As we slowly struggle out of recession, it's tempting to hope that the problems it caused will soon fade. But there are clues that things will not and cannot ever return to how they were. In fact the evidence is all around us; static or falling growth in real incomes despite bouyant stock markets, larger and larger wealth inequality, the ongoing injection of liquidity into economies through QE. And biggest of all, the mountain of government debts around the world.
The real story of the 2008 financial collapse and subsequent recession isn’t about greedy bankers, dozing regulators or complacent politicians although they all played their part. It’s a story which is bigger than all of them put together. It’s a story about the transition of the whole developed world from one economic era to an entirely new one.
It’s tempting to think that all our financial woes were created by 2008 and its aftermath. And yes, it’s true that we’ve been going through possibly the worst recession in history. But the financial crisis wasn’t the cause of this, it was a symptom of a much bigger global problem and
transformation which has been underway for decades.
And it’s only if we understand the nature of this transformation that we can figure out what each of us will have to do in the coming years to ensure that we don’t become victims. Many of us have suffered enough already from the economic collapse. But the collapse wasn’t a singular event. It was a symptom of the failure of a monetary system which has passed it use by date. The aftershocks will be just as painful to many more of us. Possibly even more, if we don’t individually figure out our own survival plan now.
But I’m getting ahead. We first need to look at what’s been going on and why.
Who is really to blame for the recession?
It’s tempting to adopt over simplistic knee-jerk explanations. People were too greedy. Lenders were too careless. Big bonuses encouraged unethical and even illegal practices. Politicians were self-serving and in league with big business. There is plenty of evidence of all these things of course, but they don’t lie at the root of the problem. They were symptoms of much more fundamental changes in the world.
The real culprits are in the shadows, or at least so low profile and mysterious to most that they attract very little attention from the general public. They are the central banks. The borrowing spree was made possible because the central banks allowed it to become possible. The money banks were lending was only available to lend in the first place because of central banks’ rules around what bankers call fractional reserves. And without over-lax fractional reserve rules, there could have been no explosion in lending and no financial crisis. Whilst much of this story is complex, this is one aspect that is really simple.
How central banks made it all possible
Central banks like the Federal Reserve and the Bank of England, require a bank to keep a reserve of capital that is in direct proportion to the amount it has lent. So let’s say the central bank imposes a fractional reserve requirement of 10%, if a bank has £100 million of deposits, they cannot lend more than a total of £900 million. The questionable idea behind this policy is that banks are responsible and prudent institutions and no event could ever undermine depositor confidence so much that everyone wishes to withdraw all their money at the same time, thereby bankrupting the bank(s).
It seems like a crazy notion when we remember that there have been plenty of bank runs throughout history. For the record these include, the Dutch Tulip manias (1634–1637), the British South Sea Bubble (1717–1719), the French Mississippi Company (1717–1720), the post-Napoleonic depression (1815–1830) and the Great Depression (1929–1939).
With hindsight today, it seems incredible that the idea of fractional reserves could persist, but it did and it still does…the fractional reserve system hasn’t been dropped. It’s merely been tweaked round the edges with requirements for slightly higher capital reserves and greater risk mitigation. The main driver of this is the Basel Accords I, II and III which have sought to apply progressively increased solvency and capital reserve requirements on banks.
The system is still viewed by governments and central banks as a reasonable means to support their economies by enabling businesses to borrow money to grow and consumers to spend. Oh and governments can easily borrow too, so their own financial position is never under too much pressure. When they need to, they can simply borrow more money…
Governments are incentivised to spend not save
Western democracy encourages politicians to make voters happy. So they can get re-elected and stay in power. But you don’t get popular by spending responsibly. You get popular by building more schools, providing better healthcare, cutting taxes, creating more policemen to keep us safe from the bad people….the list goes on and on.
There’s one slight problem though. How can a government afford to do this? Especially if the economy isn’t doing too well. Someone has to foot the bill. And that’s where the central banks become super useful to governments. Central bankers are not stupid. They are not simply going to hand over billions to governments just because they are asked. No, they demand in exchange a promise from the government that the money is in the form of a loan. The central bank issues a bill for the loan amount to the government. And in return, the government gives the bank a promise to pay the bank from its future income. It’s called a bond. Through the use of bonds, the government is mortgaging the future wealth of the nation – i.e. the future work and earnings of its population to pay for its spending today.
