What to do, what to do

Martin Wolf has usually managed to moderate his inner interventionist. No longer, it seems. In his most recent column, he casts caution aside:

“The time has come to employ this nuclear option [the printing press] on a grand scale.”

Not doing so, he says, would ensure a renewed recession with increased unemployment, falling house prices, reduced real business investment and so on. I think he’s right that these unhappy events are on the way. Question is, would employing his nuclear option make things any better?

To answer that we need to understand why we’re beset by all these difficulties. Wolf sees the root problem as feeble demand. Again, I think he’s right, but only in the sense that it’s the most visible, proximate cause. There’s a deeper question he doesn’t address; why is demand so weak? If the reasons are structural, throwing money at the problem is unlikely to help. Indeed, it could just as easily make matters worse by impeding the necessary adjustments.

The key question, then, is whether pre-GFC growth was sustainable. If instead it was a hothouse flower, then trying to revive it outside of the conditions that allowed it to flourish is not only impossible but foolish.

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Looking back, the outstanding feature of this period was the growth in debt, particularly by households. Much of it, indeed most of it, flowed into property, fuelling the most extravagant and widespread boom ever seen. In some countries, such as the US, the aftermath is already well advanced, with housing prices down over 30% from the peak; in others, such as Australia, it’s hardly begun. The UK is somewhere in the middle.

If the only consequence had been a widespread real estate bubble, things would have been troublesome, but not disastrous. Unfortunately, there were others. The sense of growing wealth occasioned by the remarkable asset appreciation profoundly affected economic behaviour. Saving from current income seemed less and less necessary as the boom went on, and so consumption took more of the economic pie. If investment also remained strong, then growing external deficits necessarily followed. In addition to this indirect effect on savings, some borrowing also fed directly into consumption; at the peak of the boom in the US, for example, households were borrowing 5-6% of GDP through mortgage equity withdrawal against their appreciating houses. No other country quite matched this lunacy, but many shared the general trend.

Clearly, some of the resulting demand was unsustainable. When consumption is funded by borrowing (whether directly or via reduced savings because of the wealth effect from credit induced asset appreciation), it’s effectively stolen from the future. This essentially artificial demand disappears once the credit boom ends. On top of that, the need to restore weakened balance sheets means higher future savings will further depress demand in rough proportion to the earlier excess.

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None of this is hard to grasp. Still, this core structural impediment is usually ignored when responses to our current woes are considered. In part no doubt because it’s a particularly unpleasant thorn to grasp, but also because conventional economics has long paid too little attention to the effects of credit on the real economy. What we’re in (and are likely to remain in for a long time) is a balance sheet crisis, against which the usual nostrums are helpless. Even measures that until recently were regarded as extraordinary are losing their mojo.

Quantitative easing, for example, no longer makes sense. Since 2007, when the first open rumblings of the coming crisis sounded, base money in the UK rose from £70 billion to £200 billion; in the US, from $800 billion to $2.6 trillion.[1] As a result, excess bank reserves at the BoE and Fed are at unprecedented levels, in both cases roughly equal to 10% of GDP. The sort of illiquidity which QE can remedy is no longer a weak spot in the system (indeed, it hasn’t been for a long time).[2]

As for the alleged benefits of lower long term real rates brought about by QE, the picture’s far from clear. Ashwin Parameswaran at Macroeconomic Resilience argues that suppressed real rates can have “perverse and counterproductive effects”. It’s usual to focus on the plight of debtors, who clearly benefit from lower rates. That’s only one side of the equation, however. The world is full of savers and investors too, who (particularly in ageing demographics) may respond by “increased savings and reduced consumption in an attempt to reach fixed real savings goals in the future”.

Whether or not Wolf has considered such potentially perverse effects, he certainly recognises that illiquidity isn’t the problem. He has something quite different in mind in his call for gloves off QE: namely, the full-blown monetisation of government spending.

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I guess it was always going to come to this. The accumulated imbalances are simply too large to ultimately respond to lesser measures. Indeed, it’s the continued employment of those fiscal and monetary measures over recent decades (albeit on a lesser scale) that brought us to this impasse. At no stage were the necessary adjustments and corrections allowed to unfold. The political incentives all pointed the wrong way.

Now it’s true that for as long as belief in the efficacy of central banks and governments persists, such lesser measures may give the appearance of working, as they’ve done in the last three years. Once that faith begins to seriously erode, however, the game is up. I imagine Wolf sees that moment as nigh, and again, I think he’s probably right. The unfolding train wreck in the Eurozone is displaying all too clearly the limits of officialdom. They may cobble together another solution that the market is willing to buy, at least for a while, but it does look more and more as though the tide is inexorably going out. Recent events in the US are hardly more comforting.

Here’s what Wolf favours:

“Personally, I would favour the “helicopter money”, recommended by that radical economist, Milton Friedman. This would be a quasi-fiscal operation. Central bank money could pass via the government to the public at large. Alternatively, the government could fund itself from the central bank, directly. Better still, the government could increase its deficits, perhaps by slashing taxes, and taking needed funds from the central bank. Under any of these alternatives, the central bank would be behaving like any other bank, creating money in the act of lending.”

