The Real Causes of the Economic Crisis - Wolf/Goldman Sachs Report

[cactusflower]

The news media constantly repeat the nonsensical story that the economic crisis "was caused by subprime" or it "was caused by the collapse of Lehmann's". Its clear that the scale of the crisis must be explainable in terms of much more fundamential problems.

Martin Wolf discusses an unpublished Goldman Sachs report here and adds his own thoughts to it:

These are the key paragraphs describing the causes of the economic crisis:

The paper points to four salient features of the world economy during this decade:

• a huge increase in global current account imbalances (with, in particular, the emergence of huge surpluses in emerging economies);
  
• a global decline in nominal and real yields on all forms of debt;
  
• an increase in global returns on physical capital;
  
• and an increase in the “equity risk premium” – the gap between the earnings yield on equities and the real yield on bonds.
  
• I would add to this list the strong downward pressure on the dollar prices of many manufactured goods.

The paper argues that the standard “global savings glut” hypothesis helps explain the first two facts. Indeed, it notes that a popular alternative – a too loose monetary policy – fails to explain persistently low long-term real rates. But, it adds, this fails to explain the third and fourth (or my fifth) features.

The paper argues that a massive increase in the effective global labour supply and the extreme risk aversion of the emerging world’s new creditors explains the third and fourth feature. As the paper notes, “the accumulation of net overseas assets has been entirely accounted for by public sector acquisitions ... and has been principally channelled into reserves”. Asian emerging economies – China, above all – have dominated such flows.

The huge capital outflows were the consequence of policy decisions, of which the exchange-rate regime was the most important. The decision to keep the exchange rate down also put a lid on the dollar prices of many manufactures. I would add that the bursting of the stock market bubble in 2000 also increased the perceived riskiness of equities and so increased the attractions of the supposedly safe credit instruments whose burgeoning we saw in the 2000s. The pressure on wages may also have encouraged reliance on borrowing and so helped fuel the credit bubbles of the 2000s.

The authors conclude that the low bond yields caused by newly emerging savings gluts drove the crazy lending whose results we now see. With better regulation, the mess would have been smaller, as the International Monetary Fund rightly argues in its recent World Economic Outlook. But someone had to borrow this money. If it had not been households, who would have done so – governments, so running larger fiscal deficits, or corporations already flush with profits? This is as much a macroeconomic story as one of folly, greed and mis-regulation

The fundamental driver of the crisis was thus a result of expansion of the work force which drove down the rate of profit which in turn put pressure on wages and prices. I would add the increasing costs of technology as another factor pushing down the average profit rate.

One half of the population (China and India) saved and loaned to the other half who ratcheted up debt. There was an investment glut that led to low interest rates and easy credit. China kept its currency low to sell and the US kept the dollar high and could buy China's output. The low wage economy which was a legacy of the Clinton era created a population who could borrow to buy houses, but who weren't earning enough to pay back. The US racked up an enormous debt to China.


FT.com / Columnists / Martin Wolf - It is in Beijing?s interests to lend Geithner a hand

The solution governments are trying (except the bankrupt countries) is to pump more money into the system to try to boost consumption.

The authors conclude that the low bond yields caused by newly emerging savings gluts drove the crazy lending whose results we now see. With better regulation, the mess would have been smaller, as the International Monetary Fund rightly argues in its recent World Economic Outlook. But someone had to borrow this money. If it had not been households, who would have done so – governments, so running larger fiscal deficits, or corporations already flush with profits? This is as much a macroeconomic story as one of folly, greed and mis-regulation.

The story is not just history. It bears just as heavily on the world’s escape from the crisis. The dominant feature of today’s economy is that erstwhile private borrowers are, to put it bluntly, bust. To sustain spending, central banks are being driven towards the monetary emissions of which Ms Merkel is suspicious and governments are driven towards massive dis-saving, to offset higher desired private saving.

This remedy seems to be the hair of the dog that bit us.

The solution, Wolf says, is either for China to change its exchange rate policy and imports from the debtor countries, or to accept defaults:


[quote]

Today, Germany wants to preserve the value of its money, while China is desperate to preserve the value of its external assets. These are understandable aims. Yet, if this is to happen, debtor countries have to stabilise their economies without another round of profligate private borrowing or an indefinite rise in government debt. Both paths will ultimately lead to defaults, inflation, or both and so to losses for creditors. The only alternative is for debtors to earn their way out. At the level of an entire country that means a big rise in net exports. But if indebted countries are to achieve this aim, in a vigorous world economy, the surplus countries must expand demand strongly, relative to supply.

