© 2019 by Henry Thornton. 

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Ch 16. The Global Crisis

January 8, 2020

Well after my departure from the monastery, I was still interested in economics and economic policy. My main outlet was Henrythornton.com, with six blogs a week, and a monthly column under the nom de plume of Henry Thornton.  Even the Queen of England was surprised by the global crisis, which changed macroeconomics in ways not yet clear.

 

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Just about everyone was surprised by the Global Financial Crisis, sometimes known as the Great Recession. Indeed the Queen of England, during a briefing at the London School of Economics, asked: "Why did nobody notice it?" The answers were unconvincing and little warning was given even by people paid a lot of money to do nothing else but predict economic outcomes. 

 

[Reference: http://www.telegraph.co.uk/news/uknews/theroyalfamily/3386353/The-Queen-asks-why-no-one-saw-the-credit-crunch-coming.html]

 

In March 2007, Malcolm Edey, then Assistant Governor (Economic) at the RBA, summed up the state of the Australian economy as follows: 'The Australian economy has had a lengthy period of expansion. By past standards, we have had reasonably stable growth and low inflation, and the economy has moved closer to full capacity’.

 

The short-term outlook for the world economy looked from the top end of Martin Place like it would be favourable to further growth in Australia.

 

'Longer term forces driven by the emergence of China and India are having some significant effects on Australia's direction of trade, and on relative prices. This has given a significant boost to aggregate incomes and spending. At the same time, it has posed some challenges for manufacturers, although export-oriented manufacturers have managed to continue to grow their businesses in recent years.'*

 

[Reference: * http://www.rba.gov.au/speeches/2007/sp-ag-070307.html]

 

After all, Ben Bernanke, US Fed chief, had told the world it was living at a time of 'Great Moderation'. Output was growing strongly, [goods and services] inflation was low and central bankers had done a wonderful job. Only problem was this 'Great Moderation' was repeating 1920s America. Everything was moderate except asset inflation, which was going through the roof. Mr Bernanke was the chief spruiker for global central banks, and had apparently forgotten that asset booms could become bubbles and turn into damaging busts, as the share bubble did in 1929 USA.

 

In retrospect, Mr Bernanke's judgment, echoed by Australia's Dr Edey, seems gloriously relaxed. The US housing market was in trouble, and known to be, due to many loans to borrowers with 'sub-prime' credit risk. US (and global) stock prices were roaring, and neglect of asset  inflation was a dire traditional mistake of national central banks and Treasuries. History shows that massive asset inflation and subdued goods and services inflation is a heady mix that mostly ends badly. 

 

 See Jonson, Prior Jonson and Ka Mun Ho, Chapter 17 in this book, for evidence of this statement. The 1920s in the USA is a prime 'aberrant experience' that should have warned central bankers.

 

In April 2007, just after Dr Edey's speech, the Aussie dollar hit another high level, trading at US 83 cents on Friday 13. The rising dollar was hurting Australian industry and cheap products were pouring into Australia from Asia.

 

In May, a prominent resource analyst, author of Henry Thornton's Raff Report, explained that he remembered Black Monday in 1987 like it was yesterday. 'Any scientist or other sensible person could see that the trend was completely unsustainable'. The report concluded that 'There would be another correction and it will be a beauty - investors leveraged to junior explorers with only moose pasture risk heavy losses ...'.

 

In June, 'Henry Thornton' discussed the vast disconnect between  asset inflation and goods and services inflation.'Extreme asset inflation with subdued consumer inflation is a global phenomenon.  Is it also a global problem?  This is a big question for modern central banks, and we encourage independent directors to ask RBA governor Glenn Stevens and his team for their answer at today’s meeting of the board.

 

'Henry’s answer is that we need to be concerned because extreme booms in any market are followed by busts.  The inevitable global asset price bust will create substantial misery.' *

 

[ Reference: https://www.henrythornton.com/single-post/2007/06/05/Asset-prices-roaring ]

 

Earlier, 'Henry' had wondered about the likely effect of the long credit boom,

 

In England, in September, the Bank of England was forced to provide emergency loans to a bank, Northern Rock. This was a distant thunderclap that warned of worse news to come.

 

In early October 'Henry' reported on a speech by RBA Deputy Governor, Ric Battellino. The summary was: 'Ric Battellino concludes by saying there are two issues that arise from the developments in household finances over the past decade or two.

 

"The first is that the rise in household debt has made the household sector more sensitive to changes in interest rates. This has meant that central banks have been able to achieve their monetary policy objectives with smaller interest rate adjustments”.

 

This general point has made the Reserve Bank cautious – too cautious it will be judged if indeed the boom is accelerating.
  