But governments are not just mortgaging our future work, they’re making the rich richer in the process
And then there’s quantitative easing (QE). In order to prop up the economy in times of extreme stress, like now, central banks print more money to maintain liquidity. Or in other words to keep everything limping along in the economy. In the US and UK this has been carried out by the Federal Reserve and the Bank of England. It’s a medicine with severe and nasty side effects though.
In August 2012, the Bank of England issued a report stating that its quantitative easing policies had benefited mainly the wealthy. The report said that the QE program had boosted the value of stocks and bonds by 26%, or about $970 billion. About 40% of those gains went to the richest 5% of British households. Dhaval Joshi of BCA Research wrote that
"QE cash ends up overwhelmingly in profits, thereby exacerbating already extreme income inequality and the consequent social tensions that arise from it".
Economist Anthony Randazzo of the Reason Foundation wrote that QE "
is fundamentally a regressive redistribution program that has been boosting wealth for those already engaged in the financial sector or those who already own homes, but passing little along to the rest of the economy. It is a primary driver of income inequality".
In May 2013, Federal Reserve Bank of Dallas President Richard Fisher said that cheap money has made rich people richer, but has not done quite as much for working Americans. Most of the financial assets in America are owned by the wealthiest 5% of Americans. According to Fed data, the top 5% own 60% of the nation's individually held financial assets. They own 82% of individually held stocks and over 90% of individually held bonds.
As the majority of people get poorer, so they are less able and less inclined to borrow money. And this is exactly what we see happening. In the UK, government debt has risen exponentially in the wake of 2008 whilst private debt has been falling:
The system makes it much easier for governments to borrow than save
To say “bond bingeing” has become a bad habit is an understatement. In the US today, government borrowing has become a debt crisis. In Between September 30 and October 17, 2013, much of the US government infrastructure was forced into shutdown due to inability of Congress to agree about how the costs of Obamacare could be met.
You’d expect in a financial crisis that a responsible government would look for every way possible to reduce spending. And yes, they attempt this. But not very successfully. Every proposal to reduce spending prompts a counter argument that it’s unfair, unpopular, impossible, or will lead to extra costs elsewhere. And this is where our governments fail us. Unlike businesses which will act fast and ruthlessly slash costs, doing whatever they can to remain solvent, governments are huge unwieldy bureaucracies and every cost cutting proposal becomes bogged down in debate, argument and ultimately delay and compromise.
Meanwhile US government debt is in crisis as it continues to soar out of control. But unlike every recession before, when government spending reduced or slowed, in the wake of the 2008 crisis, the opposite happened and it took off like a rocket:
Total US public debt in 2013 was $17.6 trillion. That’s $36,653 for every man, woman and child in the USA today. It’s 31.3% of all the debt in the world and has overtaken GDP in the US.
But other western economies are not far behind. In the UK, government debt per person is $32,553. In Germany, it is $31,945. France is $31,915 and Italy $37,956. In the most struggling western economies, the situation is even worse. Greek debt per person is $40,486, a staggering 161% of GDP.
But the worst is behind us now…isn’t it?
This wouldn’t be so frightening if western economies were showing improving domestic incomes and earnings. But this isn’t happening.
In fact the reverse has been happening for over 40 years.
Despite rising productivity, in the US, real household income has hardly grown at all since 1970!:
What we see here is critical. The vital connection between GDP and household income has broken. Permanently. And this reality has nothing to do with the financial collapse and the recession. It’s been staring us in the face for forty years or more. As technology continues to accelerate productivity, relentlessly reducing production costs and thereby lessening the need for human labor, there is absolutely no reason to believe that future GDP growth will result in increased household incomes.
This situation has little or nothing to do with party politics. It’s not about left vs. right or capitalism vs. communism. It’s to do with global economic and monetary systems, energy, technology, communications and society’s expectations.
And in the west, the expectations of what the system can and should deliver have completely outstripped its abilities to meet those expectations.
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