks (especially the big corporate ones in Germany making up only about 25 % of the market) got caught up in the turbulences and mounted huge losses the taxpayer has to pay for ultimately.

At the end of the day there is nothing the international actors have to agree on and there most probably will be no comprehensive regulation package guaranteeing global oversight as the more conservative nations wish for. They will rightly perceive that as a setback since they cannot achieve their desired, risk averse regulatory framework. As a matter of fact the Anglo-Saxon world has more pull in that issue not because they are bigger or more important but if they do not put financial institutions on an equally short leash they will almost inevitably drag others into a more risky sphere. From the Continental European point of view this appears like a classical prisoner’s dilemma where they pay the cost in terms of slower growth and others profit from their efforts to decrease the risk for the global economy. This is, however, not such a clear case as e.g. the environmental question where everybody at least acknowledges the common goal (that doesn’t necessarily trigger appropriate action). It is rather a clash of culture, attitude, and believe when it comes to economic policy and there is no right or wrong – at least not necessarily.

To bring in a personal note, I believe that most individuals would opt for a more steady economy if asked the question from before directly – which they are, of course, never confronted with that way. A quite complex structure of socio-economic and political factors builds what I described as an economy carrying more or less risk. Taking into consideration what happens right now on a global scene – riots in various European countries, migrant workers lightly forced to go back home, not least to mention the poorest and most vulnerable on this planet struggling for bare survival – is in my opinion evidence enough to opt for a tighter approach on financial regulation. The wealthy people of this world can wait another year to buy a second home or scale back on some other luxury whereas for the weaker actors of the world economy such a meltdown as the current one is an existential thread. And even the wealthy western world might sleep better knowing that their jobs will most likely exist the next day and they can provide a steady home for their families.

A lack of intellectual flexibility!

I used to have a quite favourable opinion of Mr. Krugman and I enjoy reading his blog in the New York Times. He is a quite outspoken personality and utters his views without much hesitation. I also tend to agree with many of his economic positions and think he deserves the Nobel price that he received for his work on trade theory. He once denied a government post as he considered himself to outspoken for the policy business – I begin to understand why.

I was reading recently that he finds the German response to the financial crisis a “great disappointment” and doubts the “intellectual flexibility” of the German chancellor Angela Merkel. The German finance minister is even worse; a Republican-like (that is obviously already quite a bad stigma) politician who issues know-nothing diatribes. Note, we are talking about economic views here. I am not writing about this because I am a particular fan of Mrs. Merkel, but those statements are quite unrefined in my opinion. As a Nobel laureate Mr. Krugman knows that there are different streams of thoughts in economics and he naturally thinks his position is the right one. There is nothing wrong with that. To disqualify a different view as a lack of intellectual flexibility and even a great disappointment shows a lack of respect for others and could be deemed arrogant.

Having said that we can discuss on an objective level what makes Mr. Krugman so upset. He repeatedly argued that the American stimulus is much too small to have a positive effect, hence he rallies for an increase on both sides of the Atlantic. I fully agree on his point that the effect of the stimulus will be far too small to have any significant impact on the economy. Whether Keynesian policies can get us out of the crisis is an open question as is the amount that would be necessary to do so. Mr. Krugman already denies political realities in his home country where at the moment political will seems to be lacking to take even bolder action and he does not understand that the political fortunes for putting unprecedented amounts of taxpayers money at risk are even worse in some European countries. He might be right that only a much larger stimulus could save the economy. However, if you know that there is no political environment to raise the required funds and smaller stimuli are just a drop in the ocean, why would you destroy your fiscal budget for years, if not decades in such an effort? If you see it that way the lack of intellectual flexibility lies elsewhere. And: it is not a lack of intellectual flexibility to dare to have a different opinion than somebody else – even if this somebody else won the Nobel price.

Should we end economic growth?