"Second, the household sector is running a highly mismatched balance sheet, with assets consisting mainly of property and equities, and liabilities comprised by debt. This balance sheet structure is very effective in generating wealth during good economic times, but households need to recognise that it leaves them exposed to economic or financial shocks that cause asset values to fall and/or interest rates to rise".

 

A third point was not made.  That is that the great credit bubble of the past 30 years has been caused in part by monetary policy that has been too easy.  If this great boom is followed by a great bust – as happened following the great booms of the 1880s and the 1920s – this point will be the main point.

 

It was entirely appropriate that Ric Battellino’s talk was delivered in Marvellous Melbourne, the focal point of Australia's great asset and credit bubble of the 18880s.  Could the Deputy-governor in fact be more subtle than he seems?  *

 

[ Reference https://www.henrythornton.com/single-post/2007/10/02/The-great-money-and-credit-boom ]

 

Later in October, Wall Street fell heavily, led by bank shares. Before long, the main game was cutting cash rates to zero.  Then bailing out major banks, then inventing 'Quantitative easing', or QE for short. This involves central banks buying government bonds in the marketplace, restraining bond yields to multiply the effect of zero cash rates.  Plus exchanging bonds for newly printed cash, a policy sure to promote asset inflation even if goods (or goods and services) inflation was under control.

 

There was to be a lot of bailing out and one prime example, Lehman Brothers, too complicated to bail out.  Global credit markets froze and remained frozen for six months. As already noted I told Graham Burke, CEO of Village Roadshow Ltd, on whose board I sat, that he'd have great trouble getting finance to rollover the US$1 billion debt on the package of VRL movies. After months of talking to bankers, Graham pulled it off. A stunning effort.

 

The game was beginning to change, and the overly relaxed central bankers and Treasury officials were about to experience the worst few years of their career. And the many people who lost their houses, share portfolios and jobs, were not amused.

 

An American guru visited Australia and warned of the American recession underway in his home country. Fun and games at Vlados Steak House in Richmond, a suitably Latin American place to discuss the consequences of easy policy, over-borrowing and over-lending and panic attempts to contain the consequences.

 

In early November, during the election campaign, with consumer inflation becoming uncomfortable, the Reserve bank raised interest rates by 25 basis points. A prime example of 'too little, too late' but soon there was to be a massive change of direction.

 

Following the election, John Howard's long governing and well managed government was replaced by a bunch of relative amateurs, led by Kevin Rudd. I had expected that Mr Rudd would be better than Mr Whitlam, but he had Whitlam's weakness with money and little of his great vision on social matters.  When the global crisis struck, Dr Ken Henry, Secretary of Treasury, advised Treasurer and Prime minister to 'Go early, go hard and go households'.

 

There was a massive spending package. Most households received a cheque for $900, much of which was fed into poker machines. Free insulation was to be installed in house roofs and installation resulted in several deaths of badly trained electricians, an initiative designed to increase Mr Rudd's global aspirations to fight global warming. Cash was sent to schools, often resulting in new school halls and fancy gates, but not allowed to be used for new classrooms, even if this was a struggling school's greatest need. These were the most egregious spending items, but the overall package was estimated to cost $42 billion and in my view was a great waste of taxpayer's money.

 

A Nobel Laureate, Joseph Stiglitz, described the package as 'one of the most impressive economic policies I've seen, ever'. I beg to differ. Australia was still in the grip of the China boom, and a few well chosen programs designed to increase national productivity would have served to calm nerves and would have been sufficient to see us through.  Instead, there was a lot of waste and inefficiency plus actions designed to persuade a culture of 'the government will provide', especially if you vote Labor.

 

In addition, Australia's banks relied on heavy borrowing abroad, and required a guarantee of deposits of up to $250,000 per deposit to minimize the chance of bank default. This I could live with, as a student of history remembering the great depression of the 1890s, discussed in Chapter 3 of this book.

 

Insert Bene, sheep and mountain painting here.

 

Events were far more grim in the USA and the Eurozone. For a time global job loss was faster and more serious than in the Great Depression of the 1930s, and there was no clear certainty this would end soon. Many major banks had to be bailed out and in the aftermath of this there has been valiant attempt to improve bank balance sheets and global prudential rules for bank managements to stick to in future. Ordinary people wondered how such an horrendous 'Great Recession' (except in Australia) could appear from a clear blue sky.

 

My painting, called with satiric intent 'The Great Moderation', is intended to make this point.