China’s decision to accumulate roughly $2,000bn in foreign currency reserves was, in my view, a blunder. Now it has a choice. If it wants its claims on the US to be safe, it must facilitate an adjustment in the global balance of payments. If it and other surplus countries wish to run huge surpluses and accumulate vast financial claims, they should expect defaults. They cannot have both safe foreign assets and huge surpluses. They must choose between them. It may seem unfair. But whoever said life is fair?

Wolf's bottom line message is that China should accept a big write off of its lendings to the US, or else the US will default (a possibility discussed on another thread here today). Understandably China is reluctant to do that: public reaction would not be likely to be favourable.

All countries, Germany, the US, China, India etc. are all facing into so-called choices that are not really choices at all and that are likely to prove unacceptable to their populations. Far from having been caused by mistakes, fraud or lack of regulation, the crisis was caused by a massive expansion of production and a squeeze on the average profit rate.

These tendencies are intrinsic to capitalism: they were described and analysed by Karl Marx, who concluded that violent and desctructive economic crises are an inevitable feature of capitalism, that will time and time again crack open the lid of the system and demand new solutions to production and distribution for the good of the mass of the people, rather than to risk the unmerciful destruction and upheaval of these crises mainly to the benefit of a handful of Bill Gates characters.

[20000miles]

I think the "global savings glut" theory can be safely discarded, if the arguments I've summarised hold water. It's simply an excuse that Alan Greenspan has been using to shield himself from blame.

http://www.politics.ie/economy/59388...greenspan.html

Oh yeah, and cactus, "expansion of the workforce" doesn't "cause" a decrease in the rate of profit.

[nuj]

"China’s decision to accumulate roughly $2,000bn in foreign currency reserves was, in my view, a blunder."

Two points - China's concentration on Agency paper (FNMA and FHMLC) facilitated a major compression of credit spreads and, due in large part to the lame, static, risk models in use, the gradual frog-boiling mispricing of risk, to the extent that corporate bond yields came within 40 basis points of AAA sovereign debt. This was both ludicrous and untenable but, as long as it was happening, investors were afraid to jump off.*

But China's accumulation and deployment of its reserves are only 50% of the story - deficit countries didn't recognise, or didn't want to recognise, that the growing imbalances and mispricings were bound to reverse. The further they went, the more disruptive the reversals were likely to be.

* Not strictly afraid, more happy to stay on board to milk the last bit of capital gain arising from the yield compression.

[cactusflower]

I think the "global savings glut" theory can be safely discarded, if the arguments I've summarised hold water. It's simply an excuse that Alan Greenspan has been using to shield himself from blame.

http://www.politics.ie/economy/59388...greenspan.html

Oh yeah, and cactus, "expansion of the workforce" doesn't "cause" a decrease in the rate of profit.

You're missing the point of the post, I think. I've read your post in which you seem to say that higher interest rates after the dot.com bubble burst would have solved the problems and we would have not have had the subsequent credit bubble. This is fine, but it would have meant a severe recession would have kicked in. Your money managers are between a rock and a hard place. The point is that there are underlying causes that can't be fixed by monetary means, and that the system has inbuilt instability.

I'll clarify with regard to the "expansion of the workforce" that I am talking here about the entry into the global workforce of millions of rural people in China and India (also Brazil and other developing countries) who have become highly productive in the last ten years and who are spending little.
The market is consequently flooded with low cost goods. I also made the point that increasing mechanisation also squeezes profit.

[20000miles]

You're missing the point of the post, I think. I've read your post in which you seem to say that higher interest rates after the dot.com bubble burst would have solved the problems and we would have not have had the subsequent credit bubble. This is fine, but it would have meant a severe recession would have kicked in. Your money managers are between a rock and a hard place. The point is that there are underlying causes that can't be fixed by monetary means, and that the system has inbuilt instability.

Well, I would disagree again. The system can't be fixed by monetary means, precisely because monetary means are the cause of the problem. (i.e. artificially low interest rates, expansionary policy).

[patslatt]

A rapid increase in global labour supply would normally tend to reduce wages but with globalisation sharply increasing demand for labour,wages can rise. Profits can also rise as increased technical efficiency from technology imports allows production of more units of production per worker,lowering labour costs per unit.

[ibis]

I see the man with the hammer is once again discussing exactly where the nail should go.