Should we end economic growth? There are few things that can be investigated with experimental methods in economics what is one of the inevitable weaknesses of this science. Sometimes, however, natural experiments occur. The arguably biggest natural experiment in economic history is the comparison of a planned economy and a capitalist, individual based system. Few would doubt that the latter showed to be superior. Libraries could be filled with writing on this topic, but I want to point out only two things. First, the idea of equal distribution of wealth is still considered as positive and that is why communist ideas have never entirely disappeared. Second, planned economies just do not work and that can be proven by many examples in history and the reason is simply human nature. Individuals seem to constantly strive for more and it does have a negative impact on economic performance to deprive them of any incentive to achieve more than others.

To get back to more up-to-date issues, there is a question that is not so far away from those initial thoughts. Is there a need to further expand our economies and keep on growing endlessly? In the current system there certainly is. All industrial economies are constructed in a way that they only function when there is constant growth. The current financial meltdown shows this in its extreme: everything was built on ever faster growing asset prices. Once asset prices turned the other way the system nearly collapsed. Not only the financial sector relies on constant growth, governments and the connected social systems depend on it as well. There is no alternative way to pay back the huge public deficits and pay out pensions for an overaged population. There is no way to escape from the “growth trap” as I may call it – at least not in the near future.

It is not a secret that many resources are limited and cannot be exploited endlessly. Therefore, the very nature of planet earth will end this system of permanent growth one day. Admittedly, this might be a remote point in time, but there are already some signs of depletion in different areas, namely climate and energy related issues. A different question is whether it makes sense to have growth as the prior goal. Are western industrial nations not at a point where the created wealth is enough and they should merely try to preserve it? Will two cars make us happier than one? Or do four instead of three trips to a distant paradise every year enhance our quality of life? Should we not just create a system that sustains itself in the long run and make this the goal of economic policy?

This idea – that is of course not new – is in some sense as radical and hinges on the same human traits as communism does. It would deprive people of their ambition and as probably some systems would keep their growth focus the latter ones would be superior and squeeze out the new system again. Just as communism was bound to fail due to the competition with capitalist systems. Does this mean we should drop this idea and put it into the utopia corner? To answer this question I want to explain briefly some ideas of Karl Marx, who is often perceived as the founder of communist ideas. Marx described for the most part the economic conditions of severe inequality caused by the extreme capitalism of his time. He also predicted the overthrowing of the system by a possibly violent revolution. He actually was quite vague when it comes the exact form of a new system. What he caused was an enormous fear among the establishment which reacted in order to prevent Marx’s predictions. Marx´s warnings and predictions contributed to the fact that they actually did not come true in some parts of the world (in some they did of course). The capitalist system is quite flexible and managed to incorporate many of the socialist ideas that were proposed by Marx´s fellows.

An economy that is not allowed to expand will be doomed to failure for the same reasons as an economy without any income differences. However, the postulation of such radical changes will hopefully cause what the communist ideas caused: A change in the way capitalism works and the incorporation of more sustainability. We are already in the middle of this process with a shift in the perception of renewable energies and climate issues. Hopefully, the global economies will be flexible enough to undergo the necessary changes. In general, sustainability and environmental issues suffer naturally from a political problem that is often called “free rider problem”. Without a unified global leadership this is extremely difficult to circumvent as some countries profit from others’ efforts in those areas. The current crisis is extremely harmful to that process as protectionism grows and everybody is concerned with their own troubles.

To answer my question finally: It goes against human nature to abandon the concept of growth altogether and will therefore not work. Although the idea seems promising to people rightly concerned about the future of our planet, simply ending economic growth will not fix it. This shall in no way mean that we should neglect global environmental and sustainability issues and go on with business as usual. The world is steering towards a severe environmental crisis and bold action is necessary. However, the proposal to end growth is just not thought through properly and just too radical and will in the end just bring us to the point where we started. And we might not have time to try another big economic experiment to gain that insight.