 

During the global crisis, there was genuine fear of another Great Depression. Policy makers threw every anti-depression idea they had at the problem.  Rather than the Aussie tradition of 'reduced rations' when fiscal policy was indicated, this time there were too many rations. Zero cash rates were the icing on the ration pile, and 'quantitative easing' was like the Christmas pudding that is too nice to ignore but which is likely to create severe indigestion.

 

In early July 2009, The Bank for International Settlements (BIS), often called  'the central bankers central bank', delivered a first 'official' post mortem, which may seem familiar. ''The fundamental cause of today's problems in the global economy is excessive and imprudent credit growth over a long period ...'

 

'The world economy is near a 'tipping point' that is likely to eventually slow inflation, and may even create a severe slowdown, even a global depression that converts inflation to deflation.

 

'Finally, this unhappy situation is due to lax monetary policy allowing an unprecedented credit and asset bubble'. *

 

* https://www.henrythornton.com/single-post/2008/07/01/BIS-bombshell

 

Once the immediate crisis was over, other writers and official groups began to offer similar diagnoses and specific advice. After seven years of zero cash rates in the USA, the Fed under the stewardship of Janet Yellan, raised the cash rate by 25 basis points in December 2015. This was followed by a similar hike in  December 2016 and three such hikes in 2017. Expectations then were for three such increases in 2018 and 2019, leading to a 'normal' 3.0 % by year end of 2019.  After a tongue lashing by President Trump, Janet Yellan's successor, Mr Powell at end 2018 put further rate hikes on hold.

 

There has been massive, still unfinished, review and attempted reform of rules governing financial institutions. Here is a link to a systematic list of relevant meeting provided by the US Fed. Read it and you will be pleased you are not a 'Prudential supervisor' attempting to make sense of proposed reform in this area. *

* https://www.federalreserve.gov/regreform/reform-systemic.htm

 

The US Fed also announced in September 2017 that it planned soon to begin reducing Quantitative Easing.

 

* https://www.theguardian.com/business/live/2017/sep/20/us-federal-reserve-decision-janet-yellen-markets-uk-retail-business-live

 

Other nations, and the EU, are moving, or thinking of moving slowly in the same direction. In many countries wages growth and goods and services inflation is still low but share prices have been booming. Announcements such as President Trump's major tax cut packages as well as a revival of credit seems to be pushing share prices, notwithstanding the same President's bellicose twittering about many matters, including 'solving' the challenges presented by North Korea's program to build missiles with nuclear bombs.

 

Fiscal policy has created vast mountains of government debt and few economies have so far tackled their slowing. While-ever monetary policy has rates of interest below 'normal' and government debt still growing there is little ammunition to deal with another negative shock. In my view workers of the world fear the fragility of current apparent economic recovery and are therefore reluctant to ask for rises of wages or salaries. Ironically, this reluctance is hindering the recovery of government debt as low wage inflation slows growth of tax and hinders debt reduction.

 

The good news is that this seems to have given governments an incentive to reform systems of gathering tax, which we can hope will eventually make tax systems fairer and more effective. I fear, not so fair and efficient that government spending will be cut but at least to a point where debt piles can begin to be reduced.

 

In 2017, 10 years after the worst of the Global Crisis, an esteemed group of economists held a conference called 'Reviewing Macroeconomics'. A friend, Dr Michael Folie, attended this conference and sent me a link to the conference proceedings.

 

The introductory overview was 'Rethinking macro stabilization.  Back to the future.'  by Olivier Blanchard and Lawrence H. Summers:

 

 ‘Nearly ten years after the onset of the Great Financial Crisis, both researchers and policy makers are still assessing the policy implications of the crisis and its aftermath. Previous major crises, from the Great Depression to the stagflation of the 1970s, profoundly changed both macroeconomics and macroeconomic policy’.

 

‘The crisis has forced macroeconomists to (re)discover the role and the complexity of the financial sector, and the danger of financial crises. But the lessons should go largely beyond this, and force us to question a number of cherished beliefs. Among other things, the events of the last ten years have put into question the presumption that economies are self stabilizing, have raised again the issue of whether temporary shocks can have permanent effects, and have shown the importance of non linearities’.

 

 Concerning previous crises: 'The Great Depression of the 1930s, ... led to the Keynesian revolution, a worry about destabilizing processes, a focus on aggregate demand and the crucial role of stabilization policies. The [stagflation of the 1970s] led instead to the partial rejection of the Keynesian model, a more benign view of economic fluctuations and the self-stabilizing properties of the economy, and a focus on simple policy rules’. 

 

The conclusions of Olivier Blanchard and Lawrence H. Summers includes the following.