The distinction between these alternatives is presumably clear to him. To me, they appear to be different ways of expressing much the same thing; that is, monetisation of deficit spending. At any rate, he goes on to say:

“In current circumstances, a policy of direct financing of government by the central bank should recommend itself to monetarists and Keynesians. The former have to be worried by the fact that UK broad money (M4) shrank by 1.1 per cent in the year to July 2011. The latter would have to be pleased that governments could run still bigger deficits without increasing their debt to the public.”

That M4 is shrinking despite all the BoE’s efforts illustrates the strength of the prevailing headwinds. Once a credit boom ends, the deflationary undertow that accumulates over the course of any major debt buildup soon reveals itself, its strength proportionate to the extent of the preceding boom. The private sector belatedly sets about repairing its balance sheets, reducing consumption, cutting investment and focusing on saving. This time around, governments have been offsetting the debt households and businesses are trying to shed by furiously taking on their own.

In the US, for example, household indebtedness peaked in the second quarter of 2008 at $13.929 trillion; at the end of June this year, it was $13.298 trillion. Business borrowing didn’t peak until the fourth quarter of 2008 at $11.151 trillion; although it’s ticked up again in recent quarters at the end of June was still “only” $11.019 trillion. The financial sector is the standout: at the end of 2008 it was $17.119 trillion; the latest figure was $13.830 trillion. Across the three sectors, a reduction of $4.052 trillion, or 9.6%. Set against this, the federal government owed $5.243 trillion in March 2008; today, it’s $9.778 trillion, an increase of $4.535 trillion. Plus there’s another $186.5 billion in fresh state and local government borrowing.

Given UK deficits exceeded those in the US and Wolf says he’s looking to substantially up the ante, it seems he’s not kidding about the “grand scale”.

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It’s hard not to be sympathetic. Absent fiscal and monetary support, our credit pyramid would simply collapse; quite possibly, given its scale and scope, more dramatically than in the early 1930s. Equally, even with a continuation of fairly aggressive fiscal and monetary support, private sector deleveraging is likely to continue for many years to come, weighing on consumption, dragging down investment and keeping unemployment frustratingly high.

What to do, what to do.

Keeping demand up at all costs, as Wolf so fervently desires, has its problems, not least that demand isn’t homogeneous. It’s not an abstract aggregate, it’s the result of an almost infinite multitude of individual, highly idiosyncratic demands. So too with the supply that tries to meet it; it’s also bewilderingly complex, with much productive capacity suitable only for very specific ends. Helping these two mesh as sweetly as possible is what the market’s meant to do. One doesn’t have to be an Austrian to wonder if central bankers and politicians pulling at levers they (and we) only dimly understand is likely to help this process.

One thing’s certain. When demand is hyped, whether by a credit boom or unfunded deficit spending, malinvestments proliferate. The less organic and sustainable the demand, the greater the errors that will be made as business tries to meet it. Someone has to pay for those real world errors, whether it’s lenders, shareholders, or all of us when the losses are in one form or another assumed by government. That they can apparently be paid for with dollops of freshly created money doesn’t change the underlying reality. It just disguises it, and further confuses us all.

The current complexity of economic and monetary matters, and the often disconcerting speed of change, aren’t just the fruit of globalisation and rapidly evolving technologies. Much of it’s rooted in the Alice in Wonderland quality that now pervades money and credit. It can feel like a world full of wormholes and time travel, where quite a number of impossible things do indeed happen before breakfast.

Few of them, unfortunately, are good.

In any case, I can’t help thinking deliberately goosing aggregate demand is more likely to perpetuate our problems than solve them. Highly individual, sustainable demand can’t successfully interweave with complex, specialised supply when the information needed to do so is being constantly and violently distorted. Cutting with the grain by smoothing the adjustment process seems a better bet than impeding it, particularly if we devote some of the saved resources to protecting the more exposed and vulnerable amongst us.

Does thinking that way that make me a liquidationist, one of the unaccountable sadists Wolf sees peopling the other side of his argument? I obviously don’t think so. What to me seems called for is a sort of compassionate realism; trying to understand the deeper nature of our economic problems, accepting those things (as the old prayer has it) we can’t change, and then carefully seeking to unravel the knots rather than binding them ever tighter.

Wolf’s approach risks everything. Quite apart from the fact that I don’t think it would work in the long term, if the full resources of the state are thrown into the battle, along with the very nature of money and credit, where’s the fallback position?

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That said, there is a powerful case for cushioning the deleveraging that’s underway, since left to its own devices the deflationary collapse would be shattering. More as a cautious retreat under fire, though, rather than a frontal counterattack.

Back in the early days of the crisis, we badly erred in holding bondholders immune. Not only was it inefficient, it was unjust. When financial institutions faltered, their bondholders (like any others in a failing commercial enterprise) should have been forced to take a serious haircut or, better yet, had their holdings converted to equity. The financial system would have been left in a far stronger position to weather the storm. The approach still has merit, but given how far things have deteriorated governments would almost certainly have to chip in with additional recapitalisations as the great unwinding slowly progresses.

As for the central long term goal, surely it’s the restoration of a natural balance between sustainable supply and demand. Without that, no recovery can last. I think we must accept that much pain and toil lie between here and there, even if all goes comparatively well. The multitude of errors made in recent decades can’t be wished away, however much we’d like to do so.

Excess credit, togther with the general profligacy and distortions it encourages are what brought us to this pretty pass. Is more of the same really likely to get us out?


