Dealing with the Current Financial Crisis

Well, I'm certainly not a macroeconomist and I have even less expertise when it comes to the world of money and banking and international finance.  Yet, given the current situation in financial markets and the world economy, I cannot help but wonder if the problem is also institutional. So, here it goes.

What is presently occurring on world markets is linked to the mortgage loan and financial crisis of 2008 and the ensuing global recession.  In essence, prior to 2008, the world economy had a big party, which involved a lot of debt financing.  Not everyone was invited to the party but those that attended had a great time.  The party ended, but now everyone has to help clean up – whether they attended the party or not.  In simple terms, I think this is the crux of the matter.

In the wake of the financial crisis and the recession, government stimulus programs bought time but after three years, mountains of private debt have been augmented with mountains of public debt and the world economy has still not started growing in a manner that would assist in dealing with the debts.  The U.S. economy is still mired in slower economic growth.  Europe is still facing debt problems not just in Greece but also in the larger economies of Italy and Spain.   Add into this the reluctance of politicians to face their debts as most recently illustrated in the U.S. debt ceiling debate and it is no wonder that world stock markets have decided that things are not so good.  There is a lot of debt to unwind and it basically means that there is going to be a lot less consumption in the immediate future both publically and privately.  This was apparent before Standard and Poor’s downgraded the U.S. debt – at best their downgrade was a match that lit the highly combustible world financial situation. 

Debt is a tool that enables individuals and government deal with large capital purchases or short-term fluctuations in purchasing power.   Used responsibly, it allows people to buy a house, companies to finance expansions, and governments to build infrastructure.  Used irresponsibly, it becomes a way to fuel current consumption and short term growth and postpone the day of reckoning which when it arrives can be quite brutal if the economy has slowed or interest rates are rising.  Part of the solution to the current situation requires governments and individuals taking responsibility for their current debts and institutional mechanisms that prevent the future irresponsible accumulation of both private and public debt.  In many respects, there is a crisis of confidence in world economic leadership and that confidence needs to be restored before progress can be made in dealing with debt and world economic growth. 

The leaders of the G-20 need to come together and create a new global sovereign debt stabilization fund (a global bailout package for lack of a better term?) that in essence safeguards debt issues either through the World Bank or IMF or as part of an entirely new institutional arrangement.  Coupled with this would need to be conditions for countries to deal with their fiscal deficits over a three to five year period with credible plans to restructure their finances as well as transition payments (in essence a form of global equalization grant program) from the new global fund to deal with the shock of adjustment.  The G-20 would collectively come together to bankroll this operation.  In essence, resolving the crisis in confidence needs the current ad hoc approach to be replaced with the structure of a more formal mechanism that will generate the confidence in the world financial system needed to restore stability in world markets. 

Well, that's my contribution to global financial stability.  Does it make any sense as a Worthwhile Canadian Initiative?

Comments

[Min]

Livio Di Matteo: " In essence, prior to 2008, the world economy had a big party, which involved a lot of debt financing. Not everyone was invited to the party but those that attended had a great time. The party ended, but now everyone has to help clean up – whether they attended the party or not."

Hasn't the burden disproportionally landed on those who did not attend the party?

Livio Di Matteo: "Part of the solution to the current situation requires governments and individuals taking responsibility for their current debts and institutional mechanisms that prevent the future irresponsible accumulation of both private and public debt."

Lumping public and private debt together gives me an uneasy feeling. There is a constraint which is not being acknowledged. When you hold everything else constant, a decrease in public debt means an equal increase in private debt, right? Then if you wish to decrease both, you have to address other factors aside from debt or deficit mechanisms.

[Simon van Norden]

I would not vote for such a plan. (For the record, I'm a macroeconomist with expertise in finance, money and banking, and international finance.)

To understand better some of the pros and cons of Livio's proposal, we could read up on what's going on in the Euro zone. There we have 20-odd industrialized economies trying to decide how to handle the debts that some of the members states have accumulated. Politicians in low-debt countries are being savaged by voters who don't want to pay for other country's "mistakes." Looking forward, they worry that there is no credible system to avoid a repeat of such debt crises in future. (A sovereign nation is a sovereign nation, and if it is also a democracy, the only way to have "credible plans to restructure their finances" is for people to vote for it.)

The problems are not just political. One of the economic problems is that it is not clear what is required to restore "confidence." Italy is a nice example of this, where the govt. deficit is small enough that the govt. can afford to pay for all of its expenses other than interest on its outstanding debt, of which it can only pay part. (We call this a "primary budget surplus.") If markets feel confident, they will not worry about Italy's ability to pay, so Italy faces a low interest rate; if the rate is low enough, Italy no longer has a deficit, so the confidence is justified. But without confidence, markets worry about Italy's ability to pay, so Italy has to pay higher interest rates, creating (potentially large) budget deficits. In that case, the lack of confidence is justified. The point is that, without changing anything about the Italian economy, you can justify confidence or non-confidence in their government's debt. That also means that it will be very hard to know ahead of time what is required to restore "confidence."

