15/02/2009
Are we in a credit Crisis?
José Martins Barata*
We shall see in this article that we are not in a credit crisis, but rather in an economic crisis, that began there is more than one year as an undiagnosed recession. In presence of an economic recession, it is necessary to diagnose correctly its causes and to adopt after effective measures to overcome it. Applying theoretical knowledge available, it is believed that an economic crisis can be resolved much more quickly than in the past, on condition that the situation is rapidly diagnosed and appropriate measures are promptly taken. This assumes that the policy makers have an economic strategy previously developed (i.e. a settled behaviour to put in action when facing future adverse events, with the aim of ensuring balanced economic growth) and they have the ability of implementing economic policy, i.e., to take decisions to intervene in the economy in order to achieve positive goals. We shall see below whether this has been verified.
What it has been said about diagnosis and economic policy has not been observed in Euroland, which is tied with the strict rules of the Stability and Growth Pact - SGP (Treaty of Maastricht, 1992). National politicians throw out the power of managing the economies without preserving a flexible alternative.
There was a historical development that created the framework where the "theory of the invisible hand" - as a matter of fact two centuries old - imposed itself in a generalised manner, to political and academic circles. But, nowadays it should be questioned, given the recent events.
As a matter of fact, since 1979 until 1990, it was implemented in the UK the liberal policy of Thatcher, based on the principle of "natural order" arising from non-regulated markets (invisible hand of Adam Smith, 18th century), which automatically should ensure the economic stability, full employment and growth. Thatcher advocated and promoted the reduction of government intervention, free markets, privatisation of state enterprises and services.
Since then, the Thatcher’s policy seduced most of the politicians, who started adopting it, at least partially: it happened so, surprisingly, with the socialist prime minister Laurent Fabius (1984-1986) in France and almost every other in Europe. All were affected by "thatcherite”, including the British Labourers, even after Thatcher out of power, as happened with Tony Blair ("blatcherite”). The ideology has become unique.
This climate has led to the design of the SGP in the context of neo-liberal policy, what led to the disappearance from Europe of the indicative planning, as well as the implementation of economic strategies. The economic policy concept was abandoned, in the belief that the mechanisms of free market would settle every economic problem much better. After all, this has not happened, as Alan Greenspan recognized in October 2008, when he testified before the U.S. Congress, where he stated that he had adopted by mere ideology (and therefore without a scientific basis) the principle that deregulation and free markets mechanism would guarantee automatically economic equilibrium. At that moment he considered it was an error.
Fictitious Development
An example of the fallacies about the economic development that a liberalized economy should afford, was the case of Iceland: after the adoption of liberal policy measures it "developed" so much, that in a few years it became the country with the best economic situation in the world. This was a contagious fascination ... However, after the financial crash of October 2008 the country went bankrupt! The development was fictitious! It was nothing more than a mirror image of accounting book values inflated by speculation!
The election of Republican Ronald Reagan for the U.S. presidency in 1980, inaugurated a neo-liberal period, likewise Thatcher, during which Greenspan was the "maestro" of the U.S. financial and monetary policy. Globalisation entered in this economic philosophy and is, after all, a modernized free trade regime. The financial disaster in the U.S., which began to germinate with the speculative bubble of the "new technologies" (2000) and culminated with the scandals of fraudulent mortgages (but not illegal, because deregulated!), which were securitized and sold to unsuspecting investors (“sub prime mortgages"), as well the failure of the pyramidal business fund-raising of Madoff (who had been the Chairman of technology sector stock exchange - NASDAQ), only to give some examples, became a global stock market collapse.
Is the present crisis similar to the previous ones?
We have seen "measures" to be announced , especially distribution of public funds to banks, either directly or potentially, "measures" adopted by several States. What is the efficiency to be expected and after how long? In other hand, what are the expected effects of measures taken by Obama?
In order to know whether there is any specific good feature, different from past experiences, it is worthy to do a historical analysis, referring to what happened with other crises, as well as a theoretical evaluation.
The current economic crisis has been compared to 1929 (especially with this one) and that of 1873, the two biggest crises of capitalism that preceded it. The first lasted 6 years in the U.S. and the second 10 years.