1  Fiscal policy has been no less aggressive. From 2007-2010, the UK averaged deficits of 8.9%. Much the same holds true in the US, although their deficits post crisis rose a little more slowly. Taking a much longer view, the UK managed a surplus in only five years since 1973, curiously enough exactly the same tally as the US, although the years didn’t exactly coincide. In any event, anyone wanting to claim deficit spending hasn’t really been tried has a hard row to hoe.

2  I do wonder at times if these huge excess reserves might one day wreak unexpected havoc. Contrary to conventional wisdom, their overall level is entirely in the hands of the central bank. Individual banks may succeed in getting rid of some (through making loans or purchasing investments), but they inevitably come back into the system somewhere as soon as the recipients spend or deposit the proceeds.

If the markets become more confident, or more inclined to speculate, it’s not hard to imagine an accelerating rush by individual banks to deploy reserves. All of it, at the system level, entirely fruitless. Not an easy beast to rein in, I’d have thought, if first it bolts.

I see two options for central banks were that to happen. Either vaporise sufficient reserves (through sales from their portfolio) to neuter this impulse; or, raise the rate they pay on reserves to a high enough level to discourage the process. Neither seems attractive. Brave indeed would be the central banker who embarked on the former in these tricky times. As for the latter, with the reserves outstanding it would surely not be cheap.

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55 Responses to What to do, what to do

  1. KB Keynes says:

    A few things in no particular order.

    If these countires had have paid attention to Keynes they would not have had deficits. They would have had surpluses.

    Telling these countries to adopt Austerity policies ( that clearly do not WORK)is like [putting a bankrupt in prison and wondering why he can’t pay the debt back.

    I wouldn’t worry about monetary policy at present. Go fiscal policy and then consolidate when things turn round as Keynes advocated.

    It worked here!

  2. Pedro says:

    Ingolf, if there is a balance sheet crises then the question is whether the current creditors should get it in the neck or be bailed out by new creditors who will get it in the neck. A good dose of money supply inflation means that the current creditors and replacement creditors get it in the neck less obviously. It also has the benefit of avoiding deflation.

    Sure Homer, pink batts for the world!

  3. Ingolf says:

    Oh agreed, Pedro, there’s no easy answers. Still, be nice if these generous new creditors had some choice in the matter.

  4. Rex says:

    Surely the thing that has to be protected is the parts of the economy that are productive and would be quite sustainable under normal circumstances, but whose existence is threatened by a credit crunch, price deflation and a restriction in money supply.

    To that end why can’t credit creation be directed towards those parts of the economy – that will retain productivity, whist letting the other parts (ie the speculative parts, and those locked into asset bubbles) fail.

    According to Richard Werner, Japan’s post war banking model, used a technique called ‘window guidance‘, which used credit creation to provide ample funds to the industries that they wanted to promote, whist restricting supply to other “non-productive” parts of the economy. This was extraordinarily successful in pulling Japan from its post war slump, and only went awry in the 1990s when the Bank of Japan decided that it new better than everyone else.

    Is it not possible that some form of ‘window guidance’ could be applied toward the productive parts of the economy while the speculative parts take the hit?

  5. Ingolf says:

    Rex, the issues you raise are deeply complex and also somewhat at a tangent to what I was trying to get at in this piece.

    So, FWIW, just a few general thoughts. I’m sure there have been times when central economic authorities provided effective guidance, perhaps even more so than the market itself would have managed. Maybe post-war Japan was one of those. I haven’t studied it closely enough to have any basis for making a sensible judgement.

    One of the difficulties is that we can’t know what would have happened without such guidance. Naturally enough, anyone in favour of such an interventionist approach will select the examples that appear to support their case and ignore others. As I see it, the sensible default position is that information about real demand and potential supply is so dispersed and dynamic that attempts to channel them (whether via moral suasion of the “window guidance” sort or more direct intervention) is likely to fail far more often than it succeeds.

    As to the current specifics, the questions you raise are ones I often ponder too. If we hadn’t created such a dysfunctional monetary and financial system, there’d be no need to do so since these troublesome excesses and imbalances wouldn’t have arisen in the first place. Given they have, however, we must at least consider them.

    Here too, I think the default answer should be no. Where the case for support seems particularly clear cut, I guess exceptions could be made. If one accepts my argument that demand will be soft for years to come, it follows that quite a bit of current productive capacity (however real) can’t pay its way. To keep it alive artificially is to preclude whatever alternative uses of those resources might have arisen. In economics, I think it’s the things that aren’t immediately obvious that are often the most important.

    That said, as I suggested in the piece, I do think the financial system needs help to get down off the high ledge on which it finds itself. We can’t ignore the reality that, left to its own devices, it would probably just collapse. How best to do this is a devilishly tricky question. In broad terms, the core guiding principle should probably be to convert a great deal of debt to equity. Only in this way can the system be sufficiently stabilised to survive the coming storms while still adequately serving its essential functions.

  6. Paul Frijters says:


    what an effort! Let me make two comments, one on whether you are roughly barking up the right tree and the other on what is missing.

