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“We continue to be amazed at how many commentators, otherwise very thoughtful and well-informed, seem to think that humans will find technological solutions, such as super-efficient appliances and mag-lev light rail, to cure the impending energy shortfall. That won’t happen, and our Ponzi money system is why.”
Ted Glick, in “Making a Renewable Energy Revolution,” Future Hope, March 2, 2014, writes:
A climate revolutionary is someone who works for a rapid and just transition away from oil, coal, gas and nukes to an economy powered primarily by wind, solar and geothermal energy, with energy sources increasingly decentralized and community-based, with society-wide energy conservation and energy efficiency, and with a conscious plan to ensure that this transition is done in a way which creates living wage jobs both for the currently unemployed and for workers in the fossil fuel industry who lose their jobs because of the shift to renewables. There are tens, if not hundreds, of thousands of activists in the United States who I believe are in general agreement with this perspective. They are part of the numerous local, state, regional and national groups which prioritize the climate issue in some way.
Don’t get us wrong. We admire Ted Glick.
We have been bullish on transitioning the world back to solar energy since the late 1960s, when we bought our first solar cells and started tinkering with wind generators. By the early 70s, when we started Global Village Institute as ‘Global Village Technology,’ we were constructing concentrating arrays using Fresnel lenses and exotic gallium arsenide silicon chips and bending our own windmill blades on self-made presses, as our copies of Soft Energy Paths and The Mother Earth News grew dog-eared. In the 80s we enjoyed a steady diet of encouragement from Barry Commoner, Bill Mollison and Denis Hayes and hoped fervently that the world would beat the last remaining blades of fossil sunlight into solar plowshares.
A half-century later, we are likely seeing the end of that dream, not for want of desire, but from simple arithmetic. Industrial scale renewable energy will inevitably decline. Don’t mistake this prediction as saying we are at peak renewables. Quite the contrary. Perhaps even the nascent industry has a good ways to go, borne on the wings of capital flight from fossil and nuclear, and much good can yet be accomplished. But as a share of overall energy production, renewables are still in the trough that they slid into at mid-Nineteenth Century. On a straight-line chart, they could climb out of that slump by mid- to late-Twenty-First Century. What we won’t have, though, is the technological civilization Ted Glick takes for granted. The renewable energy source with the biggest market share will be firewood.
How long the solar and wind farm phenomena persist will depend on how long our current ‘extend and pretend’ debt-based global economic paradigm can be sustained. Maybe another month. Maybe half a century. But when that is done, we will be back once more to something approaching fully solar. You can take that to the bank.
Lets run a few numbers to demonstrate.
Energy keeps our economy running. Energy is also what we use to obtain more energy. The more energy we use to obtain more energy, the less we have for anything else. That dilemma was most recently explained in superlative detail by Steve Kopits in a talk at Columbia University in February.
The trend is already clear: the energy of the future will have lower energy return on energy invested — EROEI — than the energy of the past. Apart from some rare abiogenic sources, all fossil fuels are biofuels — from plants and animals that grew and harvested sunlight over millions of years. All renewables derive from the current energy flux (sunlight, wind, tides, plant growth, or heat from the earth) in real time. Renewables have low EROEI compared to high-carbon fuels such as coal and oil. In some cases — the Alberta Tar Sands, many shale oil plays, new nuclear — the EROEI may even be net minus. What is being purchased with greater nature-debt is time.
Jeff Vail, in a 2009 post, offered these two examples:
Basic data: 1.2 MW array installed 2009 in Los Angeles, cost $16.5 million up front (ignoring rebates/tax credits/incentives), projected financial return of $550,000 per year. At the rough California rate of $.15 per KWh, that’s about 4 GWh per year (conservative).
Price-Estimated-EROEI Calculation: The $16.5 million up-front is, at $0.09/KWh (here using national average, as there’s no reason to think that manufacturers would use primarily California peaking power to build this system), an input of 183 GWh through installation (I’m ignoring the relatively small maintenance costs here, which will also make the figure more conservative). If we assume a life-span of 40 years, then the energy output of this system is 160 GWh. That’s a price-estimated EROEI of 0.87:1.
Wind Example: I’ve had a more difficult time finding a recent wind project where good data (on both cost and actual, as opposed to nameplate, output) is available. As a result, I’ve chosen a 2000 Danish offshore wind project at Middelgrunden. While up-front expenses may be higher off-shore (making the resulting EROEI more accurate for offshore projects than on-shore), I think this is a relatively modern installation (2MW turbines).
Basic data: Cost of $60 million, annual energy output 85 GWh. Price-Estimated-EROEI Calculation: At the US national average rate for electricity ($0.09/KWh), the $60 million up-front energy investment works out to 666 GWh. Using a life-span of 25 years (and assuming zero maintenance, grid, or storage investment, making the result artificially high), the energy output comes to 2125 GWH. That’s a price-estimated-EROEI of 3.2:1.
While it might have been possible to build a Maya-type or Roman-type civilization on an EROEI of 3:1, it is not possible to sustain modern technological complexity on anything much below 5:1. Remember, we put men on the moon and laid internet fiber cables under the oceans when EROEI was 100:1, so even 5:1 is pretty speculative, and would likely require some significant technological leaps that have not occurred despite vast capital being thrown at them, and now seem unlikely (i.e.: “fairy dust”).
One bellweather is air travel. Since Peak Oil was hit globally in 2005, airlines have been operating on the edge of bankruptcy, cutting amenities to allocate more cash to purchasing fuel. It has been reportedthat without the quick and dirty impact of US shale oil in 2012, some airlines would have already gone into receivership.
We continue to be amazed at how many commentators, otherwise very thoughtful and well-informed, seem to think that humans will find technological solutions, such as super-efficient appliances and mag-lev light rail, to cure the impending energy shortfall. That won’t happen, and the Ponzi money/debt system is why, but frankly, we find it difficult to imagine a civilization approaching ours in complexity being able to subsist on daily solar income in much the same style it had on that 500-million year fossil energy trust fund, even if money were magically reformed.
Since 2008 it has become clear that the timing of the crash of our oil-dependent civilization comes around to the fate of a single indicator. It comes down to James Carville’s famous imperative for the Clinton Campaign: “It’s The Economy Stupid!” We can count ourselves lucky, from a climate standpoint, that globalization was still relatively young when the party ran out of ice and had to break up.
All political systems exist to concentrate wealth at the center at the expense of the periphery. So to maintain their complex central operating systems and lavish gifts upon their extremely wealthy and wasteful bazillionaires, London, New York, Stockholm, Moscow and Beijing sucked wealth out of very large moneysheds — Africa, South America, Eastern Europe, Asia and Australia. When they can’t do that anymore — because the EROEI crisis has become a financial crisis — the sell orders will start to cascade. Distant trading relationships have a hard time remaining stable. Empire centers have to start maintaining their unsustainably high standards of living by sucking up marginal wealth from smaller, closer areas. This is what happened in ancient Rome and is now happening on the European periphery. That strategy only gets you so far before the local wealth is completely exhausted and there is nothing left to drain.
