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.