    I think that your assertion that the current crisis is effectively one of de-leveraging is correct. And I fully agree that the challenge is to figure our why deleveraging is such a painful process and what can be done to ease that pain.
    That recognition is immediately a problem for nearly all of mainstream economics though: in most macro-models there is no good reason why de-leveraging would have the consequences on the economy that it seems to have. After all, de-leveraging does not obviously destroy any production factors, nor should it change expectations about productivity. We have some micro-stories about bank lending and displacement that give a bit of insight on what is going on, but the issue is essentially one that is too complex to adequately capture in a model of the macro-economy. And the reality of academic economics is then that debates about what is actually going on have to survive on the margin, forever overshadowed by shadow-debates on things that can more easily be understood. Hence very few of our best minds are actually turned towards this problem because our education has not prepared us for it and the few who try cannot come up with models that would appeal to the rest of the congregation to come and join them in figuring stuff out. That reality is well-understood, but is not going to change any time soon. Too many people with too much intellectual capital to lose. The Keynesian comment you got first is a perfect example: a pure derailment of the ‘I have always known the answer, just catch up with me and you will too’ type. I am afraid you will get the same reaction in academia, but instead of Homer it will be Nobel prize winners.

    Then as to what is missing. The big missing element in your story is profit and the financial sector. There is a huge amount of profit being made, with many records smashed in 2010. Huge fortunes are also being made in the financial sector. That is a real challenge to much of what you are saying: if profits are not actually low, then why the unemployment and lack of investment. Why is the financial sector able to eat up 50% of profits, and why do no alternative investment mechanisms emerge when big banks are in trouble? I am not saying I have answers to these questions, but they are the key ones in terms of understanding the link between de-leveraging and the real economy.

    What we hence lack is a simple and useful framework for thinking about de-leveraging. We just haven’t got one at the moment, which is partially why all kinds of things are being tried.

  7. Pedro says:

    Paul F, I don’t know what goes into models, but wouldn’t widespread deleveraging be deflationary, other things, like the money supply, being pretty equal? That’s surely a transmission mechanism for problems in the general economy. It’s a fall in AD.

    As for the profits, I suppose I should go look, but just how wide spread are those profits? I thought that plenty of businesses are not making much profit. Or am I just being gulled by claims about a 2 speed economy. Finance sector profits can easily be exceptional, especially when competition is reduced. I remember reading that plenty of small banks bit the dust in the US, and obviously the competition for the 4 pillars has been reduced.

    Rex, assuming the window policy to be effective, I wonder if that is supported by the fact that Japan was a virtual one party state? The policy was really winner-picking, and in a robust democracy winner-picking will quickly turn into vote-harvesting.

  8. Dan says:

    So it seems our problem is drawing distinctions between tangible profits and fictitious ones.

    A similar distinction drawn by Veblen a long time ago – that between productive and speculative activity (or in his terms, “industry” and “business” – he used the term business in a much more circumscribed sense than we do today).

    The former is, needless to say, an economic good, while the latter is an economic bad – essentially, economic pollution – regardless of who might be getting rich along the way.

    Where does this take us – maybe it’s not *deleveraging* that’s the underlying problem – that (and the attendent pain) are inexorable symptoms of the cause, which is excessive or unproductive leveraging.

    I know this is a broad-brush thesis; if anyone can elaborate, or for that matter, critique, I’m very interested.

  9. Ingolf says:

    I’m sure there’s much more than the story of profits and the financial sector missing, Paul. However, as you rightly suggested, the whole thing was already quite long enough . . . .

    Now, a few thoughts on your points.

    I think deleveraging is more effect than cause. The true driver is what’s happening with demand and the business response to that. The whole process is so painful because everything was geared (literally and metaphorically) to a credit induced level of activity. As the realisation that those times aren’t coming back any time soon slowly percolates into the general consciousness, animal spirits sink lower and lower. Letting go of dreams is hard. Debt is seen more and more as a sentence to hard labour rather than a ticket to paradise so deleveraging just keeps grinding on. At least amongst households.

    As for the record-breaking profits in the real economy, I don’t know that they’re all that surprising. Much consumer demand in recent years has come from government transfers; that means business still gets much of the revenue but avoids paying a disproportionate share of the costs. The difference goes straight to the bottom line. And the finance sector? Well, much of it’s effectively a ward of the state; it’s plied with large amounts of essentially free money and allowed to extend and pretend. We’ll see in time how much of these apparent profits were actually real. The truly irritating part is that even if they prove in large part to have been a chimera, management will still have made out like bandits. Anyway, that’s a whole different discussion.

  10. Ingolf says:

    Dan, sorry I missed your comment before I posted my reply to Paul. As you’ll see there, I’m pretty much in agreement with your broad-brush thesis.

  11. Paul Frijters says:

    ingolf, dan,

    profits have been increasing for decades: it is a general puzzle for economics, not just a continuing element of the last few years. Under nearly all long-run economic models, profits should disappear with competition. The notion that our societies might in some way become less competitive over time is a very odd one to get our heads around.

    To simply dismiss the finance industry as the beneficiaries of free money who extend and pretend is to walk away from the challenge of understanding what they do and how they relate to the real economy. It is a lazy answer.

  12. Dan says:

    Galbraith and Veblen have two answers for that one: the rise of the planning system (ie. oligopoly, duopoly, monopoly), and conspicuous consumption (ie. people paying a premium in return for the social acknowledgement of being in a position to pay a premium).