Fighting fire with fire

The Federal Reserve is again printing money and buying all kinds of assets that either nobody would buy otherwise or to keep long term interests down. If the measure unfolds as desired by the FED the ability and willingness of banks to lend will be improved and both consumers and companies will have the possibility to borrow again. Let us assume this indeed works and the already heavily indebted consumers will increase their spending and the money flowing into the economy will eventually create a recovery of asset prices – and everything is fine.

Of course, I´m ironic here. All debts have to be payed back sooner or later. Take an individual perspective: What would you do if you have already taken on a lot of debt to finance all kinds of consumer goods and bought a house that is worth much less then the loan you are paying off for it? In principal, you would like to keep your spending, but the only way to do this is to take on more debt and in a couple of years you know the situation will be worse. I severely doubt that the majority of individuals would opt for taking on more debt versus a belt tightening consolidation. That is why I think the plan of the FED won´t work and if it does, it it will only increase problems in the long run. I think I mentioned something like that already: the only way out if this crisis is saving and consolidation and that will take time – a much longer time than short term thinking politician usually have.

European countries such as France and Germany refuse to support similar measures so far. This is only rational, although the short term benefits could also boost politicians’ poll results. Countries that never created such a high dependence on debt and such big bubbles are much less desperate and are wise not to let themselves be dragged into that system. Debt as such is not a negative thing and a vital part of capitalist economies, but once it becomes excessive it can cause severe damage to economies. Therefore, Mr. Greenspeen takes a fair share of the blame for this crisis. His duty as the chairman of the FED was to prevent a situation like this and he – although he frequently warned – did not act and stop the oversupply of cheap money. Mr. Greenspan used to fight fire with fire and before having to cope with the consequences, he gave over to Mr. Bernanke. The people may have changed, but the approach has obviously not.

Does history repeat itself?

Mainstream economics claims mostly the existence of equilibria that are regularly disturbed by external shocks and therefore the economy is in disequilibrium at certain points in time. To give an example: a sudden tax increase brings the economy in disequilibrium and it takes a while until it reaches the new equilibrium. Since such shocks are quite frequent economies are rarely in equilibrium. However, there is such a tendency towards it that is merely constantly disturbed by external events.

What was the event that brought the disequilibrium this time? The fall of Lehman brothers? If so, is this really an external event/shock? There is a maybe not widely known scholar, well at least I had not heard about him before I stumbled over his work. His name is Hyman P. Minsky (1919-1996) and his work explains why disequilibria (this is actually more a euphemism for crisis as I use it here) are caused endogenously, that is to say, the system creates them itself and not something external.

Minsky illustrates that in prosperous times the financial sector gets more and more lenient with its credit policies. He distinguishes between three types of credit collateralization, a hedged credit, a speculative credit, and a Ponzi credit. Hedged credits are secured by assets; if the borrower defaults the risk is limited as the lender obtains the collateral. Speculative credits are riskier and rely on the productivity of the borrower who has to generate enough revenue with the underlying business to fulfill credit obligations. The most extreme form is what Minsky calls “Ponzi” finance, that became famous lately again through Bernard Madoff and goes back to 1920 when a Mr. Ponzi created a similar fraud. A “Ponzi” scheme is the tip of the iceberg and the ability to pay interest and pay back the loan is solely based on taking on new debt. This is of course fraudulent and criminal as it ends in a certain default and the last lenders or investors lose most of their money if not all.

Minsky claims that the financial sector has a tendency to go into the direction of “Ponzi” credit and does this in increasingly innovative ways. The reason is simply a desire to grow and exploit all possible revenue channels. As said at the beginning this happens during prosperous times, so the development may continue over an extended period and even fuel further positive growth rates. This works well until somebody starts to claim debt back for whatever reason – some call this a “Minsky” moment. Asset prices drop, liquidity dries up, Ponzi schemes get uncovered – short: the system collapses. This causes a sudden halt of lending severely hampering investment and via that channel creating a recession in the overall economy.