[Min]

Correction:

I did not say what I had in mind. I said, " When you hold everything else constant, a decrease in public debt means an equal increase in private debt, right?"

I meant, "When you hold everything else constant, a decrease in the public deficit means an equal decrease in private saving, right?"

[Simon van Norden]

Min: No, when you hold everything else constant, a decrease in the public deficit does not mean an equal decrease in private saving. Increasing the public deficit does not generally increase savings. An nice example would be what we saw in the US under George W. Bush; deficits increased, savings stayed low, requiring massive borrowing from abroad (e.g. China.)

[Mandos]

OMG. Really? The Confidence Fairy? Here?

What is happening is nothing less than yet another attack on the benefits of civilization for ordinary people, and a another large-scale attempt to break the social contract in developed countries. (See "Ratings downgrade, USA, S&P".) That this will end in further and further instability as various populations come up with increasing motives to force their politicians to default on foreign debts is not in doubt. It is already happening. Stick that in your confidence pipe and smoke it.

The answer is not "more confidence" through "adjustment". The answer is strengthening and guaranteeing the social contract within democratic countries, and punishing those who undermine it. Such as ratings agencies.

[Nick Rowe]

Min: "I meant, "When you hold everything else constant, a decrease in the public deficit means an equal decrease in private saving, right?""

Also, (to add to what Simon said) you have forgotten about investment. Private saving can be offset by private investment.

Also, you can have private debt even with no investment, no government, and no foreigners. One person borrows from another person. One consumes more than his income, the other consumes less than his income.

[Nick Rowe]

Livio: it takes 2 to tango. For every debtor there's a creditor. For every borrower there's a lender. If we want to understand debt, we can't just look at borrowers' behaviour. We need to look at lenders' behaviour too. We need to look at both supply and demand.

But I tend to agree that the problem is institutional. It's the overall debt/equity ratio that's wrong. Partly that's because the tax system, including CIT, subsidises debt- vs equity-finance (I think). Partly because compulsory pension plans -- everything from CPP on down -- require saving in the form of debt rather than equity. (My savings go into a pension, so I have to get a bigger mortgage to buy a house). Plus the moral hazard problem from bailing out debtors (e.g. banks) but not equity holders (e.g. stock mutual funds.

If I had better knowledge of all the factual detail on this subject, I would want to write a post listing all the ways in which the government, via taxes, subsidies, regulations, bailouts, and probably some stuff I haven't thought of, implicitly subsidises debt and taxes equity.

The 1987 crash, and the 2001 tech wreck, didn't bring down the economy. Because they were equity crashes.

[Livio Di Matteo]

Well, these are not the most ringing endorsements of my attempt to save the global financial system and bring us peace and prosperity in our time. I agree that the burden of adjustment will likely be heaviest on those who "did not party" but the point is that those who did not party are still going to be stuck with costs. Its not fair but that is what will happen. in addition, saying it is not clear what is needed to restore confidence seems to be a reason to do nothing. Nothing wrong with that if doing nothing is better than doing something. Not sure if we have the tools to decide that. As for punishing bond rating agencies - anything particular in mind?

[Mandos]

I agree that the burden of adjustment will likely be heaviest on those who "did not party" but the point is that those who did not party are still going to be stuck with costs. Its not fair but that is what will happen.

Oh? Why? We are not just talking chump change here. We are talking about portions of the population that have been largely uncompensated for global trade liberalization---essentially, double victims of an increasingly anti-resilient global economic system. Some of these people are going to be "adjusted" out of their lives. Yes, even in wealthy countries.

It is not confidence at all that needs to be restored, it is justice. The other side of the political equation are the bondholders and the large holders of property and the business hoarding cash. Give them their requisite haircut. The first move is to shut down S&P, Moody's, and so on---all the private subverters of democratic sovereignty over the economy.

Whatever more sustainable system needs to be in place will shake itself out from there. Be it MMT or whatever.

[Determinant]

Livio, replace "debt" with "currency" and you have the Bretton Woods System. The Great Depression of the 1930's featured defaults primarily in the form of currency depreciation rather outright repudiation of government debt, except in the extreme case of Weimar Germany. We won't even touch the subject of First World War debts.

The Bretton Woods system had a chronic problem in that countries were encouraged to run balance of payments surpluses and punished for running BOP deficits, yet in total the world's BOP must come to zero, so it was a system of deficit countries constantly getting punished by surplus countries. Nobody has thought up a workable way to make running a surplus of any sort as unattractive as running a deficit which makes a net-balance guarantee system like you are proposing very, very difficult to implement in a stable way.