  13. Paul Frijters says:


    can you explain yourself? What does conspicuous consumption, which is a phenomenon I would immediately acknowledge as important in any walk of life, have to do with de-leveraging or the finance industry’s role in this economy? What planning system has given rise to greater profits?

  14. Dan says:

    Sorry – yes, I should have been clearer.

    The comment was in response to:

    “profits have been increasing for decades: it is a general puzzle for economics, not just a continuing element of the last few years. Under nearly all long-run economic models, profits should disappear with competition. The notion that our societies might in some way become less competitive over time is a very odd one to get our heads around.”

    Essentially I was saying that I have no trouble imagining that societies might have become less competitive over time.

    The planning system is just as relevant to the finance industry as to any other.

    If the planning system is not yielding greater profits, then it’s not doing its job. The whole point of it is to attempt to control both supply and demand.

  15. Paul Frijters says:

    ehmm, you have still lost me. You talk about the planning system the way i would talk about the 5-year plans of the soviets. ‘control both supply and demand’.

    Who is doing the controlling in our societies though?

  16. Dan says:

    Oh dear.

    I’m not talking about anything conspiratorial or even, I thought, particularly cotroversial – just that, if you have a substantial amount of market dominance and an enormous amount invested in fixed capital (or something close to fixed capital), you’re hardly going to allow yourself to be buffeted by the whims of the market – that’s frankly irresponsible as far as your shareholders are concerned.

    What you’d seek to do is influence consumer behaviour (demand) and also supply, or at least prices, to increase profits.

    Galbraith famously used the example of GM (during more halcyon days, obviously) as a market player that was influential in its market and thus had a substatial ability to set prices.

    As for the above’s application to finance – I’ll have to keep thinking, but the continuous mergers and acquisitions that have characterised the sector don’t exactly point to increased competition.

  17. Paul Frijters says:


    sure, many market players dream of becoming big enough and have some market power. That would have been as true in 1950 as it is now though. You would have to spin a story whereby somehow there have been forces leading to more concentration now than in the 50s.

  18. Dan says:

    (Oh – and I should append – the conspicuous consumption thing was just a supplementary reason that profits might increase, with or without more market players. However, of course if we’re paying premiums for a lot of particularly luxury goods, we’re probably spending more than we otherwise would – it doesn’t seem like we’ve given any other consumption up in return for the opportunity to display brand names – and therefore probably taking on more debt than we otherwise would.)

  19. Dan says:

    You don’t think market power is more concentrated now than in 1950!? Apple, Microsoft, Google, Facebook, the too-big-to-fails…?

  20. Ingolf says:


    Profits have been increasing in recent decades, but it doesn’t seem unduly odd to me.

    I’m looking at a chart of US corporate profits/GDP from 1947 to now, and they’ve ranged between about 4.5%-7.5%. In the few years before the GFC and the last little while the ratio did set marginal new highs of about 8.5%, but those aberrations kind of make sense with the macro picture in mind. In the secular run-up from the lows of the early 80s, the growing credit boom seems to me a reasonable (at least partial) explanation. Not only because profits of the finance sector itself grew like topsy, but also because the credit progressively supercharged demand. As for our current extreme, that’s what I was talking about in my earlier comment.

    Lazy answer on the financials? Sure, but I thought we were talking about why the sector had managed to come back after the GFC, not about its place in the long-term scheme of things. Seems to me most official efforts since the crisis have focussed on propping up the status quo rather than encouraging change and innovation. The beast is seen as too scary to tackle head-on: if things went really wrong, the downside hardly bears thinking about. Besides, I suspect hardly anyone deep down feels they really understand what’s under the hood.

    Update: On the extent and pretend business, interesting little piece from Barry Ritholtz.

  21. conrad says:

    “The notion that our societies might in some way become less competitive over time is a very odd one to get our heads around.”

    Isn’t that the just the natural way of the world? We start poor, work really hard, get rich, then get lazy. Then our education level drops, corruption sets in, we think of magic schemes to stay rich, and finally people blame each other (often violently) until everything falls apart. I can’t help but think of the history China, Rome, Greece (and every other once great empire) here.

  22. FDB says:

    Conrad the nihilist.

    I’d never have thought.

  23. Ken Parish says:

    I’m not at all sure I understand all this, but Ingolf’s analysis seems quite impressive to me. Another long-ish post about the Euro zone by a guest poster named Lorenzo over at Skepticlawyer also makes a lot of sense and provides a complementary approach to Ingolf (at least I think it does, but I might be completely misunderstanding both of them). Both are the type of thing that we should but seldom do find in the MSM.

  24. Ingolf says:

    Thanks Ken, and thanks too for Lorenzo’s wonderfully full-blooded critique of the whole Eurozone project.

  25. Alphonse says:

    To debt, I would add inequality. The “hothouse flower” previously watered by debt could have been watered by pre-1980 levels of equality.

  26. Ingolf says:

    It’s an interesting point, Alphonse. I don’t doubt the credit boom made inequality worse; many ill-equipped to do so were drawn into chasing “the better life” by taking on debt.

    I’m not so sure a more equal distribution of income would have prevented the boom. After all, countries like Sweden have also succumbed to credit manias.