How is the current one? It is interesting to examine the common elements of them and see what are the differences.
The crisis of 1873 began to develop in Europe since 1870, after the Franco-Prussian war. The depression manifested itself openly with the collapse of the Vienna Stock Exchange, which at the time held a summit in Europe. In Prussia, the heavy indemnities for war damages, that France had just finished to pay in 1873, arose an exaggerated economic euphoria, which induced speculative bubbles in shares of railways and industries. That developed a climate of false expansion and fraudulent speculative manipulations, during a stunning period of economic liberalism, common throughout the West since the mid-century.
The European production had been troubled by competitive innovations of the 2nd industrial revolution, especially the new American transport systems of grain to Europe (this is the "destructive creation" that Schumpeter considered to be the cause of business cycles: for example the car destroyed the transport system of animal traction and such phenomena continues to occur, as it is the case with the CD that replaced the tape). But I do not think this is the cause of economic crises, because usually there is conversion of enterprise activities. Thus, creative destruction arises industrial sector difficulties but not an economic generalised problem.
It will be seen below that the current crisis is similar to the previous ones, but it may be overcome more quickly.
Great Crisis of 1873: liberalism, property and equities speculation, panics
Several banks opened bankruptcy after the Viennese stock market fall in 1873 and spread to the continental banks, many of them committed to mortgage loans granted in a period of great real estate speculation: in France, during the euphoria of the economic liberalism of Napoleon III; in Vienna and Berlin, during the era of urban construction also frantic. The British banks restricted lending in the money market, given the fear of being hit by the problems of continental partners involved in speculative mortgages. All that made interbank interest rates to increase much.
The high interest rates affected the market of New York and led several American companies of railways to bankruptcy, mainly those financed by fixed rate bonds (their prices crashed with rising interest in the market). Investors turned away and they used the short-term credit. Hence many bankruptcies, such as the bank of Jay Cooke (owner of a major rail company that went bankrupt) and others. The panic widespread ("Panic of 1873 ").
There were runs on banks and big failure of many industries and huge unemployment. It is considered that the crisis ended in 1877 in the U.S., after much trauma and return to protectionism. It became known as the "long recession."
In Prussia it finished before, thanks to the protection of Bismarck to the national production, creating an anti-liberal protectionism, which put an end to the difficulties that had caused American exports to the traditional European economy in the period of widespread liberalism.
As it was said, in all the countries involved in this crisis, there was previously and during it a period of liberal economic policy. In England the Liberal Gladstone was in power and in the U.S. Republican Ulysses Grant. As the liberal doctrine prevented the government intervention in the economy, combating the crisis was characterized only by protectionism in foreign trade (1879 in Germany and 1888 in the U.S.).
Crisis of 1929: liberalism, economic euphoria, speculative bubbles, bankruptcy and panic
The crisis of 1929 has become visible with the crash of the New York Stock Exchange and ended a period of great economic euphoria of blind faith in unregulated capitalism, where the policies of American presidents encouraged speculative bubbles (the stock exchange investors had bank credit to buy shares in stock exchange) and a high growth of industrial production, following the impetus for the European demand during and after the First World War. President Warren G. Harding (1921-23) promised in his campaign: "Less government in business and more business in government." Everything seemed possible in those "crazy 20s", a period of Republican presidencies.
The New York stock market crash of October 1929 triggered a lack of liquidity, successive failures of banks (5,100 from 1930 to 1932) and other corporations, as wel as panic and mass unemployment (this increased from 5 in 1930 to 10 million in 1931). Usually that crash is presented as a cause of the crisis, but it was rather the consequence of what had been happening in the economic real sphere (overproduction in the post-war) and of speculation.
From 1929 to 1933 chaired the Republican Herbert Hoover, who tried to contain the crisis with a policy of trade protectionism. At the same time, the FED System imposed limits to the money supply, fearing inflation ...