[Bob Smith]

"CIT, subsidises debt- vs equity-finance (I think)"

It might, but it's hard to tell, because there are so many complicating factors. One the one hand, since income from equity investments (whether as dividends or capital gains) is generally taxed at a lower rate in the hands of (taxable) investors than interest income (certainly true in Canada, I believe it's true in many/most other western countries as well), there is arguably an offsetting subsidy for equity finance (or offsetting tax on debt finance, depending on your starting point). Indeed, some countries explicitly permit the deducion of dividends in order to equalize the treatment of debt/equity financing. On the other hand, that offsetting subsidy (tax) may not be available if your investors are non-taxables (RRSPs, Pension Plans) or non-residents (although, the non-residents may be subject to similar rules under their tax system that has the same, or similar, effects. Or not)

[Phil Koop]

Livio: the time to make a post along these lines is when you can formulate a convincing rebuttal to Michael Pettis here: http://mpettis.com/2011/07/current-account-dilemma/. (In a nutshell, he is expanding on Determinant's point that it is meaningless to speak of "controlling deficits" without controlling the corollary surpluses. But it's definitely worth cracking the shell.)

[Min]

Simon van Norden: "Min: No, when you hold everything else constant, a decrease in the public deficit does not mean an equal decrease in private saving. Increasing the public deficit does not generally increase savings. An nice example would be what we saw in the US under George W. Bush; deficits increased, savings stayed low, requiring massive borrowing from abroad (e.g. China.)"

But everything else was not held constant, right? :)

Nick Rowe: "Min: "I meant, "When you hold everything else constant, a decrease in the public deficit means an equal decrease in private saving, right?""

"Also, (to add to what Simon said) you have forgotten about investment. Private saving can be offset by private investment."

Investment is included in everything else. :)

I am afraid that my words were inadequate to express my meaning. Let me try again.

By the public deficit I mean (G - T) in

G - T = S - I + M - X

IIUC, S is broader than private savings. I. e., S = S(private) + S(other).

Then

G - T = S(private) + S(other) - I + M - X

Holding S(other), I, M, and X constant, a decrease in (G-T) means an equal decrease in S(private). Right?

[jesse]

Sovereign debt stabilization fund? Does that get people back to work? I should think quite the opposite.

[Nick Rowe]

Min: that's (almost) right. (Except I'm not sure what "S(other)" means, it should normally be included in S(private), which is conventionally defined as Y-T-C, from which, together with Y=C+I+G+X-M, you can derive I-S+G-T+X-M=0)

But that still leaves out the possibility that debt can increase inedpendently of that equation. If I borrow from you, and I dissave and you save, so total private saving stays the same, debt has still increased.

[Simon van Norden]

....and if I borrow from you to invest in an offshore Special Investment Vehicle that you own, we call it "financial innovation."

[Min]

@ Nick Rowe:

Thanks for the clarification, Nick. :)

Nick Rowe: "But that still leaves out the possibility that debt can increase inedpendently of that equation. If I borrow from you, and I dissave and you save, so total private saving stays the same, debt has still increased."

Indeed. Doesn't most of our money supply (as we have set things up) derive from private debt? I have missed that aspect of things in our current public discourse. Perhaps because it does not lend itself to slogans and sound bites.

[Matthew]

Makes sense to me, and I agree that

One thing thats apparent from the crisis is that politics matters. Many mainstream economists are strangely marxist in their view that economic circumstances shape social and political ones. But it was the political imperatives driving Euopean integration that created the Euro, clientelist politics in countries like Greece that created large and powerful constituencies dependent on unsustainable government spending, and its becoming increasingly clear that US factionalism and the nature of congressional institutions are playing a big role in the inability to deal with the fiscal situation and the subsequent debt downgrade.

I think the contributors to this blog do a great job of considering the political variables, but most economists don't, and when the authoritative accounts of this crisis are written by academic economists they will probably leave the politics out.

[Matthew]

Sorry, didnt finish my first sentence. I meant to say that I agree the problem is institutional in nature.

[Determinant]

Quite right, Matthew. In my boredom I read "House of Commons Practice & Procedure" which is available online for free from the House of Commons website. The glories of the Internet. When you come to the Budget sections it is glaringly apparent that the power to govern and the power to spend money are inextricably linked, in fact it's the primary force that has shaped our present parliamentary system.

First, there is a constitutional provision that only the Crown can request funds from Parliament. A Money Bill has to have the "Royal Recommendation" which can only be given by Cabinet. Money Bills without the Royal Recommendation will be ruled Out of Order by the Speaker and are dead on the spot. The power to drive the financial agenda rests primarily with the Government and not with the Opposition, in fact it's a crucial distinction in power between the two.

The fact that the Cabinet has the ear of the Crown though the Spending Power easily gives rise to the Confidence Convention. The Crown requests money, the House of Commons assets to that request. If the Commons rejects the request it means that the Commons no longer has confidence in the Crown's current advisors, the present Cabinet. So the Crown logically has to get new and more suitable advisors, a new Cabinet.

This is exactly how governments fall. In parliamentary systems the Government has to be able to spend money or we will get a new government in short order. The Canadian system is set up to quickly replace a government that way, usually after no more than two months if an election is called.