    Your comment prompts another thought. Credit booms severely skew monetary obligations. When the music stops, the sector(s) that took on debt face a drawnout, and sometimes near impossible, slog to pay it back while their creditors may well be unable to collect. There is of course often considerable overlap (mortgagees, for example, will usually also be creditors through say their superannuation holdings), but in net terms I do think there’s a meaningful divide. If the boom was big enough, these misshapen obligations distort not only economic activity, but also social relations, for a very long time.

    At worst, I imagine the consequences could be revolutionary.

  27. Dan says:


    There’s a significant body of work from institutional economics proposing that rising household debt was a response to stagnant or declining real wages. Of course, we make decisions based on a) what everyone else is doing and b) keeping slightly ahead of the Joneses. Add to that the increasingly ready availability of consumer credit throughout this period.

    The old house-of-cards analogy is apt here.

  28. Marks says:

    Conrad @ 21, I would have put it a little differently:

    First you get on, then you get honour, then you get honest.

  29. Alphonse says:

    Dan, Ingolf,

    Demand for credit to maintain living standards as median real income declines is one side of it. But money becoming used more as a store of value than as a means of exchange is the corresponding supply side. Inequality drove both sides of the debt explosion and bloated the financial sector.

    To address debt and financial sector bloat is merely to address a symptom.

    The time to tax-advantage unproductive investment of surplus wealth over wage and salary income passed long ago. We don’t need a mere levelling of the playing field now; we need a counter-tilt.

  30. Ingolf says:

    Alphonse, would you mind elaborating on your last comment?

  31. Alphonse says:

    Little time now, more later, but an instance of elaboration: indexed capital gains should be taxed, by now, at a greater rate than earned income. Howard’s move in the opposite direction was exactly the wrong policy at the wrong time in the long term economic cycle.

    I’d add that taxes are less than half the answer to inequality, but the are the first obvious countermeasure to address a deeper structural problem.

  32. Ingolf says:

    Thanks, Alphonse. That helps clear up at least part of what you were saying.

    However, what mostly puzzled me (perhaps I’m just particularly dense this morning) is what you meant by ” . . . money becoming used more as a store of value than as a means of exchange is the corresponding supply side.”

  33. desipis says:

    In line with what Alphonse is saying, I think fiscal policy targeted at assets rather than activity (labour/sales) is needed to address the imbalance caused by high asset appreciation relative to low consumer price inflation. No amount of monetary policy (i.e. changing the relative value of money) is going to be able to address an imbalance between asset and consumption prices (or perhaps the more important relationship is between asset prices and consumption volume).

    The large amounts of cheap debt resulted in people perceiving much more future wealth being available than there actual was, meaning they felt free to spend more now creating artificial and unsustainable demand. Part of the way people are dealing with the shock of discovering the truth about the limited future wealth is to sacrifice current consumption in an attempt to save their imaged future wealth (meaning demand is below its sustainable level). However, with falling demand there’s going to be few productive investment opportunities in a capitalist economy, meaning their money will flow towards simply pumping up non-productive asset prices (e.g. gold), or simply held on to due to low inflationary expectations (i.e. using money “more as a store of value than a means of exchange”). This causes supply issues with credit by causing productive investments to require a higher than normal marginal efficiency in order to compete with non-productive investments.

    Attempting to solve the issue with a more expansionary monetary policy will just exacerbate the issue by enabling people to shift more wealth away from current demand (although may be needed to some extent to restore the financial industry to a position where it has the confidence to lend again). Lowering income/sales taxes (or increasing government spending) is one way to make more funds available to stimulate economic activity, however it has a detrimental effect on government fiscal position. The end result is simply continuing the over valuation of assets through public (instead of private) debt.

    Raising asset based taxes would help shift that money from propping up asset prices into consumption. This would happen either directly through increased government spending, or causing people to spend their money on consumptive items rather than non-productive assets. At the same time it would encourage investment in productive rather than non-productive assets (i.e income through dividends rather than capital appreciation). The effect would be to stimulate economic activity and productive investment but with a relatively positive effect on the government fiscal position.

  34. Ingolf says:

    Thanks, desipis. Pending any further response from Alphonse, that helps greatly in fleshing out what he was saying.

    I obviously have no argument with the notion that the credit fuelled asset boom created “artificial and unsustainable demand”. You go on to say, however, that people’s discovery that many of their dreams of wealth were illusory, amongst other things, reduces demand below its sustainable level. If you’re talking about deviations from some notional long-term trend in sustainable demand, I’d agree, but I think the current deviation below that trend is simply the inevitable counterpoint to the lengthy earlier deviation above.

    You see one of the consequences of money being used “more as a store of value than a means of exchange” as a restricted supply of credit. I agree, which is why I was so puzzled by Alphonse’s apparent assertion that this phenomenon was responsible for the greatly increased supply of credit during the boom. I can only imagine I misunderstood what he was trying to say; hence my queries.

    As for your broader points about fiscal policy targeting assets rather than activity, I’m unsure. It’s not something I’ve thought about enough to have a sensible viewpoint. I think I see what you’re driving at, though, and there may well be some useful policy ideas down this road. That said, I have doubts that funds tied up in assets (whether speculative or “productive”) can ever realistically be squeezed into consumption. To the extent tax policies are aggressive enough to hurt, wouldn’t most investor efforts be devoted to finding ways around that problem rather than giving up and blowing it all on a world trip (so to speak)?

    Anyway, interesting discussion. Thanks.