'What we specifically suggest is the following: The combined use of macro policy tools to reduce risks and react more aggressively to adverse shocks. A more aggressive monetary policy, creating the room needed to handle another large adverse shock—and while we did not develop that theme at length, providing generous liquidity if and when needed. A heavier use of fiscal policy as a stabilization tool, and a more relaxed attitude vis a vis debt consolidation. And more active financial regulation, with the realization that no financial regulation or macroprudential policy will eliminate financial risks. It may  not sound as extreme as some more dramatic proposals, from helicopter money, to the nationalization of the financial system. But it would represent a major change from the pre-crisis consensus, a change we believe to be essential.’ 

 

My first point is perhaps obvious.  These policies depend on normalising monetary policy, with US cash rates back to 3 %, with costs of bailouts recovered or subsumed by normal budgetary processes and Quantitative Easing reversed. In addition fiscal and debt management must be normalised also, preferably with the Federal US budget in surplus and Federal government debt on a solidly downward path.  Such outcomes will take time, and for now there is little fiscal or monetary policy ammunition to use.

 

Three specific ways to improve the working of financial markets and implications of failure by major financial institutions deemed too big to fail follow.

 

Here is a bold hypothesis. An economy, even one as complicated and many-layered as the global economy, has its own tides and timetables. Governments can steal (or borrow) from the future by spending more, but the future demands its payment which come in the form of debt that needs to be serviced. Indeed, if markets come to think debt is too large, the debt needs to be repaid or else borrowers need to default. Governments can provide temporary stimulus, but this will be very unlikely to much change the overall level of activity, taking one decade with another.

 

A similar theorem applies to monetary policy. Stimulus now will increase economic activity now but the cost comes in the form of inflation and the tightening of future monetary policy, both responses that slow future activity.  If goods and services inflation is low and seemingly stable, and if Animal Spirits are robust, excess money will spill into asset inflation.

 

In the case of Australia, monetary policy as represented (at time of writing) by a 1.5 % cash rate is consistent with low goods and services inflation. If this rate was raised, the already excessive exchange rate would very likely be raised, adding pressure on the trade exposed export industries.

 

Update re later rate cuts and fiscal weakness

 

If interest rates were cut, this would encourage house prices, already on the east coast cities far too high and already falling sharply.  It would also encourage additional borrowing and spending by households already deep in debt. Monetary policy appears gridlocked for now and the foreseeable future.

 

The RBA may say its only requirement is low and stable [goods and services] inflation, but that is inconsistent with the Reserve Bank Act. Excessively high house prices or an exchange rate sufficiently high to inhibit exports of trade exposed industries are both outcomes inconsistent with the Reserve Bank Act.

 

The great monetary economist, Milton Friedman, said that 'monetary policy cannot serve two masters'. In the case of a small open economy like Australia's there are three apparent 'masters' for the central bank to attend to. The late 1980s saw a case where interest rates were cut in an attempt to restrain increases in the value of the Australian dollar. The right approach was to raise interest rates to prevent the development of a damaging boom that produced a major bust.  Trouble is, raising interest rates increased would have raised  an already over-valued currency.

 

In recent experience, interest rate cuts (to support the economy and check the rising exchange rate) helped stoke a strong housing boom that at the time of writing is showing signs of a healthy housing bust. 

 

In my opinion, three objectives requires three policies. Restraining an exchange that is damaging national competitiveness should be handled by a tax on capital inflow. Tiny steps in this direction have been taken in banning overseas purchases of second-hand houses, but an overall tax on capital inflow would be far cleaner and easier to use.  The exchange control department of the Reserve Bank, dismantled overnight when the Australian dollar was floated in 1983, needs to be restored to handle the problem of an exchange rate that make Australian industry uncompetitive.

 

 So called 'Prudential policy' needs to be used to limit the build up of asset prices, especially in Australia house prices. Such a policy has been attempted by the newly created Australia Prudential Regulatory Agency (APRA), created on July 1, 1998 from the prudential rib of the Reserve Bank.  APRA is famously regarded as lacking teeth, a point hinted at in the findings of the Banking Royal Commission] and needs in my view to be restored to the central bank and given a more active role in resisting asset inflation.

 

And regulatory policy in cases of severe asset boom or bust needs to be supported by tightening monetary policy (in a serious boom) or easing (in a severe bust). Recent policy in many nations has responded that way to the bust, but so far asset booms have generally run free.

 

With these changes, the enhanced central bank would have three powerful instruments to modify the overall economy and goods and services inflation ('monetary policy'), maintain external competitiveness ('exchange rate policy') and prudential policy ('asset inflation policy').  The board of the RBA would need greater expertise to handle the more complex tasks it would be charged with.  But the existing Reserve Bank Charter embedded in legislation first formulated in 1959, would still be relevant, and its aims would  more likely to be achieved. 