This is the soft underbelly of industrial scale renewable energy. It is not shortages of rare earths or energy inputs to make solar cells and windmills. It is the ability to finance production when your economic system is in free fall.
Dani Rodrik reviews the fundamental lessons about emerging economies that economists have refused to learn. – Project Syndicate
But now the emerging-market blues are back. The beating that these countries’ currencies have taken as the US Federal Reserve begins to tighten monetary policy is just the start; everywhere one looks, it seems, there are deep-seated problems.
Argentina and Venezuela have run out of heterodox policy tricks. Brazil and India need new growth models. Turkey and Thailand are mired in political crises that reflect long-simmering domestic conflicts. In Africa, concern is mounting about the lack of structural change and industrialization. And the main question concerning China is whether its economic slowdown will take the form of a soft or hard landing.
This is not the first time that developing countries have been hit hard by abrupt mood swings in global financial markets. The surprise is that we are surprised. Economists, in particular, should have learned a few fundamental lessons long ago.
First, emerging-market hype is just that. Economic miracles rarely occur, and for good reason. Governments that can intervene massively to restructure and diversify the economy, while preventing the state from becoming a mechanism of corruption and rent-seeking, are the exception. China and (in their heyday) South Korea, Taiwan, Japan, and a few others had such governments; but the rapid industrialization that they engineered has eluded most of Latin America, the Middle East, Africa, and South Asia.
Instead, emerging markets’ growth over the last two decades was based on a fortuitous (and temporary) set of external circumstances: high commodity prices, low interest rates, and seemingly endless buckets of foreign finance. Improved macroeconomic policy and overall governance helped, too, but these are growth enablers, not growth triggers.
Second, financial globalization has been greatly oversold. Openness to capital flows was supposed to boost domestic investment and reduce macroeconomic volatility. Instead, it has accomplished pretty much the opposite.
We have long known that portfolio and short-term inflows fuel consumption booms and real-estate bubbles, with disastrous consequences when market sentiment inevitably sours and finance dries up. Governments that enjoyed the rollercoaster ride on the way up should not have been surprised by the plunge that inevitably follows.
Third, floating exchange rates are flawed shock absorbers. In theory, market-determined currency values are supposed to isolate the domestic economy from the vagaries of international finance, rising when money floods in and falling when the flows are reversed. In reality, few economies can bear the requisite currency alignments without pain.
Sharp currency revaluations wreak havoc on a country’s international competitiveness. And rapid depreciations are a central bank’s nightmare, given the inflationary consequences. Floating exchange rates may moderate the adjustment difficulties, but they do not eliminate them.
Fourth, faith in global economic-policy coordination is misplaced. America’s fiscal and monetary policies, for example, will always be driven by domestic considerations first (if not second and third as well). And European countries can barely look after their own common interests, let alone the world’s. It is naïve for emerging-market governments to expect major financial centers to adjust their policies in response to economic conditions elsewhere.
For the most part, that is not a bad thing. The Fed’s huge monthly purchases of long-term assets – so-called quantitative easing – have benefited the world as a whole by propping up demand and economic activity in the US. Without QE, which the Fed is now gradually tapering, world trade would have taken a much bigger hit. Similarly, the rest of the world will benefit when Europeans are able to get their policies right and boost their economies.
The rest is in the hands of officials in the developing world. They must resist the temptation to binge on foreign finance when it is cheap and plentiful. In the midst of a foreign-capital bonanza, stagnant levels of private investment in tradable goods are a particularly powerful danger signal that no amount of government mythmaking should be allowed to override. Officials face a simple choice: maintain strong prudential controls on capital flows, or be prepared to invest a large share of resources in self-insurance by accumulating large foreign reserves.
The deeper problem lies with the excessive financialization of the global economy that has occurred since the 1990’s. The policy dilemmas that have resulted – rising inequality, greater volatility, reduced room to manage the real economy – will continue to preoccupy policymakers in the decades ahead.
It is true, but unhelpful, to say that governments have only themselves to blame for having recklessly rushed into this wild ride. It is now time to think about how the world can create a saner balance between finance and the real economy.
I was born and raised in New York City, on the east side of Manhattan (with a brief intermezzo in the long Island Suburbs (1954 – 1957) though I have lived upstate, two hundred miles north of the city, for decades since. I go back from time to time to see publishers and get some cosmopolitan thrills. One spring morning a couple of years back, toward the end of Mayor Bloomberg’s reign, I was walking across Central Park from my hotel on West 75th Street to the Metropolitan Museum of Art when I had an epiphany.
Which was that Central Park, and indeed much of the city, had never been in such good condition in my lifetime. The heart of New York had gone through a phenomenal restoration. When I was a child in the 1960s, districts like Tribeca, Soho, and the Bowery were the realms of winos and cockroaches. The brutes who worked in the meatpacking district had never seen a supermodel. Brooklyn was as remote and benighted as Nicolae Ceausescu’s Romania. The Central Park Zoo was like a set from Riot in Cellblock D, and the park itself was desecrated with the aging detritus of Robert Moses’s awful experiments in chain-link fencing as a decorative motif. Then, of course, came the grafitti-plagued 1970s summed up by the infamous newspaper headline [President] Ford to City: Drop Dead.
Now, the park was sparkling. The sheep’s meadow was lovingly re-sodded, many of Frederick Law Olmsted’s original structures, the dairy, the bow bridge, the Bethesda Fountain, were restored. Million dollar condos were selling on the Bowery. Where trucks once unloaded flyblown cattle carcasses was now the hangout of movie and fashion celebrities. Brooklyn was a New Jerusalem of the lively arts. And my parents could never have afforded the 2BR/2bath apartment (with working fireplace) that I grew up in on East 68th Street.
The catch to all this was that the glorious rebirth of New York City was entirely due to the financialization of the economy. Untold billions had streamed into this special little corner of the USA since the 1980s, into the bank accounts of countless vampire squidlets engaged in the asset-stripping of the rest of the nation. So, in case you were wondering, all the wealth of places like Detroit, Akron, Peoria, Waukegan, Chattanooga, Omaha, Hartford, and scores of other towns that had been gutted and retrofitted for suburban chain-store imperialism, or served up to the racketeers of “Eds and Meds,” or just left for dead — all that action had been converted, abracadabra, into the renovation of a few square miles near the Atlantic Ocean.
Nobody in the lamebrain New York based media really understands this dynamic, nor do they have a clue what will happen next, which is that the wealth-extraction process is now complete and that New York City has moved over the top of the arc of rebirth and is now headed down a steep, nauseating slope of breakdown and deterioration, starting with the reign of soon-to-be hapless Bill de Blasio.
Mayor Bloomberg was celebrated for, among other things, stimulating a new generation of skyscraper building. There is theory which states that an empire puts up its greatest monumental buildings just before it collapses. I think it is truthful. This is what you are now going to see in New York, especially as regards the empire of Wall Street finance, which is all set to blow up. The many new skyscrapers recently constructed for the fabled “one percent”— the Frank Gehry condos and the Robert A.M. Stern hedge fund aeries — are already obsolete. The buyers don’t know it. In the new era of capital scarcity that we are entering, these giant buildings cannot be maintained (and, believe me, such structures require incessant, meticulous, and expensive upkeep). Splitting up the ownership of mega-structures into condominiums under a homeowners’ association (HOA) is an experiment that has never been tried before and now we are going to watch it fail spectacularly. All those towering monuments to the beneficent genius of Michael Bloomberg will very quickly transform from assets to liabilities.
