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Economic Stabilization Does Not Indicate Recovery, Part 3


Cures to the Global Financial Crisis may act merely as placebos.


Editor's Note: This is Part 3 in a multiple-part series. Part 1 can be found here and part 2 here.

Fundamental Truths

Belief in the recovery story and sharp financial market rallies fail to recognize that little has actually changed since the Global Financial Crisis (GFC) began. Fundamental failures have not been fully addressed. Writing in 1937 in Prosperity and Depression, Gotfried Haberler observed that:

"The length and severity of depressions depend partly on the magnitude of the 'real' maladjustments, which developed during the preceding boom and partly on the aggravating monetary and credit conditions."

The required reduction in debt levels has not been completed. Increases in government debt have substantially offset reductions in the private sector debt.

Instead of dealing with the problem of leverage, the debt has also merely been rolled forward through a variety of clever warehousing structures and the manipulation of accounting rules.

In a system that has excessive leverage, there are only two adjustment mechanisms. The value of assets supporting the debt and income available to service the borrowing can be increased, usually by inflation. The value of the debt can be reduced through writing it down to the real value of the assets.

Governments and central banks have gambled on inflation despite its social and economic costs. In reality, inflationary pressures in the global economy are not apparent. The rebound in energy and food costs has prevented deflation. The absence of demand, excess capacity, reduced credit creation and low velocity of money circulation may mean that it's dis-inflation or deflation that is the problem going forward.

Faith Based Recovery

There is now faith-based reliance on the Governments' ability to rescue the economy. Intervention has helped stabilize economic activity and the financial system but it's improbable that government actions alone can prevent the necessary adjustment in debt levels and growth rates.

The Government's share of most developed economies is around 25-40% of GDP. Its role in liberal democracies is limited by the fact that it's fundamentally an intermediary, not dissimilar to a bank. It derives its resources through taxation from certain sectors of the economy and redirects it to other sectors. This means that its ability to control an economy has limits in the absence of nationalization of all productive activity.

In the short run, governments can borrow or print money to augment its resources. Like all debt it borrows from tomorrow to pay for today. Quantitative easing (the now respectable name for 'printing money') also has limits unless governments are willing to risk hyper-inflation and the social dissolution of the Weimar Republic or Zimbabwe. While governments can influence an economy, they cannot completely reverse inevitable adjustments dictated by market forces.

Governments may also be impeding necessary adjustments. Rising government investment is increasing capacity in a world with stagnant demand and over-capacity in many sectors.

China's current growth is being driven by government investment that is increasing capacity which, in the absence of sufficient domestic demand, may be directed to exports increasing the global supply glut. Politically and socially motivated bailouts of national champions and strategic industries mean the necessary reductions in capacity through bankruptcy and corporate failure have not been allowed to happen.

There are even signs that the financial sector is rediscovering old habits. The government and taxpayer paid for the return to profitability of major financial institutions. Also, the return of remuneration levels to pre-crisis levels raises fundamental questions about whether any change has occurred. Despite the egregious excesses, governments seem collectively to lack the will to reform the financial system to avoid the problems of the past.

In 2007, when the US housing bubble collapsed, satirical magazine The Onion demanded that the American people be given another bubble to speculate in. Their wish now appears to have been granted.

Actions to stabilize the global economy seem only to have created 'new' bubbles – in government debt and emerging markets. Government actions seem to be primarily designed to ensure continuation of the ponzi game. The only lesson learned is that no ponzi game can ever be allowed to stop.

As one anonymous saying states: "Never in the history of the world has there been a situation so bad that the government can't make it worse."

Global Questions

There is broad agreement that a key component of the GFC was the problem of global capital imbalances. A central feature was debt funded consumption by the US that allowed 5% of the global population to constitute 25% of its GDP, 15% of consumption and 48% of global current account deficit. Japan, China, Germany, and the other savers funded the consumption. At its peak, the US was absorbing about 85% of total global capital flows to fund its government and private debt.

Any lasting solution to the GFC requires this imbalance to be dealt with. The glib solution requires the US to save more and consume less and the savers to save less and consume more. The problems in implementing the solution are considerable.

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