[cactusflower]

A rapid increase in global labour supply would normally tend to reduce wages but with globalisation sharply increasing demand for labour,wages can rise. Profits can also rise as increased technical efficiency from technology imports allows production of more units of production per worker,lowering labour costs per unit.

Its the overproduction resulting from the increase in the labour force that has squeezed profits. Just the same as how wheat price drops when there is a good harvest.

Initially new technologies give an advantage to the first users. They then become essential for all producers who can't afford to be left behind. The costs of technology are different to labour costs. Computers, say, are viewed as an asset and can only be written off over 10 years. Once everyone has them, they are no longer a competitive advantage. They allow for expanded production which puts a downward pressure on price. When they break you have to buy a new one, unlike workers who are just replaced by a new person. They have ongoing maintenance costs. I've seen this process in action in different firms over the last ten years.

[cactusflower]

Well, I would disagree again. The system can't be fixed by monetary means, precisely because monetary means are the cause of the problem. (i.e. artificially low interest rates, expansionary policy).

So how would high interest rates have helped the situation in 2002 when the dot.com bubble burst ?

How can you run capitalism without pressure for growth ? All profits are reinvested to look for more profits. Its exponential.

[Dios]

The solution governments are trying (except the bankrupt countries) is to pump more money into the system to try to boost consumption.

They aren't trying to boost consumption as such, they are trying to devalue their own currencies so the debts become meaningless. This is also why China is in deep trouble, since their foreign currency reserves likewise become meaningless, as do all static sums, such as bank account savings.

These tendencies are intrinsic to capitalism: they were described and analysed by Karl Marx, who concluded that violent and desctructive economic crises are an inevitable feature of capitalism, that will time and time again crack open the lid of the system and demand new solutions to production and distribution for the good of the mass of the people, rather than to risk the unmerciful destruction and upheaval of these crises mainly to the benefit of a handful of Bill Gates characters.

Regulation and a balanced mix of socialist policies are the best solution to all of these problems. For example, the global economic tailspin can be traced directly back to the removal of the Glass-Steagall regulatory act which was put in place after the last depression to prevent another great depression. This was not so much the fault of the subprime crisis as it was the cause of it, encouraging banks to lend more and more recklessly under the illusion that they were immune to the consequences.

Take a look here:

A lot of blame has sloshed around for the sub-prime meltdown, from greedy borrowers to greedy mortgage brokers to Alan Greenspan, but if you want the real culprit, it was the repeal of the Glass-Stegall Act. On November 12, 1999, the champagne must have been shooting from the walls at Citigroup, which had worked behind the scenes for over 30 years to get the act overturned. After recovering from their hangover, they and their banking buddies went on a sub-prime lending orgy. But what was Glass-Steagall and how did it use to protect us?

Glass-Steagall was passed under the Roosevelt administration in 1933 in direct response to the Wall Street shenanigans that ushered in the Great Depression where banks shoved their own depositors into buying the stocks the banks were dealing. The basic idea was to keep banks from speculating with the savings that American citizens were entrusting within their vaults.

Its repeal, under the Gramm-Leach-Bliley Act, drafted and passed by a Republican congress, and signed by Billiam Jefferson Clinton, allowed commercial banks to merge with investment banks. For instance, Citigroup merged with Traveler's Insurance (although this merger was announced in 1998, before the act was passed, at the time Citigroup CEO Sanford I. Weill said that he spoke with the Feds and, "that over that time the legislation will change...we have had enough discussions to believe this will not be a problem.").

Now, on the one side they could sell mortgages to homeowners, and then invent fancy investment structures which they sold on Wall Street. Because they were "covered" on both ends, banks felt free to sell increasingly dicey mortgages, just so long as another sucker was picking up the garbage. This sucker was picking it up because he had a plan to repackage it and sell it to another sucker, and so on. Eventually we end up with no-doc stated income interest-only option-ARM no money down mortgages being repackaged as "sound investments" being sold as "stable assets" for city pension plans to park their money in. (See "Subprime Meltdown As Told By Stick Figures").

We can only imagine the level of machination exerted over those 30 years, but we do know this. Robert Rubin was Secretary of Treasury, which had oversight over Glass-Steagall regulation. Days before he resigned, Glass-Steagall was repealed. Just over a year later, he became chairman of the Citi executive committee, with an annual compensation of $40 million, a position he still holds, despite Citigroup's $24 billion in subprime-related losses.

The devil is very much in the details.