This is only one feature of a breakdown in mega-cities that will astonish those who think the trend of hypergrowth is bound to just continue indefinitely. It will probably be unfair to blame poor Mr. de Blasio (though he surely can make the process worse), even as it would be erroneous to credit Michael Bloomberg for what financialization of the economy accomplished in one small part of America.
“The powers of financial capitalism had (a) far-reaching aim, nothing less than to create a world system of financial control in private hands able to dominate the political system of each country and the economy of the world as a whole. This system was to be controlled in a feudalist fashion by the central banks of the world acting in concert, by secret agreements arrived at in frequent meetings and conferences. The apex of the systems was to be the Bank for International Settlements in Basel, Switzerland; a private bank owned and controlled by the world’s central banks which were themselves private corporations. Each central bank… sought to dominate its government by its ability to control Treasury loans, to manipulate foreign exchanges, to influence the level of economic activity in the country, and to influence cooperative politicians by subsequent economic rewards in the business world.” – Carroll Quigley, member of the Council on Foreign Relations
If one wishes to truly understand the actions behind private Federal Reserve policy, one must come to terms with a fundamental reality – everything the Fed does it does for a reason, and the most apparent reasons are not always the primary reasons. If you think that the Fed simply acts on impulsive stupidity or hubris, then you haven’t a clue what is going on. If you think the Fed only does what it does in order to hide the numerous negative aspects of our current economy, then you only know half the story. If you think the Fed does not have a plan, then you are sorely mistaken…
Central Bankers and their political proponents espouse a globalist ideology, meaning, they are internationalists in their orientation and motivations. They do not have loyalties to any particular country. They do not take an oath to any particular constitution. They do not have empathy for any particular culture or social experiment. They have their own subculture, with their own “values”, and their own social hierarchy. They are a kind of “tribe” or “sect”; a cult,if you will, that views itself as superior to all others. This means that when the central bankers that run the Fed act, they only act with the intention to support and promote globalization, not the best interests of America and Americans.
The process of globalization REQUIRES the dissolution of the U.S. economy as it exists today. Period. There is no way around it. America can no longer remain a superpower in the face of what globalists call “harmonization”. The dollar can no longer maintain its petro-currency status or its world reserve status if total centralization under a new global currency is to be achieved. Globalists believe that America must be sacrificed on the altar of “progress”, and diminished into a mere enclave, a feudal colony of a greater global system. The globalists at the Fed are no different.
Once this driving philosophy is understood, the final conclusion is obvious – the Fed exists to destroy the U.S. financial system and the U.S. currency mechanism. That is what they are here for.
This is why the dollar has lost 98% of its value since the Fed was established in 1913. This is why the Fed deliberately engineered the derivatives bubble crisis through the implementation of artificially low interest rates. This is why their response to the crisis was to create yet another massive bubble in stocks and bonds through QE stimulus. This is why the Fed is cutting stimulus today.
How does the taper play into the long running program of dollar destruction and globalization? Let’s take a look…
The Multifaceted Taper Strategy
In my article ‘Is The Fed Ready To Cut America’s Fiat Life Support’, and my article ‘Expect Devastating Global Economic Changes In 2014’, I predicted that a Fed taper was highly likely. Central banks almost always implant policy shift rumors into the mainstream media a few months before they implement them. They did this for TARP, for QE1, QE2, QE3, and the Taper. In fact, the Fed spent the better part of the past quarter conditioning investors to the idea of stimulus cuts, so I was not at all surprised when they followed through.
The Fed has, of course, now announced a $10 billion QE reduction just in time for Christmas and the 100th anniversary of the privately run institution. In the past, I have pointed out the tendency of central banks to enforce detrimental policy changes while the government, the economy and/or the bank itself is in the midst of a major transition. The Fed’s taper announcement comes just in time for the end of Ben Bernanke’s term as chairman, and the expected nomination of Janet Yellen.
This is done, I believe, because it provides an opportunity to divert blame for a crisis event they know is on the horizon. If attention is ever focused on the Fed specifically for a market downturn or bond disaster triggered by the ever present dollar bubble, Yellen can simply blame the QE policies of Bernanke (who will be long gone), while promising that her “new” policies will surely repair the damage. This placates the public and buys the central bankers time to do even MORE damage.
The taper itself is not just a “head fake”, however. It is a far more complex action. Tapering provides a method of psychologically distancing the Federal Reserve from the consequences of market movements. The banksters are essentially proclaiming to the public that their work is done, they have saved the economy, and now they are moving on, be it only $10 billion at a time. Whatever happens from here on is “not their fault”.
Most alternative analysts expected no taper of QE, and for good reason. While the mainstream touts the propaganda of economic recovery, independent financial experts understand that little to nothing was actually accomplished by the bailouts. Virtually no stimulus was absorbed in a localized way by mainstreet business. Real unemployment counting U-6 measurements still stands at around 20%. Real estate markets and home prices have a received a small boost, which at first glance appears positive until one examines who is actually buying; namely big banks and international investment firms snapping up properties only to reissue them on the market as rentals:
U.S. holiday retail sales and annual retail sales have been the weakest since 2009:
The only thing that QE ultimately accomplished was a spectacular rise in stocks through direct manipulation, which Fed agents like Alan Greenspan and Richard Fisher now openly admit to. The problem is, while gamblers in equities proudly boast about the Fed induced bull run in the Dow and how much money they have made, they remain oblivious to the underlying cost of the charade. Market investors have been enriched, yes, but little do they know that stock legitimacy is about to be sacrificed.
The price to earnings ratio of stocks (the market value of stocks versus what they SHOULD be valued according to the actual earnings of the companies listed) in the S&P 500 today stands at around 15, which is the highest it has been since before the 2008 market crash. Mainstream economists attempt to dismiss the issue by using a 15 year average while claiming that the P/E ratio in 2013 is mild compared to the tech bubble of the late 90’s. What they don’t seem to grasp is that the market of the past four to five years is an entirely different animal compared to 15 years ago.
Stocks in general have received considerable support through purchases by Fed bolstered banks and the Fed itself, creating an atmosphere of artificial demand for equities using QE fiat injections. Though no full audit of the bailouts exists (TARP is the only measure audited so far), it is projected that the banking sector alone has garnered tens of trillions in Fed fiat, which they have used to bolster their otherwise debt ridden holdings. It is only logical to expect that this capital tsunami has been used by numerous companies as a way to present false earnings.Goldman Sachs, JP Morgan, and Morgan Stanley all reported substantial profits for 2009 while at the same time reporting massive liabilities caused by the derivatives crash so that they could collect on the bailout bonanza.
So which one is it? Are companies making profits, or are they wallowing in insurmountable debt while presenting government stimulus as a form of profit?
