Monday, 23 March 2009
The Credit Crunch – Causes And Resolutions
A lot of ink has been spilt analysing the causes of the Credit Crunch. Much of the discussion has understandably focussed on the culpability of financial institutions, regulators and even central banks.
There is no question all three must take their share of the blame for bringing the world economy to the brink of depression. Financial institutions were reckless, regulators asleep at the wheel, while central banks were at best naive, at worst, complicit in the creation of grotesque credit bubbles.
And in one respect, Prime Minister Brown is right when he claims this crisis is global.
Based on IMF data, there are over a hundred countries which have seen private sector borrowing rise faster than the UK since the millennium. Many have seen increases that are multiples of the rise in UK debt. Top of the poll goes to Ukraine, where private sector debt has jumped by an astonishing 5671% since the turn of this decade.
From the Baltics, down to the Balkans and across to Kazakhstan, eleven countries are in more trouble than Thailand during 1997, in the midst of the infamous SE Asian crisis.
Another nine countries are on the critical list. Eastern Europe is the fault line of a global capitalism that is badly ruptured.
And one Eastern European economy has already slipped into depression. The accepted benchmark for a depression is a contraction in real GDP of 10%. Latvia passed that unwelcome benchmark in the fourth quarter of 2008. Many more will follow.
They will be quickly matched by the major manufacturing exporters. Japan is likely to report a decline in GDP of 10% or more from its 2008 peak, when it publishes first quarter data for 2009. The collapse in exports – down 45.7% in January from a year earlier - has been astonishing. The February report on manufacturing production is expected - by the government – to show a decline of 37% from a year ago.
These rates of decline are easily comparable to the Great Depression. Indeed, in the worst year of the US slump, manufacturing output fell 21.0%. From peak to trough, it shrank 47.9%. That was over three years, between 1929 and 1932. In Japan, we have seen a large proportion of that decline in just one year.
Other big manufacturers are suffering too. Taiwan, South Korea, Germany and Sweden have all seen a collapse in exports, and will soon be in depression.
But it is wrong for Mr Brown to take comfort in the travails of Britain’s partners. The global credit bubble was a manifestation of economic policies he espoused. And Adair Turner and Hector Sants, respectively chair and chief executive of the Financial Services Authority, have come closer than most to recognising an important truth: politicians were ultimately responsible for allowing banks to lend freely.
However, even they are reluctant to admit to an even deeper and politically more uncomfortable explanation. As we argued last year in our book The Credit Crunch, the growth in lending was a necessary antidote to the pernicious effects of globalisation.
Shipping jobs abroad to cheaper locations, from China, to Eastern Europe to Turkey and India, has been a fallacy. The median wage has been relentlessly squeezed, not just in the UK, but in the US and other European countries too. If there had been no credit boom, GDP growth would have been almost negligible after the collapse of the dotcom bubble. Deflation would have become entrenched.
Led by their obsession with free trade, politicians in the West were happy to preside over the resulting housing bubbles, believing that low inflation would sustain the extreme house prices. For a while, it did.
But it is perhaps ironic, that when inflation did eventually accelerate, it was never likely to last precisely because of globalisation. Wages were being squeezed even during the boom, and as oil prices rose, there was not the slightest chance that inflation pressures would become embedded, as seen in the 1970s and 1980s. Tragically, central banks in the West could not see that. They kept interest rates too high for too long. They misjudged, because they did not understand the forces of globalisation that gave rise to the credit bubble in the first place.
Indeed, it is quite possible to show that a more timely response on interest rates, particularly in the US, but also in the UK and in Euroland, would have alleviated much of the distress we are now seeing.
But that is for the history books. What matters now is the response of central banks and governments to a looming depression.
The Bank of England’s decision to embrace quantitative easing should be welcomed on one level. This in essence involves a central bank targeting long term interest rates. The base rate may be 0.5%, but it is only one borrowing cost. There are many more interest rates, and the most important of these is the long term rate on government debt. This underpins all other credit costs. If a central bank drives the long term rate down, it can have a demonstrable impact on other borrowing costs.