  35. Paul Frijters says:

    unfortunately, things are much, much, much, much more complicated and it is by no means clear that a closed-economy story around stores of value or means of exchange really help much.

    For instance, examine the central argument that the GFC was effectively the arrival of new information about future production possibilities, leading to an increase in savings. The proper questions on that are:

    1. What information arrived about the future? Much of the world kept growing quite happily, innovations kept occuring, and the economic system has not imploded. How has the bursting of the property bubble really told us much about future income growth? There has certainly been a shift in expectations, but true new information about the future?

    2. From a world point of view, the savings should simply flow to where the rates of return to capital are higher, i.e. to Asia. Yet, most of the capital nevertheless stays within countries and small regions. Why? Because of a large amount of information and institutional constraints. Should you break down those constraints? Maybe yes from an optimal savings point of view, maybe no from a domestic aggregate demand point of view.

    Neither the ‘information has arrived’ point of view, nor the ‘we now save for the future’ point of view hold up against deeper scrutiny. Institutions are far more involved.
    It is just all so damned hard.

  36. Ingolf says:

    New information? I don’t think so, Paul, although I obviously can’t speak for Alphonse and desipis. The GFC simply marked the end of a collective delusion. Without repeated fiscal and monetary stimulus over the years, it would have ended far sooner.

    Much capital has flowed to Asia, and for quite some time. However, in net terms, the region has long been and continues to be a capital exporter. Their mercantilist policies deliberately suppress consumption in pursuit of, amongst other things, that end.

    As an aside, given the force-fed nature of much investment there (particularly in China of late), I do wonder how good the “return to capital” now really is.

  37. Paul Frijters says:

    yes, capital market distortions within China and India are huge. Lots of capital being spent by government directive and lots of barriers to flows of capital within and between Asian countries. More complications yet again ….

  38. desipis says:


    I think the current deviation below that trend is simply the inevitable counterpoint to the lengthy earlier deviation above.

    If the current crisis was a real supply crisis, that is there had been a lack of investment for so long that it caused a real supply slump, then I’d agree with you. People would have to cut back their consumption and increase investment until the new supply became available. Given the current bias towards speculative investment it’s certainly a possible medium term outcome, but I don’t think it’s the (primary) cause of the current crisis.

    I would describe the GFC as more of a nominal demand crisis. People still want roughly the same amount of goods/services and they are still capable of producing roughly the same amount of goods/services, but they are unwilling to actually spend the money they have either because of a lack of confidence (in future income) or a lack of liquidity (due to debt/unemployment). That is the problem is more to do with peoples ability to deal with the existence and uncertainty of the shock, rather than the magnitude of the shock. There might have been some real loss of supply due to malinvestment (e.g. oversupply of housing) however I don’t see the magnitude of that loss as matching the magnitude of the crisis.

    I guess what I’m trying to describe is a process by which sticky speculative asset prices are preventing investment markets from reaching an efficient equilibrium, thus playing a similar role that sticky wages did in the great depression. The mechanism is different: self referencing asset prices based on an imagined security of future value vs employee contracts and psychology; however the general effect of impeding market efficiency and thus economic recovery is the same.

    Fiscal policy targeting asset price is simply a suggestion on how to deal with the problem. There might not be all that much money flow from the speculative assets into consumption, however restoring the long term balance between consumption and asset prices is important in itself. That said, I do suspect that if a tax (or even a some form of regulation) were to have a dampening effect on speculative asset prices that less money would flow into speculative asset markets which would leave more money supply for other sectors of the economy without increasing the long term inflation risk. I suspect the difficult part would be to decrease cash holdings in the short term without increasing fear and uncertainty about liquidity and debt.

    I’ll add that I agree with Paul’s point about things being far more complex than they’re being made out to be, but disagree with his comments about new information. I think one important question from a long term perspective is how modern markets handle risk. I think there’s a trend for entities to externalise as much risk as possible, and when this occurs systemically the whole system can end up geared in an all or nothing way. There’s a strong incentive to increase relative wealth at the risk of losing absolute wealth across the system where the marginal impact on the absolute risk is small. If the aggregate increase in absolute risk across the system is significant then things will eventually go bad. It seems to me to be a similar issue whether we’re talking buying into a bubble along with everyone else, or collectively hoarding cash/wealth in a way that freezes the economy.

  39. Ingolf says:

    We’ve somehow ended up talking at cross purposes, desipis.

    Right at the beginning of the article, I noted that feeble demand was the obvious, proximate problem. Much of the rest of the piece was devoted to the question of why it’s so weak. I thought (#34) we were in agreement on this point.

    Given the size of the credit crisis, the degree of leverage in the system, and the extent of official interventions both fiscal and monetary, it’s hardly a surprise that investment markets (and indeed almost everything else) are struggling to find any sort of equilibrium.

    Agreed, restoring an appropriate balance between consumption and asset prices is important. So too, though, with a multitude of other imbalances. Where we perhaps differ is that I think, wherever possible, that process should be left to the markets. Interventions tend to produce unintended consequences, which in turn require yet more interventions and so on ad infinitum. Bit like US foreign policy.