What the Fed and corporate banks have done is create a market in which neither earnings, nor stock values can be trusted. The fact that the P/E ratio is higher than it has been since 2008 despite this manipulation should concern anyone with any sense.
Worst of all, the Fed’s monetization of U.S. Treasury debt has only expanded while foreign investment in long term debt has contracted. With our official national debt growing by at least $1 trillion per year, our country cannot continue to function without an ever increasing amount of foreign investment, or, Federal Reserve printing. The Fed cannot make cuts to QE if our system is to survive (if you want to call it survival), the Fed must expand QE forever, or at least until the dollar implodes due to hyperinflation.
So then, why has the taper been introduced at all? No one wants it. The government shouldn’t want it. Investors certainly don’t want it. Our economy is utterly dependent on the opposite. What purpose does it serve?
The assumption has always been that the Fed wants to keep the system afloat. I submit that things have changed. I submit that the Fed no longer wishes to prop up our fiscal structure, or at least, no longer wishes to be seen as propping it up. I submit that the Fed is not pursuing dollar destruction through standard hyperinflation, but rather, they are preparing the U.S. for default, which also will result in currency implosion.
The Taper Parallels
“It must not be felt that the heads of the world’s chief central banks were themselves substantive powers in world finance. They were not. Rather they were the technicians and agents of the dominant investment bankers of their own countries, who had raised them up, and who were perfectly capable of throwing them down. The substantive financial powers of the world were in the hands of these investment bankers who remained largely behind the scenes in their own unincorporated private banks. These formed a system of international cooperation and national dominance which was more private, more powerful, and more secret than that of their agents in the central banks. “ – Carroll Quigley, Tragedy And Hope
Initial shock over the taper scenario has not sunk into the markets yet (as Zero Hedge points out, the last time a major central bank cut stimulus measures to a dependent country, stocks rallied, then crashed within months). Few people see much difference between $75 billion per month and $85 billion per month, but the size of the cuts is not really the issue. Rather, it is the Fed’s act of fading into the background that should concern us.
The taper announcement parallels perfectly with the accelerating debate over the U.S. debt ceiling, and I do not think this is at all a coincidence. Tapering seems inconceivable to many, but for the Fed it makes perfect sense if the goal of the globalists is to generate a default scenario while diverting blame. I believe that Americans are being prepared psychologically for just such an event. Already, the White House is warning that government funding will essentially disappear by the end of February:
The expectation fostered by the mainstream media is that a debt fight similar to the October theater will not happen again. I agree. I believe the next debate will be much worse. The vast majority will assume that the “can” will be kicked down the road again, and they may be right, but given the Fed’s behavior, and given that they have begun to taper despite what appears logical, many people may be in for a shock when our government also suddenly decides one day soon to buck assumptions and default rather than prolong the pain.
The full spectrum failure of Obamacare only adds excuse and incentive. There is no longer a legislative centerpiece rationale for further spending. Obama’s approval rating is at historic lows for any president. The stage has been set for the most epic of fake political battles.
The Left and Right leadership, at the top of the pyramid, are nothing more than flunkies for the global elite. If globalists have decided that it is time to apply the final death blows to the dollar, default would be the quickest and most efficient way, and political puppetry can easily make it happen. The calamity would be blamed on “partisan bickering” and “government gridlock”, or even the inefficiency of “democracy”. The Fed, with its taper in place and its fake recovery established, would be presented as the only “sane” institution at America’s disposal.
Perhaps at this point even more pervasive QE programs would recommence, perhaps not. At bottom, though, the taper is not a peripheral issue. It is an action at the center of a much more elaborate process, an action that seems to have been undertaken in preparation for a larger event. The next year is shaping up to be the most chaotic since the debt crisis began in 2008, and as the situation progresses, the subtleties of the Federal Reserve and the international banks that back it must not go unnoticed, or in the end, unpunished.
An economist recently recommended that I read a paper by three Fed researchers titled: “Why Did So Many People Make So Many Ex Post Bad Decisions? The Causes of the Foreclosure Crisis.” It was presented at a major conference last year and made the rounds again in the economics blogosphere this year with generally positive reviews. It seems to have been influential.
The authors – Christopher Foote, Kristopher Gerardi and Paul Willen – argue that the financial crisis was caused by over-optimistic expectations for house prices, while other factors such as distorted incentives for bankers played only minor roles or no roles at all. In other words, it was a bubble just like the Dutch tulip mania of the 1630s or South Sea bubble of the early 1700s, and had nothing to do with modern financial practices.
Then the authors make absolutely sure of their work being well-received by those who matter. The financial crisis is surely a touchy subject at the Fed, where the biggest PR challenge is “bubble blowing” criticism from those of us who aren’t on the payroll (directly or indirectly). But Foote, Gerardi and Willen are, of course, on the payroll. They tell us there’s little else that can be said about the origins of the crisis, because any “honest economist” will admit to not understanding bubbles.
Here’s their story:
[I]t is deeply unsatisfying to explain the bad decisions of both borrowers and lenders with a bubble without explaining how the bubble arose. …Unfortunately, the study of bubbles is too young to provide much guidance on this point. For now, we have no choice but to plead ignorance, and we believe that all honest economists should do the same. But acknowledging what we don’t know should not blind us to what we do know: the bursting of a massive and unsustainable housing bubble in the U.S. housing market caused the financial crisis.
We don’t often critique papers like this (who cares about Fed research outside of academic economists?) But what the heck, the bolded sentences above – in particular, the hypocritical reference to “honest economists” – deserve at least a few words of rebuttal.
We’ll limit our comments to two areas. First, we’ll offer a redline edited version of a key section in the authors’ conclusion, mostly to share a different perspective on the financial crisis. Second, we’ll point out an example of dishonesty from these economists who brazenly claim that their own perspective is the only one that can be called honest.
Where did the bubble come from?
In practice, the authors don’t completely “plead ignorance” about the causes of bubbles as they claim to do. They offer a few “speculative” ideas about the housing bubble, writing:
One speculative story begins with the idea that some fundamental determinants of housing prices caused them to move higher early in the boom. Perhaps the accommodative monetary policy used to fight the 2001 recession, or higher savings rates among developing countries, pushed U.S. interest rates lower and thereby pushed U.S. housing prices higher. Additionally, after the steep stock market decline of the early 2000s, U.S. investors may have been attracted to real estate because it appeared to offer less risk. The decisions of Fannie Mae and Freddie Mac may have also played a role in supporting higher prices…
This smells to us like a strategy of gently acknowledging criticism (of the Fed’s interest rate policies), while at the same time attempting to neutralize it. The authors imply that low interest rates were an unavoidable byproduct of the Fed’s recession fighting, and then shift some of the blame to foreigners in developing countries before moving on to other possible explanations.
But even if you believe the Fed’s anti-recession measures were worthwhile, the authors’ story is nonsense. It needs corrections for the facts that the Fed continued to slash rates nearly two years after the 2001 recession and then maintained an ultra-easy stance for a few years after that. It also begs the question of why the Fed responded to high foreign savings rates – which were the flip side to U.S. current account deficits and primary source of disinflation – with even greater stimulus. Moreover, there’s much more to the Fed’s role in the housing boom than these factors.