He was followed by the Democrat Franklin Roosevelt, who found 13 million unemployed and almost all banks closed. Roosevelt presented and implemented a program for economic recovery (New Deal) that had a positive effect until 1935. But due to boycott by powerful social and economic forces, who feared the budget deficit and the effects of abandonment of the gold standard, did not achieve the objectives until the outbreak of World War II. In the New Deal it was made the mistake of presenting a program for short term (until 1935) and other for long-term, to adopt in 1935. The latter was boycotted by various means (including the judiciary, with declaration of the measures as unconstitutional).
What is the cause of the crisis?
Various explanations for an economic crisis have been given, one of them the theory of cycles. But in our view, it is insufficient.
All great crises were preceded by several decades of total economic liberalism. In our opinion, it seems plausible to assume that the phenomena occurring in that system are at their genesis. Thus, the cycles will be of political nature and they do lead to economic cycles. In fact, the liberal economic practices have the feature of distorting the income distribution favouring the profits and damaging the remuneration of work by various routes (legislation unfavourable to labour, automation, delocalisation, import of goods produced with social dumping, etc... ). However, preventing the growth of real wages implies stagnation in global demand. These spectacular profits, giving the impression of strong economic progress, no longer are invested in productive capital, after reaching a point where the demand does not justify it. So the growing profits are directed to speculation, more profitable and easier, while the bubble does not burst. So, taking up buying power to the masses of consumers, who earn wages, and sterilizing it in profits, reduces the global demand and leads to a situation of overproduction. The equity prices fall strongly because the shareholders are early aware of the crisis in the real economic sphere. Forecasting reduction of activity and fearing bankruptcies, they try to sell their shares by all means.
Thus, the financial crisis is preceded by a latent economic crisis, which worsens after the crash of several stock markets and bankruptcies, including those of banks.
How is the present crisis?
By comparison, it is concluded that the present crisis has all the features described above: it developed in a climate of liberalism, domestic and international (globalisation), which contributed much to its origins. Saying that it was caused by the "greedy and unscrupulous" bankers and brokers of Wall Street, is a misleading way to hide the consequences of the unregulated markets; those "bandits" acted within the law and "moral" of the system, which is characterized by situations of fraudulent speculation (adjective put at light of another ethical system), as "normal" as other fair practices.
The crisis began in the sphere of the real economy, where unemployment has caused lack of compliance with the payments to banks and other mortgage loans. The situation caused a drop in prices in Wall Street, immediately propagated to the stock markets of other countries. Then, the speculation capitals turned to the prices of goods (oil and cereals) and only ended when the disaster was clear and everyone began to leave the financial markets. The inflated price of oil fell strongly, from 150 to $40!
Many banks are de facto bankrupt, since they are full of "toxic assets" ("subprimes", etc..). But they are being sustained by the public powers, willing to avoid panic. But what contributed most to avoid panic was the statement of States that depositors would not be affected in the event of possible bankruptcy.
As usual, the crisis is being wrongly diagnosed in Europe, because those in power are responsible for policies that led to it (the ideological blockages prevent the correct vision of reality).
The closure of firms and unemployment rise every day.
As usual, the measures taken so far in Europe, imitating the U.S. of Bush, are incomplete and ad hoc (concerned with the problems of banks, that is, non-economic objectives). Merkel, Trichet and Sarkozy should not believe what is happening after the Inauguration of President Obama, having been concerned with fighting inflation (almost nonexistent) and idle budget deficits. Now, they only see the difficulties in financial markets, whicht are an intermediate cause and not the root cause of the crisis, that is the lack of global demand.
It is false that banks do not lend money for lack of liquidity, as propagandised, because they have the ability of creating bank-money several times multiplied by refinancing with central banks (the multiplier mechanism of credit). In Monetary Economics it is taught that the granting of credit creates demand deposits (i.e. bank-money), based on idle central bank refinancing, and not the reverse. In fact, the main reason for central banks existence is to refinance commercial banks and these exist to finance economy! Or it is not so any more???
Hence, in this way we see that the present crisis is not a credit one.