    Government has critically important roles to play; setting broad standards, redistributing income, protecting the vulnerable and so on and so on. Given the size of the current credit pyramid, it also needs to cushion its return to a more sustainable reality and help to work out a more productive and sustainable financial system for the future. In all this, however, I think it should aim for transparent, general, ideally easily understood guidelines within which markets can then work rather than trying to push and prod with particular targets in mind. The goal, as I said, is the restoration of a natural balance between sustainable supply and demand.

    Apropos “complexity”, I’m not clear on who’s supposedly making things out to be so simple. From my point of view, they’re complex, indeed almost unimaginably so as I noted in the article. It’s one of the reasons I favour decentralised decision making, not only in markets but also in government. To my mind, the best results are likely when those most knowledgeable and immediately concerned are also in the position to make decisions.

  40. desipis says:

    Ingolf, we do differ in our confidence in the markets to sort themselves out (or at least to do so timely and efficiently). One key point though, is that by setting income/capital gains/sales taxes governments are intervening in the market whether they like it or not. Thus it’s important they are aware of the impact they have on a range of balancing issues and ensure they aren’t exacerbating a particular imbalance through fiscal policies (such as tax mix).

  41. Ingolf says:

    Oh agreed, desipis, and you’re also almost certainly right that there’s a more effective mix out there somewhere.

  42. Pedro says:

    But that mix will only be found by luck.

    “The goal, as I said, is the restoration of a natural balance between sustainable supply and demand.”

    Is there any such thing? Both demand and supply change so there can only be a tendency towards or away from equilibrium, not it’s achievement. I do think there is such things as sustained demand and supply, and both arise from the same thing, the production of desired goods and services.

    The other thing I think is apparent, is that the right policies during the reduction in demand phase of this crisis are not the policies needed to move back to trend growth. Artificial demand through fiscal action is not sustainable and the funding of the artificial demand seems to be a constraint on the creation of sustained demand.

  43. Ingolf says:

    Pedro, by “natural balance”, I didn’t mean some permanent state but one where supply and demand are as little affected as possible by credit induced distortions and government intervention. Organic, if you like, or, as you put it, arising from the production of desired goods and services. In short, I don’t think there’s much difference in our views on this.

    I’m not so sure artificially induced demand is the right policy during the crisis phase, in part for exactly the reasons you give about its long-term sustainability. Government needs to help those left most vulnerable by the crisis, but expansion in these areas should probably be offset by contraction in others, or at least by increased taxation at the top end. All attempts to fend off what I see as necessary contraction almost certainly do more to delay resolution of our problems rather than solve them.

    As for that mix, luck is certainly part of finding “it”, but surely not all.

  44. Pedro says:

    Ingolf, I think at the start of the recession, dumping money into the system must be able to ameliorate the downward spiral. The animal spirits go both ways. Once you’ve found a bottom I can’t see how gov’t spending has much probability of setting the path to recovery. It doesn’t matter that there might be lots of money being hoarded, waste is still waste, even climbing out of recession. I wonder what effect govt waste has on the animal spirits aspect of economic trends?

  45. Ingolf says:

    Interesting question, Pedro. Many on the “right” claim uncertainty associated with all this changing intervention accounts for most of business reluctance to invest. They’re in turn regularly pilloried for this viewpoint by the “left”.

    That reluctance is rooted in real world factors, not just mood, but I can’t see how it doesn’t have some effect. I also suspect the widespread feeling that governments are digging a even deeper hole dampens consumer spirits as well.

    On your first point, no argument. Without all the fiscal and monetary support things would have collapsed. So, (given governments were entirely complicit in creating the mess), some cushioning is undoubtedly called for. It’s just (did I say just!) a question of doing that as intelligently as possible.

  46. Pedro says:

    Inflation was once supposed to trick people into real wage cuts and overcome the sticky wage problem. It didn’t for long. Perhaps pump priming has followed the same path. The question I asked when the fiscal blizzard hit in 2008/09 was whether spending that you knew had to end would create much confidence about the future.

  47. Ingolf says:

    Agreed. Plus of course to the extent people view the spending as wasteful, those doubts are heightened.

  48. Dan says:

    @46, 47,

    I think in a crisis those are secondary concerns to confidence *now* and employment *now*. Anyone who has seen how long it took the Australian economy to recover from te early 90s recession would not question the sense of keeping the thing ticking over until it begins to sort itself out.

  49. Ingolf says:

    Dan, it’s a tricky topic, and of course an intensely controversial one. For my broad point of view see #5, 39 and 43.

  50. Pedro says:

    Dan, that is to beg the question of what to do. Even in the 90s recession things were ticking over. If there is 11% unemployed there is still 89% employed. but what can the govt do to create a sustainable recovery? Of course, we never know the counterfactuals.

  51. Dan says:

    Pedro – I think you should read the explanatory notes of a labour force publication to work out what 11% unemployment *actually* implies.

    As for what to do – while granting it is about as far from simple as it’s possible to get, here’s my 2c:

    -moving away from a system built on fictitious capital via the (re-)introduction of stringent lending standards and banking regulation
    -countercyclic economic policy

    Not too much uncertainty there.

  52. Ingolf says:

    I hadn’t, Pedro, thanks. Good article.

  53. Pedro says:

    More for you

    I wonder if in the 30s people were noticing that things were about to get better. Pessimism about future sources of jobs is the flipside of “this time its different”.

  54. Ingolf says:

    I don’t know, Pedro, but that was a very good article, particularly the second half. Thanks (again).

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