As we see it, the financial crisis validated certain principles that aren’t reflected in mainstream models but feature in fringe areas such as Austrian business cycle theory orbehavioral economics. Economists in these areas offer far more detailed explanations for the housing bubble than the “speculative story” above. For example, recent Nobel Prize winner Robert Shiller filled a whole book with bubble theories. While Foote, Gerardi and Willen would presumably call these economists dishonest, we beg to differ. Borrowing from non-mainstream ideas, here’s our edited version of the excerpt:
If this version is accurate, the Fed’s failures include three whoppers:
- Monetary policy was too stimulative throughout the boom.
- Two decades of Greenspan/Bernanke “puts” created a mentality that risky bets couldn’t lose (moral hazard).
- The Fed applauded rather than stopping the deterioration in lending standards, blithely disregarding its status as only institution that was mandated to set nation-wide lending requirements.
As you might expect, Foote, Girardi and Willen weave a story that either denies or diverts attention from all three failures. One part of the story is their claim that bubbles can’t be explained and anyone who thinks otherwise is dishonest. If the defining feature of the crisis can’t be explained, then it can’t be blamed on the Fed, right?
Other parts of the story are embedded in 12 “facts” that are said to describe the crisis. As written, many of the “facts” are strictly true. Some may have even added to the public debate because they weren’t widely known in policy circles, even as they were understood in the fixed income business. Others, though, can only distort that debate. The worst of the so-called facts are somewhere in between flat wrong and technically accurate but interpreted in ways that don’t stand up to scrutiny.
Lending standards didn’t really change during the boom?!?
We’ll point out a single example, from pages 9-11 of the paper and sub-titled, “Fact 4: Government policy toward the mortgage market did not change much from 1990 to 2005.” In this section, the authors deny that policymakers dropped the ball on lending standards. They don’t mention central bankers explicitly (that would be too obvious?), choosing instead to absolve the Clinton administration of blame for its ill-fated National Home Ownership strategy. Of course, their argument also exonerates the Fed if you happen to believe it.
The argument depends partly on a history lesson that begins like this:
It is true that large downpayments were once required to purchase homes in the United States. It is also true that the federal government was instrumental in reducing required downpayments in an effort to expand homeownership. The problem for the bad government theory is that the timing of government involvement is almost exactly 50 years off. The key event was the Servicemen’s Readjustment Act of 1944, better known as the GI Bill, in which the federal government promised to take a first-loss position equal to 50 percent of the mortgage balance, up to $2,000, on mortgages originated to returning veterans.
The authors then tell a nostalgic tale about loan-to-value (LTV) ratios in the 1950s and 1960s, before skipping ahead to the 1990s and 2000s. For the latter period, we’re told to believe that lending standards didn’t decline in a meaningful way:
Figure 6 shows LTV ratios for purchase mortgages in Massachusetts from 1990 to 2010, the period when government intervention is supposed to have caused so much trouble … But inspection of Figure 6 does not support the assertion that underwriting behavior was significantly changed by that program [Clinton’s National Homeownership Strategy].
Here’s the key chart that goes with this claim:
Here are a few reasons why the thesis doesn’t fit the reality:
- The authors share data for only one state (Massachusetts), while failing to mention that it didn’t have much of a housing bust. Consider that Boston is one of only four cities (out of 20) in the S&P/Case-Shiller Home Price Index for which prices didn’t fall by more than 20%. During the bear market period for the full index, the Boston component fell only 16%, less than half the 34% drop in the national index.
- The authors’ sweeping argument relies on not only a single state, but also a single indicator (LTV ratios). You might wonder: What were the credit scores of borrowers at each LTV level? How did their incomes compare to monthly mortgage payments? Were their incomes verified? These types of questions need answers before you can draw general conclusions about underwriting behavior.
- Even the cherry-picked data – Massachusetts LTV ratios! – doesn’t support the authors’ conclusions. It shows that the incidence of ratios greater than 100% tripled during the housing boom, from about 8% of all Massachusetts mortgages to about 25%. The claim that this change isn’t significant is incredulous.
- LTV ratios in the 1950s and 1960s, while interesting, are irrelevant to the early 21stcentury housing boom. Different era, different circumstances, different implications.
Needless to say, the authors’ attempt at defending fellow public officials falls well short. Lending standards declined sharply during the boom, and this was encouraged by both the federal government and the Fed. No amount of data mining can change these facts.
Overall, the Fed staffers’ paper fits a common pattern. It’s stuffed with enough data to be taken seriously, but inferences are based more on spin than objective analysis. The approach aligns conclusions with an establishment narrative, while protecting the authors’ establishment status. The last thing you would call this paper is an honest piece of research.
As long as we’re at it, here’s an extra edit, this one offering another perspective on Foote, Gerardi and Willen’s conclusions about our knowledge of bubbles (from the first excerpt above):
Is the unemployment rate real or fake? It is obviously fake, but we want to believe the fake is real for a variety of reasons.
We like to think we know the difference between what’s real and what’s fake. When we’re fooled by a fake Rolex watch purchased for $20 on some humid Asian street corner, we shrug it off: it’s no big deal because the fake isn’t harming anyone.
And when it’s difficult to discern the fake from the legitimate, as in fine art paintings and financial policy, we rely on experts to differentiate between the two.
But what if the “experts” are as clueless as the rest of us? What if they’ve been corrupted by easy money to authenticate the fake as legitimate? Consider ObamaCare, an extraordinarily complex policy that “experts” assure us is a phenomenal advancement that is “working well.”
But what if ObamaCare is a fake? What if it is really not insurance at all, but a giant skimming machine designed to enrich and solidify the power of the state-cartel that operates the sickcare system?
“Experts” (PhDs and Federal Reserve economists) assure us our financial system is the core engine of “growth” in our economy. But what if this assertion is simply a useful illusion, and the reality is that the U.S. financial system is a giant skimming operation that harvests immense profits off the real economy to the benefit of the few, the financial cartels and their lapdogs in the Central State?
“Experts” in the Federal government assure us the unemployment rate is 7%. But if we include the 91.5 million people of working age who could be working (and would be working in a work-fare economy), then the real unemployment rate is double the official rate: 14% or even higher.
Is the unemployment rate real or fake? It is obviously fake, but we want to believe the fake is real for a variety of reasons.
The 1974 Orson Welles documentary (recommended by correspondent K.K.) F For Fake helps elucidate this peculiar dynamic of human nature.
The master art forger who plays a central role in F For Fake noted (self-servingly, but amusingly so) that his addition of a few fake Modigliani paintings into the world’s collections did no damage to Modigliani (long since deceased) or the collectors, who benefited from the opportunity buy a Modigliani masterpiece.
We want to believe the fake unemployment rate of 7% rather than the real rate of 14+% because the officially sanctioned forgery feeds our belief that our bloated, corrupt Empire of Debt is sustainable, fair and working well. To accept that we’ve been bamboozled, ripped off, taken advantage of and ultimately cheated out of an authentic economy and life by swindlers is too painful.