What Minsky proposes as a remedy is nothing new and widely accepted even among more liberal economists: regulation and supervision of the financial sector. However, he himself gives the reason why this is hard to achieve: financial innovation. Banks are already regulated to an extent that some claim all they do is administrate themselves and comply with laws and regulations. Apparently, they found ways to circumvent those and do exactly what they should not do: take on too much risk that finally created the credit crunch we are in now. You can bet that the reaction of governments will be fierce when it comes to banking regulation and financial institutions will be kept on a short leash for a while.

So back to my initial question: Does economic history repeat itself? Yes, it does. Not one to one, but in principle we had it all (Mark Twain once expressed it that way: history doesn't repeat itself, but does rhyme). And one thing is for sure: we will have it again. Banking regulations will be softened through intense lobbyism and new innovations found to circumvent them. It seems premature to claim that in the midst of a very much unsolved crisis, but I believe this is a problem that cannot be solved permanently within a democratic and capitalistic system where everybody is allowed to pursue their own interest. Unless this premise changes, and I severely hope it doesn´t, we will have the exact same problem on the agenda again some time. The problems will not be identified as hedge funds, CDOs, and CDSs, but they will eventually bring us to a point we can call credit crunch again.

Where will growth come from?

Obama´s speech was again full of encouraging rhetorics and I in principal agree with his views on how to spend the money of the stimulus especially if it comes to energy policy and health care. He also mentions the long term goal of fiscal discipline after the crisis which I think shows that Obama indeed has some long term policy goals in mind. However, I still think that most of the politicians and many economists do not realize or for psychological reasons do not publish their views on how severe and persistent this downturn is. That includes the Obama administration.

I believe that the American supremacy both in political and economic terms is drawing to a close in the not so far future. Nevertheless, the global faith of the global economy is very much depending on the United States of America right now. I oversimplify the world a bit and divide the major actors in two groups: there are the consumer-demand driven economies (e.g. US, UK, Spain, Ireland) and the export driven economies (e.g. most emerging markets in particular China, Germany). It is hereby not so important which group a specific country falls into and some stand certainly somewhat in the middle. The system developed by those two groups worked quite well. The exporters gave the consumers money to buy their products. This created huge global imbalances (e.g the often cited twin deficit of the U.S, which should actually be named triplet deficit adding the debt of private households) could not go on forever as many economists have warned for a long time. Those global imbalances are next to the obvious credit crunch that triggered the recession one of the reasons why the crisis might persist longer than expected. Because: again, where will the growth come from?

The exporters shrink because their export markets shrink. Their way out is to strengthen domestic demand which can at best ease the pain of the breaking away of the export markets. The only economy which is taking a comprehensive approach to try to manage this shift and strengthen domestic demand in a non-protectionist way is right now China. By the way, I think, humanitarian issues taken aside, the Chinese political leadership peruses very wise long-run economic policies. However, this will not save the world economy. China’s economy is simply too small to have a sustainable affect.

What can the second group do? Revive their domestic demand as well. Is this likely to happen? Not at all as the consumers are already highly indebted and the current panic does not encourage them to take on more debt; rather the opposite will happen and private households will pay pack their debts; in economic terms the private sector will save. The U.S saving rate was down to zero, what is economically not sustainable and will have to go up. The government stimulus measures will have a hard time to overcompensate this saving, in fact I regard it as highly unlikely and I bet this package will not be the last in this recession.

So if both groups are struggling to find a bottom, what is the answer, who will save the world economy? The answer is time which is more or less equivalent with nobody. The excessive spending of the past has to be gradually reversed and this will take time. It is as simple as that. How much time? I am not a prophet, but longer then many want to imagine. Five years is not unrealistic, look at Japan; they lost a whole decade. To get back to the start and Mr. Obama´s address about his post crisis plans: an American president has eight years at the most if he gets reelected and time will show how much of those eight years will be in the post crisis period.