There’s plenty that separates the 1930s from today’s business cycle. Unfortunately, “debt” isn’t one of them. I’m writing this because I think we are at a critical juncture where policymakers can either get out in front of this thing — globally — or tinker at the edges as it all comes down. In other words, there’s a normative meme here and a positive one. More on this in a minute.
The kernel of the market’s worries over Europe has been debt. First it was the sovereign debt of Greece. Then its neighbours’. Now it’s the debt of the private banking sector. This is what has me writing today. Because the more we learn about what’s on the balance sheet, the less we like it. Are banks, whether in the USA or Europe, forthright about the quality of their assets? Of course not. Are they coddled by supervisors and regulators? Sure, to some extent. What else do you call relaxation of mark-to-market accounting? It seemed like a wise move at the time, as the world was coming to an end and we just needed to stabilise the banking system when it was tottering. But it doesn’t change the underlying reality of the balance sheet. And this is what brings to mind the chain-of-events in the Great Depression. Debt was a key link in the transmission and the severity of that downturn. Although debts were souring all over the place from 1928 onwards (yes, 1928, before 1929), it wasn’t till 1931 that a major sovereign came under fire. Guess what: that was three years after the peak of the credit boom (1928). Our credit boom peaked in 2007.
1931. Till this point there had been no major sovereign debt default. That was about to change. Souring loans among the commodity exporters killed the appetite for foreign lending, and this “transformed the Central European financial situation” (p.261). The banking system there had grown heavily dependent upon foreign funds. As those vanished, there was little left to provide domestic depositors who wanted out. In May 1931, a lot of them did: the financial status of Austria’s biggest bank was revealed: “deteriorating loan performance had completely wiped out” its capital, in a bank whose balance sheet was as large as the government’s total budget (p. 265). The ensuing bank crisis was enough to bring down the Austrian currency and turn the spotlight on troubles in Hungary and Germany, bringing down their currencies too.
The star player in that story was Credit Anstalt. Worth googling. My point is that events by this point had escaped the grasp of policymakers. Now, I want to point out what we are doing (the positive), and then finish with what we can do (the normative).
Doing. Policymakers in 1931 were hamstrung by the notion that the fixed exchange-rate-regime in Europe must be preserved at all costs. What motivated this prioritisation? The prevailing wisdom at the time held defence of the gold standard to be defence of civilisation itself. (Later, when those countries which left the gold standard performed remarkably better than those that didn’t, this assertion was shown to be unsupported — which makes it an example of dogma.) Today, policymakers are bent on maintaining the EMU exactly as it stands, and making the creditors ‘whole’ (i.e. no haircuts). What policies suit this prioritization? Austerity and suffocation. No haircut=austerity. No currency devaluation=suffocation. Even if wages are cut drastically, they can’t be cut far enough to generate an external surplus. Did you know that, according to the IMF’s own programme (pdf), Greece will still have a debt/GDP ratio of 120% in 2020? (Tops out at 150% in 2013 I think.) That’s if everything goes to plan. Why the emphasis on keeping the eurozone in tact at all costs? Dogma. Whether it’s political (We face an “existential” crisis — Merkel) or economic (“leaving the monetary union would be a dramatically disastrous event for everyone” — Wyplosz). Where are the foundations for these categorical assertions? What are the costs of complying with them? At minimum, they spell years of depression in at least part of the eurozone, and the markets know it. My guess is there’s no way to ring-fence these.
Can do. If it’s true that we can’t ring-fence the troubles in Club Med/Ireland, and if it’s true that the web-of-debt today is no less impressive than that befuddling policymakers in 1931, then we’ve got to get ahead of this. Globally, it’s time to take an extremely broad and realistic view. The credit boom from which we are all contracting was epic. So start in Europe. Get a debt solution over with. It won’t be pretty but it won’t be nearly as bad as the hard money people will have you believe. AS SOON AS the overhang of debt is addressed in a realistic way, which explicitly countenances a realistic growth path for the debtors, the markets will start discounting high growth. Because this is a bullish platform. Take the hyperinflationistas with a pinch of salt: paper money is not going to go up in flames. There is over-ample supply capacity in the global economy, and the worth of money comes not from the intrinsic value of the medium but the technology it serves: money is a means-of-exchange and has tremendous transactions utility. That’s why paper money has value. Come to mention it, this is the only way to explain why gold coins circulated at far in excess of their intrinsic metallic value in the 19th century. They fulfilled a transactions utility. You could have as easily looked at the gold standard back then and cried “fiat money!” as you can now. Not quite … but that’s a pandora’s box for later.