How is the Federal Reserve’s creation of money out of thin air not officially sanctioned forgery, a forgery we accept because we are like the collectors who are willing to buy forgeries as masterpieces, as long as they’re good forgeries, rather than forego the joy of owning a masterpiece?
Just as the belief in the provenance of a masterpiece creates its value in the marketplace, so it is with money: if it is created by a central bank and ultimately backed by the State’s right to tax its citizenry, we consider it legitimate, even though it is clearly an intrinsically worthless forgery of real value (i.e. gold, silver, land, cans of beans, machine tools, etc.).
And just as the value of a masterpiece is shattered by the loss of faith in its value, so it is with money: should the belief that creates the value fade, so to will the practical utility of the money.
Any doubts about the value of the euro, yuan, yen or dollar are dismissed by the mainstream as the confused ravings of a lunatic fringe, because maintaining the faith in the provenance of paper money is essential to the power created by financial engineering. But it’s worth keeping in mind that this belief in the value of money created out of thin air by the conjurer’s wand is just that, a belief.
By Louise Egan
OTTAWA (Reuters) – Soaring consumer debt and a robust housing market pose an “elevated” risk to Canada’s financial stability, but the overall level of danger has fallen from six months ago, the Bank of Canada said on Tuesday.
“In Canada, the high level of household debt and imbalances in the housing sector are the most significant domestic vulnerabilities to address,” the central bank said in its semi-annual Financial System Review.
These risks could make Canadians vulnerable to an adverse macroeconomic shock and a sharp correction in the housing market, it said.
The bank cut its overall level of risk to the country’s financial system to “elevated” from “high”, citing among other factors continuing stabilization in the euro zone and the start of a modest recovery in that region. Despite the brighter outlook for Europe, it remains the biggest threat to Canada, the bank said.
Tuesday’s report marked the first time the bank has eased its overall risk level since it began classifying risk in this way in December 2011.
The overall level of risk could fall further with continued progress on banking sector reform and other reforms in the euro area. That said, the level could increase if the current low interest rate environment in advanced economies persists longer than anticipated, it added.
The bank listed risky financial investments in a prolonged period of low interest rates as a “moderate” risk and added financial vulnerabilities in emerging markets as another moderate threat.
Canada’s housing market has been a source of concern for policymakers and economists since a property boom helped fuel the economy’s rebound from the 2008-09 recession.
After four government interventions to tighten mortgage rules, the market cooled in late 2012 only to regain momentum through the spring and summer of this year.
The bank, the finance ministry and the banking regulator monitor the market closely. The bank noted an oversupply of multiple-unit dwellings in some areas, and cited an elevated number of high-rise condos under construction in Toronto.
“If the upcoming supply of units is not absorbed by demand as units are completed over the next few years, there is a risk of a correction in prices and construction activity,” it said.
Such a correction could spread to other parts of the market and hit the overall economy, it added.
The bank said simple indicators suggest there is overvaluation in the housing market overall and it said any sharp downturn in a large city could spread, ultimately affecting sentiment, lending conditions as well as jobs and income.
While the latest data suggest some stabilization in the market, there is still much debate among economists over whether housing is poised to crash and damage the economy, or have a so-called “soft landing”.
Bank of Canada Governor Stephen Poloz has placed himself in the latter camp, saying he expects record-high household debt to ease gradually as the housing market softens.
The report on Tuesday supported that view.
“The overall moderating trend is expected to resume in due course,” it said. “As long term interest rates normalize with the strengthening global economy, the risk will diminish over time.”
The ratio of household debt to income in Canada hit a record high in the second quarter of 163.4 percent, although the pace of credit growth has been slowing.
Statistics Canada will release third-quarter data on household debt on Friday.
(Reporting by Louise Egan; editing by David Ljunggren; and Peter Galloway)
While the distraction of Japanese currency collapse, the resultant nominal offsetting surge in the value of the Japanese stock market, the doubling of the Japanese monetary base and the BOJ’s monetization of 70% of Japan’s gross issuance have all been a welcome diversion in a society still struggling with the catastrophic aftermath of the Fukushima explosion on one hand, imploding demographics on the other, and an unsustainable debt overhang on the third mutant hand, the reality is that Japan, despite the best intentions of Keynesian alchemists everywhere, is doomed.
One can see as much in the following two charts from a seminal 2012 research piece by Takeo Hoshi and Tatakoshi Ito titled “Defying Gravity: How Long Will Japanese Government Bond Prices Remain High?” and which begins with the following pessimistic sentence: “Recent studies have shown that the Japanese debt situation is not sustainable.” Its conclusion is just as pessimistic, and while we urge readers to read the full paper at their liesure, here are just two charts which largely cover the severity of the situation.
Presenting the countdown to Japan’s D-Day.
The technical details of what is shown below are present in the appendix but the bottom line is this: assuming three different interest rates on Japan’s debt, and a max debt ceiling which happens to be the private saving ceiling, as well as assuming a 1.05% increase in private sector labor productivity (average of the past two decades), Japan runs out of time some time between 2019 and 2024, beyond which it can no longer self-fund itself, and the Japan central bank will have no choice but to monetize debt indefinitely.
and Exhibit B.
Figure 12 shows the increase in the interest rate that would make the interest payment exceed the 35% of the total revenue for each year under each of the specific interest scenarios noted in the chart above (for more details see below). The 35% number is arbitrary, but it is consistent with the range of the numbers that the authors observed during the recent cases of sovereign defaults. In short: once interest rates start rising, Japan has between 4 and 6 years before it hits a default threshold.
The paradox, of course, is that should Japan’s economy indeed accelerate, and inflation rise, rates will rise alongside as we saw in mid 2013, when the JGB market would be halted almost daily on volatility circuit breakers as financial institutions rushed to dump their bond holdings.
In other words, the reason why Japan is desperate to inject epic amounts of debt in order to inflate away the debt – without any real plan B – is because, all else equal, it has about 8 years before it’s all over.
Here is how the authors summarize the dead-end situation.
Without any substantial changes in fiscal consolidation efforts, the debt is expected to hit the ceiling of the private sector financial assets soon. There is also downside risk, which brings the ultimate crisis earlier. Economic recovery may raise the interest rates and make it harder for the government to roll over the debt. Finally, the expectations can change without warning. Failure in passing the bill to raise the consumption tax, for example, may change the public perception on realization of tax increases. When the crisis happens, the Japanese financial institutions that holds large amount of government bonds sustain losses and the economy will suffer from fiscal austerity and financial instability. There may be negative spillovers for trading partners. If Japan wants to avoid such crisis, the government has to make a credible commitment and quick implementation of fiscal consolidation.
A crisis will happen if the government ignores the current fiscal situation or fails to act. Then, the crisis forces the government to choose from two options. First, the Japanese government may default on JGBs. Second, the Bank of Japan may monetize debts. The first option would not have much benefit because bond holders are almost all domestic. Monetization is the second option. Although that may result in high inflation, monetization may be the least disruptive scenario.