Thus, it is wrong to give public money to banks (by buying toxic assets or other means), because no theory supports such a measure (nor liberal neither Keynesian ...) and it is obvious that banks will use these funds for its own benefit (e.g. purchase of a luxury plane for Citibank in the U.S.) or to fill own financial holes and not going to lend to businesses, which, moreover, are likely to fail, given the uncertainty and lack of demand. To save the financial system of panic it is enough that the State guarantees all deposits of individuals. The efficient solution to deal with bank failures is only nationalization. Similarly the movements of capital achieved through off-shore should be controlled.
It is wrong not to reduce taxes on income and not to increase public spending with deficit financed by central bank to restore the global demand.
It is wrong to decrease interest rates to near zero, because in the situation of insufficient investment (formerly known as the liquidity trap) that does not implement economic recovery. Indeed, even without interest payment, no businessman would invest, if immediately no one expects demand for new production. Consequently the investor could not pay the credit and would lose the collaterals that guarantee the contract.
This means that monetary policy (the only possible in Euroland!) is inefficient to attack the crisis.
It is wrong to cause unemployment with regulatory measures, because this will reduce the global demand, worsening the crisis, and it is wrong to reduce the pension reforms and real wages, for the same reason. The concentration of oligopolistic firms and encouragement of high profits only aggravates the crisis, because it reduces the purchasing power of workers, i.e., the great mass of consumers.
It is wrong not to give unemployment benefits adjusted to a crisis situation and other social support, because in this way it is not offset the reduction in overall demand due to loss of employment.
The present crisis will last longer in Europe
In euro zone the measures that governments may take are not efficient, unless they radically alter the Maastricht Treaty, which would take time (in addition to necessary wills, which do not arise).
On the other hand, in the U.S. the situation is much better, because the Americans have never done anything similar to the SGP, i.e., institutionally they maintained intact the traditional concept of economic policy. They never prevented the use of the budget deficit as an instrument of economic policy, either by reducing taxes or by increasing spending. The election of Obama began a political turnaround, in economic and in social grounds, despite the total opposition of Republicans in Congress. Moreover, it lacks 60% of votes in the Senate, needed to deliberative independence.
Hopefully, it will not happen the same as Roosevelt, due mainly to the strategic difference between the New Deal and the Obama Law ("Global Poverty Act"). In fact, this law contains a financial plan that goes from 2009 to 2019 and has been approved and promulgated by the President on 17/2/09 measures of short and long term. In economy, no one saw anything of this kind for several decades before this date. There are short term measures of public expenditures (construction and works in schools, libraries, laboratories, roads and highways, bridges), to be initiated within six months. They have a clause "Buy American", i.e. the purchases of materials for buildings financed by the plan should be made to American producers. This makes perfect economic sense in terms of the efficiency of measures, but has raised controversy because of international trade agreements. It is the first stroke in globalisation, which, considering the existing economic crisis, has to be reviewed.
It was also planned public expenditure for rural development, renewable energy, environment, education, training, scholarships, health, housing, transportation, tax cuts, support for the unemployed (unemployment benefit and other allowances) and health insurance, which will be launched partly in 2009. The financing of the various measures implies, of course, an increase in the annual budget deficits, that sum at the end of 11 years the amount of 787 billion dollars ($ Bn). Its worthy to note that expenses will be $ 184.9 Bn in 2009, $ 399.4 3 Bn in 2010, $ 134.4 Bn in 2011 and smaller amounts in subsequent years.
Considering this plan and the fact that the bulk of budget spending is planned for 2010, the U.S. should halt the crisis already this year and give back to recovery within 2 years if everything goes as planned.
In the EU, because of the weakness of the announced measures, the crisis will last longer, perhaps 4 or 6 years, and even then, only if the U.S. recovery has strong inducing effect of growth of production abroad.
Given the current lack of strong leaders in Europe (it is common place to say this), this is not yet the time to see reformed the unfair international monetary system of Bretton Woods (1944), transformed into a global system of dollarization in 1971 (the U.S. may buy everything abroad paying with their own bills, that they print as much as they want!). It is not expected from the U.S. the initiative to abandon this privilege. And the euro will have not the place in the world economy that was desired. Let us hope that, in the European political world, something radically will change in the positive sense.
* Professor of Economics, Technical University of Lisbon