 

Without the changes outlined here, the Charter will certainly not be achieved, except occasionally by chance.

 

My thoughts follow on more operational matters, including how to handle financial institutions deemed too big to fail.  With large and still rising debt in developed nations – government, corporate and household – how big are the headwinds produced even while interest rates are so low. And what happens when interest rates rise to more normal levels?  For government debt, there is some opinion that once government debt reaches around 90 % of GDP headwinds are likely to be important and likely to make the net effect of deficit financing and debt financing roughly equal.

 

For households, Australia's current household debt at near twice the level of household income seems dangerous. National culture needs changing in this respect in the direction of 'limited debt'. At this point, with existing leaders, it seems likely to require a severe recession in which large numbers of overleveraged households go broke.

 

 On ‘nationalisation’, what about bailout by governments  being paid for by shareholders issuing new paper to government – at least 10 or 20 % of existing – so long suffering taxpayers can be paid for their efforts by sale of the new capital when companies recover?

 

And surely senior managers should ‘pay’ for their incompetence by loss of accumulated bonuses. These should be kept for, say, 5 years after retirement or move to new job and only paid out if company is still in reasonable shape by them.

 

With fiscal policy hobbled by accumulated debt, and monetary policy compromised by confusion about its policy aims and instruments, one conclusion is clear. The only reliable way to improve a nation's rate of growth is to find and implement a set of policies to increase productivity. Decent economists will have a range of ideas to suggest, and governments need to explain why deficit funding is no longer to be used, except when debt levels are greatly reduced. 

 

Governments, or reformed central banks, need to explain why they care about excessive asset inflation was well as goods and services inflation. For small open economies with floating exchange rates there is a need to also control excessive moves in currency values, and the possibility of taxing excess capital inflows or subsidising (or improving productivity enhancing policies) capital inflows when outflows are too great, is an additional monetary policy well worth holding in reserve to curb excessive currency flows.

 

To improve scientific knowledge about modern economies, which seems to be lacking, my solution would include the building and use of carefully constructed, empirical models where hypotheses can be rejected. This approach is now practically unknown, which is a great pity. My attempts to have it taken up by an apparent 'Macroeconomic' department at Melbourne University have been rejected. My proposal was to train up some bright young economists in how to use the programs developed by Clifford Wymer and set up a group that would be able to test hypotheses in the context of solid models containing all the generally agreed macroeconomic relationships.

 

I expressed my disappointment after one sad occasion when such a discussion including our work on 'Animal Spirits' was presented to a few postgraduates and an even fewer members of staff. My friend Professor Ross Garnaut said something like 'Don't worry too much Pete'. Nowdays economists generally work on small subjects, not on big topics such as you are tackling'. Sigh!

 

To go back to the conference of eminent macroeconomists. Here is a link to the full program and supporting material.

 

* https://piie.com/events/rethinking-macroeconomic-policy

 

 Here is a gem from the final paper in the set, by Gita Gopinath.

 

 'Rethinking Macroeconomic Policy: International Economy Issues.'

 

 ‘There is now a new consensus that capital account liberalizations are a mixed blessing, they are associated with excess volatility tied to abrupt surges and reversals in capital flows, and consequently there can be prudent limits to capital account liberalization’.

* https://piie.com/system/files/documents/gopinath20171012paper.pdf

 

My paper on 'Taming the Aussie dollar' in 2013 has a similar conclusion, and it is a nice discovery to find such an eminent fellow traveller.

 

* https://www.henrythornton.com/single-post/2013/01/12/Monetary-policy-revamp

 

In conclusion

 

 The bottom line is that economists have a long way to go to reach an agreed position on some major issues in Macroeconomics. Most economists and central banks should have learned never to regard asset inflation with such benign neglect as asserted so strongly by Alan Greenspan. We now know that a 'Great Moderation', if it involves excess credit expansion and asset inflation needs policy action, though there is no certain solutions yet on how to tame this unholy pair and at what cost to the vital engine of capitalism. We have reinforced the case for stimulatory monetary and fiscal policies when there is risk of a savage downturn.

 

One warning is that we have to hope it is another half-century to get our house in order if we are to safely  act with large scale fiscal and monetary policies. We know that throwing fiscal and monetary expansion will eventually produce headwinds that render such policies impotent. And above all, we need to establish macroeconomics on a stronger scientific basis, preferable with a best practice program of model building and hypothesis testing within the framework of sound structural models.

 

4242 words.

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