Finally, this is how the BOJ’s epic monetization was seen by the paper’s authors back in March 2012.
Bank of Japan could help rolling over the government debt by purchasing JGBs directly from the government. The Bank of Japan, or any other central bank with legal independence, has been clear that they do not endorse such a monetization policy because it undermines the fiscal discipline. However, at the time of crisis, the central bank may find it as the option that is least destructive to the financial system. If such money financing is used to respond to the liquidity crisis, this will create high inflation.
The prospect for high inflation will depreciate yen. This will partially stimulate the economy via export boom, provided that Japan does not suffer a major banking crisis at the same time.
An unexpected inflation will result in redistribution of wealth from the lenders to the borrowers. This is also redistribution from the old generations to the young generations, since the older generation has much higher financial assets whose value might decline, or would not rise at the same pace with inflation rate. This may not have such detrimental impacts on the economy, since many who participate in production and innovation (corporations and entrepreneurs) are borrowers rather than lenders.
For now monetization is indeed less disruptive. The question is for how much longer, since both Japan and the US are already monetizing 70% of their respective gross debt issuance. And once the last bastion of Keynesian and Monetarist stability fails, well then…
Once the crisis starts, the policy has to shift to crisis management. As we saw above, the crisis is likely to impair the financial system and slow down consumption and investment. Thus, the government faces a difficult tradeoff. If it tries to achieve a fiscal balance by reducing the expenditures and raising the taxes, the economy will sink further into a recession. If it intervenes by expansionary fiscal policy and financial support for the financial system, that would make the fiscal crisis more serious. This is a well-known dilemma for the government that is hit by debt crisis…. If not helped by the government, the banking system will be destroyed, and the economy will further fall into a crisis. Rational depositors will flee from deposits in Japanese banks to cash, foreign assets or gold.
* * *
The private saving ceiling is the absolute maximum of the domestic demand for the government debt, but the demand for JGBs will start falling well before the saving ceiling is ever reached. One potential trigger for such a change is that the financial institutions find alternative and more lucrative ways to invest the funds. In general, when the economic environment changes to increase the returns from alternatives to the JGBs, the interest rate on JGBs may start to increase. If this suddenly happens, this can trigger a crisis. Increases in the rate of returns may be caused by favorable changes in the economic growth prospect. The end of deflation and the zero interest rate policy would also lead to higher interest rates.
In Figure 6 , the authors calculate Japan’s debt’GDP over the next three decades using the following assumptions on the interest rate:
- R1: Interest rate is equal to the largest of the growth rate (?t) or the level at 2010 (1.3%).
- R2: Interest rate rises by 2 basis points for every one percentage point that the debt to GDP ratio at the beginning of the period exceeds the 2010 level (153%).
- R3: Interest rate rises by 3.5 basis points for every one percentage point that the debt to GDP ratio at the beginning of the period exceeds the 2010 level (153%) .
R1 is motivated by the fact that the average yield on 10 year JGBs over the last several years has been about the same as the GDP growth rate during the same time interval, but constrains the interest rate to be much lower than the current rate even when the GDP growth declines further. R2 and R3 assume that the interest rate rises as the government accumulates more debt. Many empirical studies have demonstrated such relation. R2 (2.0 basis points increase) uses the finding of Tokuoka (2010) for Japan. R3 (3.5 basis points increase) assumes the coefficient estimate used by Gagnon (2010). It is the median estimate from studies of various advanced economies
A more reasonable scenario is to assume the growth rate of GDP per-working-age person (or an increase in labor productivity) to be similar to that of the 1990s and 2000s. We consider two alternative growth rates per-working-age population. The low growth scenario is that the increase in labor productivity at 1.05% (average of 1994-2010) and the high growth scenario is at 2.09% (average of 2001-2007, the “Koizumi years”).12 Table 6 shows the growth decomposition on the assumption of the 1.05% growth rate of GDP per-working-age person…. The upper bound for the debt accumulation is reached by 2024 at the latest.
By Marc Faber
As a distant but interested observer of history and investment markets I am fascinated how major events that arose from longer-term trends are often explained by short-term causes. The First World War is explained as a consequence of the assassination of Archduke Franz Ferdinand, heir to the Austrian-Hungarian throne; the Depression in the 1930s as a result of the tight monetary policies of the Fed; the Second World War as having been caused by Hitler; and the Vietnam War as a result of the communist threat.
Similarly, the disinflation that followed after 1980 is attributed to Paul Volcker’s tight monetary policies. The 1987 stock market crash is blamed on portfolio insurance. And the Asian Crisis and the stock market crash of 1997 are attributed to foreigners attacking the Thai Baht (Thailand’s currency). A closer analysis of all these events, however, shows that their causes were far more complex and that there was always some “inevitability” at play.
Take the 1987 stock market crash. By the summer of 1987, the stock market had become extremely overbought and a correction was due regardless of how bright the future looked. Between the August 1987 high and the October 1987 low, the Dow Jones declined by 41%. As we all know, the Dow rose for another 20 years, to reach a high of 14,198 in October of 2007.
These swings remind us that we can have huge corrections within longer term trends. The Asian Crisis of 1997-98 is also interesting because it occurred long after Asian macroeconomic fundamentals had begun to deteriorate. Not surprisingly, the eternally optimistic Asian analysts, fund managers , and strategists remained positive about the Asian markets right up until disaster struck in 1997.
But even to the most casual observer it should have been obvious that something wasn’t quite right. The Nikkei Index and the Taiwan stock market had peaked out in 1990 and thereafter trended down or sidewards, while most other stock markets in Asia topped out in 1994. In fact, the Thailand SET Index was already down by 60% from its 1994 high when the Asian financial crisis sent the Thai Baht tumbling by 50% within a few months. That waked the perpetually over-confident bullish analyst and media crowd from their slumber of complacency.
I agree with the late Charles Kindleberger, who commented that “financial crises are associated with the peaks of business cycles”, and that financial crisis “is the culmination of a period of expansion and leads to downturn”. However, I also side with J.R. Hicks, who maintained that “really catastrophic depression” is likely to occur “when there is profound monetary instability — when the rot in the monetary system goes very deep”.
Simply put, a financial crisis doesn’t happen accidentally, but follows after a prolonged period of excesses (expansionary monetary policies and/or fiscal policies leading to excessive credit growth and excessive speculation). The problem lies in timing the onset of the crisis. Usually, as was the case in Asia in the 1990s, macroeconomic conditions deteriorate long before the onset of the crisis. However, expansionary monetary policies and excessive debt growth can extend the life of the business expansion for a very long time.
In the case of Asia, macroeconomic conditions began to deteriorate in 1988 when Asian countries’ trade and current account surpluses turned down. They then went negative in 1990. The economic expansion, however, continued — financed largely by excessive foreign borrowings. As a result, by the late 1990s, dead ahead of the 1997-98 crisis, the Asian bears were being totally discredited by the bullish crowd and their views were largely ignored.
While Asians were not quite so gullible as to believe that “the overall level of debt makes no difference … one person’s liability is another person’s asset” (as Paul Krugman has said), they advanced numerous other arguments in favour of Asia’s continuous economic expansion and to explain why Asia would never experience the kind of “tequila crisis” Mexico had encountered at the end of 1994, when the Mexican Peso collapsed by more than 50% within a few months.