This policy has many critics, but the recovery in the US from 1932 would never have happened without quantitative easing. Indeed, had the Federal Reserve in particular followed this policy more aggressively, the recovery would have been more robust.
Unemployment would have come down more quickly. It is beyond dispute that quantitative easing is a powerful monetary weapon.
There are however, several problems. The Bank of England cannot reflate in isolation. The Swiss Central Bank has joined the along with the Federal Reserve. But it remains to be seen how far the Fed, the most important central bank of all, is prepared to push this policy. It may yet fail if not used radically enough.
And it should not be seen as an excuse for profligate fiscal policies. Quantitative easing does make it easier for a government to expand its budget deficit to support an economy.
But the funds should still be used judiciously. The debt still has to be paid back.
Japan’s experience illustrates the pitfalls. Eleven emergency government budgets stretching over ten years pushed the public debt burden up from 64% to 175% by 2005. Quantitative easing has pinned down the long term interest rate – it has not been above 2% this decade, and is currently languishing close to 1%. But the sheer scale of the rise in the government debt means that 46% of tax receipts will be used to cover interest payments this year.
In this respect, we have to be alarmed that the UK budget deficit has raced towards 10% without the increased funding being put to more effective use. A bigger budget deficit tied towards an industrial strategy based around alternative energy, green technology, biotechnology and new growth sectors, would represent a sound investment in a UK recovery.
Instead, the deficit is being driven higher in part by the cost of bank bailouts. The government claims that banks have to be rescued otherwise the credit lifeline to companies would be severed, and many more would default pushing unemployment up even faster.
But the banks should have been nationalised from the outset. The government may still have needed to recapitalise the stricken financial institutions. But once nationalised, the banks could have been turned into utilities. Instead, they are being driven on commercial grounds to increase margins, to repay their loans to the taxpayer.
This way spells disaster. Loan rates need to be lowered, not maximised. Bankruptcies need to be minimised. With banks under full public control, they can be used as an extension of monetary policy, ensuring credit flows on terms that ensure companies stay afloat.
State supervised banks can also provide the support needed to allow many companies to restructure towards the new products that will help to combat climate change. The alternative technology already exists to generate a new wave of green industries.
The proposed rescue of LDV, the troubled van maker, is an acid test of the government’s willingness to marry the preservation of jobs with its carbon emission targets. It is unconscionable that LDV is on the verge of default for want of such a small capital injection, jeopardising the company’s plans for an expansion in battery powered vans.
The Bank of England's recent shift to quantitative easing will not be enough. Now is the time for an industrial strategy to reverse the huge job losses in manufacturing, which have disproportionately hit Wales, the Midlands and the North East. The 138,400 increase in the claimant count for January may have come as a shock to some. However, this could be a long way from the peak.
The Government must use its control of banks to support industry, otherwise vital skills and manufacturing capacity needed to sustain any recovery, will be lost.
The Government needs also to take proper, effective and accountable control of banks, to arrest the wave of business foreclosures. Banks need to be run as utilities and not on the basis of profit maximization, otherwise soaring defaults will entail huge social costs.
The UK is danger of following the US into mass unemployment. The wider measure of US unemployment - the so-called U6 rate - has already soared to 14.8%. This includes those who have given up looking for work and thus do not count in the official rate, and it also includes involuntary part-time workers, many of whom may lose their job. The U6 rate is heading for 20% by year-end, and could top 25% next year. It is a warning to New Labour. If it does not intervene to support industry, unemployment will soar here too, topping 4.0 million by next year.
Graham Turner is an Economist and Author of The Credit Crunch, from Pluto Press. Available from Bookmarks The Socialist BookShop, for £10 plus postage and packaging. Phone 020 7637 1848. Or www.bookmarksbookshop.co.uk