In 1994, the Fed increased the Fed Fund Rate from 3% to nearly 6%. This led to a rout in the bond market. Ten-Year Treasury Note yields rose from less than 5.5% at the end of 1993 to over 8% in November 1994. In turn, the emerging market bond and stock markets collapsed. In 1994, it became obvious that the emerging economies were cooling down and that the world was headed towards a major economic slowdown, or even a recession.
But when President Clinton decided to bail out Mexico, over Congress’s opposition but with the support of Republican leaders Newt Gingrich and Bob Dole, and tapped an obscure Treasury fund to lend Mexico more than$20 billion, the markets stabilized. Loans made by the US Treasury, the International Monetary Fund and the Bank for International Settlements totalled almost $50 billion.
However, the bailout attracted criticism. Former co-chairman of Goldman Sachs, US Treasury Secretary Robert Rubin used funds to bail out Mexican bonds of which Goldman Sachs was an underwriter and in which it owned positions valued at about $5 billion.
At this point I am not interested in discussing the merits or failures of the Mexican bailout of 1994. (Regular readers will know my critical stance on any form of bailout.) However, the consequences of the bailout were that bonds and equities soared. In particular, after 1994, emerging market bonds and loans performed superbly — that is, until the Asian Crisis in 1997. Clearly, the cost to the global economy was in the form of moral hazard because investors were emboldened by the bailout and piled into emerging market credits of even lower quality.
Above, I mentioned that, by 1994, it had become obvious that the emerging economies were cooling down and that the world was headed towards a meaningful economic slowdown or even a recession. But the bailout of Mexico prolonged the economic expansion in emerging economies by making available foreign capital with which to finance their trade and current account deficits. At the same time, it led to a far more serious crisis in Asia in 1997 and in Russia and the U.S. (LTCM) in 1998.
So, the lesson I learned from the Asian Crisis was that it was devastating because, given the natural business cycle, Asia should already have turned down in 1994. But because of the bailout of Mexico, Asia’s expansion was prolonged through the availability of foreign credits.
This debt financing in foreign currencies created a colossal mismatch of assets and liabilities. Assets that served as collateral for loans were in local currencies, whereas liabilities were denominated in foreign currencies. This mismatch exacerbated the Asian Crisis when the currencies began to weaken, because it induced local businesses to convert local currencies into dollars as fast as they could for the purpose of hedging their foreign exchange risks.
In turn, the weakening of the Asian currencies reduced the value of the collateral, because local assets fall in value not only in local currency terms but even more so in US dollar terms. This led locals and foreigners to liquidate their foreign loans, bonds and local equities. So, whereas the Indonesian stock market declined by “only” 65% between its 1997 high and 1998 low, it fell by 92% in US dollar terms because of the collapse of their currency, the Rupiah.
As an aside, the US enjoys a huge advantage by having the ability to borrow in US dollars against US dollar assets, which doesn’t lead to a mismatch of assets and liabilities. So, maybe Krugman’s economic painkillers, which provided only temporary relief of the symptoms of economic illness, worked for a while in the case of Mexico, but they created a huge problem for Asia in 1997.
Similarly, the housing bubble that Krugman advocated in 2001 relieved temporarily some of the symptoms of the economic malaise but then led to the vicious 2008 crisis. Therefore, it would appear that, more often than not, bailouts create larger problems down the road, and that the authorities should use them only very rarely and with great caution.
Central Banker Admits Faith In “Monetary Policy ‘Safeguard'” Leads To “Even Less Stable World” | Zero Hedge
While the idea of the interventionist suppression of short-term ‘normal’ volatility leading to extreme volatility scenarios is not new, hearing it explained so transparently by a current (and practicing) central banker is still somewhat shocking. As Buba’s Jens Weidmann recent speech at Harvard attests, “The idea of monetary policy safeguarding stability on multiple fronts is alluring. But by giving in to that allure, we would likely end up in a world even less stable than before.”
Excerpts from Jens Weidmann – Europe’s Monetary Union
Harvard, 11/25/13 (Full speech here)
In the eyes of many politicians, economists, at least if they are central bankers, cannot have enough arms now – arms with which they are to pull all the levers to simultaneously deliver price stability, lower unemployment, supervise banks, deal with sovereign credit troubles, shape the yield curve, resolve balance sheet problems, and manage exchange rates.
It is probably safe to say that this change in attitude is not just due to a sudden surge in the popularity of economists and central bankers. Rather, it reflects the widespread view that central banking has come to be the only game in town. And quite a few economists seem to agree with this notion.
To some, the notion that the primary goal of central banks is to keep prices stable has become old-fashioned. Against the backdrop of the financial crisis, they argue that financial stability has become just as important, if not more so, than price stability.
By tearing down the walls between monetary, fiscal and financial policy, the freedom of central banks to achieve different ends will diminish rather than flourish. Put in economic terms:Monetary policy runs the risk of becoming subject to financial and fiscal dominance.
Let me explain these mechanisms a bit more in detail, starting with financial dominance.
The financial crisis has provided a vivid example of how financial instability can force the hand of monetary policy. When the burst of an asset bubble threatens a collapse of the financial system, the meltdown will in all likelihood have severe consequences for the real economy, with corresponding downside risks to price stability.
In that case, monetary policy is forced to mop up the damage after a bubble has burst. And, confronted with a financial system that is still in a fragile state, monetary policy might be reluctant to embrace policies that could aggravate financial instability.
Public debt and inflation are related on account of monetary policy’s power to accommodate high levels of public debt. Thus, the higher public debt becomes, the greater the pressure that might be applied to monetary policy to respond accordingly.
Suddenly it might be fiscal policy that calls the shots – monetary policy no longer follows the objective of price stability but rather the concerns of fiscal policy. A state of fiscal dominance has been reached.
Technically, fiscal dominance refers to a regime where monetary policy ensures the solvency of the government. Practically, this could take the form of central banks buying government debt or keeping interest rates low for a longer period of time than it would be necessary to ensure price stability. Then, traditional roles are reversed: monetary policy stabilises real government debt while inflation is determined by the needs of fiscal policy.
A lender-of-last-resort role would violate this principle of self-responsibility – in that same way as Eurobonds in this setting are at odds with it. Therefore, it would aggravate, rather than alleviate, the problems besetting the euro area.
The idea of monetary policy safeguarding stability on multiple fronts is alluring. But by giving in to that allure, we would likely end up in a world even less stable than before.This holds true especially for the euro area, where a Eurosystem acting as a lender-of-last-resort role for governments would upend the delicate institutional balance.
To disentangle the euro area’s fiscal and financial conundrums, we should practice the art of separation – especially with regard to the sovereign-bank doom loop. Or let me put it this way: Rather than for monetary policy to waltz with fiscal and financial policy, we need to erect walls between banks and sovereigns.
Of course, Taleb’s somewhat seminal piece on vol suppression remains a concerning glimpse of the inevitable.