Paper to ‘Drinking Liberally’ forum, 12 February 2009.
The paper is in two parts.
Part IIKeywords: Macroeconomics & Money;
The world economy is in an extremely unsatisfactory state – some would say it is teetering on the edge of a depression comparable to that which occurred in the 1930s. There are no quick fixes. It is going down a difficult path, which will be traumatic for most of us.
Understanding the problem may help us mitigate the effects, or at least cope with them personally or nationally. Tonight is in two sessions. First I’ll talk about the world economic problem. On occasions I shall use New Zealand illustrations, but I am not really going to talk about New Zealand’s problems, which are in some ways are quite different, until the second session. To make that clear, we’ll take a break between the two; you can refill your glasses and I’ll take a few questions.
Even so I have no time to go through a detailed analysis of how the world economy got into the current pickle. Instead I focus on its key element, which is contained in the term ‘toxic assets’, or for the more genteel ‘troubled assets’. These are assets in the financial system which have uncertain value, but ones considerably below what they appear in the balance sheets of financial institutions. In effect, they are assets which have no funding backing.
For instance you may have deposited in a finance company a sum of $100,000. The finance company has spent your money on a property development which is worth far less than the financial outlay. Thus there is nothing in the company’s balance sheet to match your deposit – it is worthless. If you still value it at $100,000 it is a toxic asset.
So toxic assets are financial assets which are far less valuable than what the holder records. For instance they may have bought a mortgage – the stream of revenue that the mortgagee promised to pay – and found that there was little prospect of the mortgagee paying. Because no one is certain of the extent of those future payments, no one knows what the residue mortgage is worth. Yet it sits in a balance sheet somewhere in the financial system. It’s a toxic mortgage.
Toxic assets tend to be more complicated than this, because international financiers have sliced and diced debts, reselling them as complex financial assets. Had they got the probability of repayments correct there would be no problems. But they got them wildly wrong; the economic slowdown will make the repayment rates even worse.
We don’t know the total size of the toxic assets. I have seen them claimed to be a trillion US dollars, I have seen ten trillion. Let’s split the difference at five trillion. That amounts to $US1000 per world citizen, three years of the income of the poor of the world’s. Spreading the toxic assets across just the rich is about $US5000, or $NZ10,000 a head. That is not a large amount, what is pernicious is that we don’t know where the toxic assets are.
Suppose a bank has some. All banks have bad debts, which are going to rise as the world economy contracts, but there is a standard procedure for provisioning for them. The trouble with toxic assets is that we don’t know how toxic they are, so we cant value them. The bank has a fuzzy valued asset on its balance sheet which compromises the bank’s equity – the difference between its assets and liabilities. If that equity is too small, the bank’s lending is overcommitted. If it is negative – its liabilities exceed its assets – it is unable to pay its creditors in the long run, and the financial institution is bankrupt. (If it cant pay its current creditors it is insolvent.)
If the bank does not know the value of its toxic assets, we don’t know whether it is solvent or not. So the bank will tend to want to overvalue its toxic assets – none are going to admit just how fearful they that the assets are contributing little to their balance sheets – and in any case no one really knows. At the same time potential lenders to the banks will tend to assume the worse.
Unable to borrow from other institutions, and in any case cautious and perhaps over-extended, a bank will not expose itself by new lending. So there is a credit contraction. All economic transactions which depend upon credit will have to be cut back; businesses have to cut back their investment, they sell out of inventory rather than production, consumers relying on credit cut back their purchases. Firm turnover falls, there are fewer hirings, layoffs increase, some firms collapse from a loss of sales and very shortly there is an economic contraction.
The contraction ripples out to the rest of the world economy, because of its interconnectedness so that a fall in demand in one economy, results in lower exports from others to it. They contract, reduce their imports and the world economy goes into a downward cycle. A year ago, there was the claim that East Asia was disconnected from the troubles of the North Atlantic economies. What was meant was that the East Asian financial institution balance sheets were strong, with few toxic assets. Today, predictably, the East Asian economies are suffering from the falloff in their exports.
In recent years such downturns were met by lower interest rates which one way or another staunched the downswing. This time, interest rates are near zero, yet there is no evidence of an economic recovery. What is different is the toxic assets; additional or cheaper cash is not encouraging the banks to lend as long as they have substantial toxic assets on their balance sheets.
I need to say something about money which is both obvious and yet frequently overlooked. Our high standard of living with all its choice and opportunities is a result of specialisation. Such a division of labour would be impossible without a medium of exchange. Yet monetary economies have a downside as well as the upside of prosperity beyond our ancestors’ wildest dream. Money based economic systems have inherent fluctuations from the way the money works, as well as from external impacts like the fourteen year cycle Joseph experienced in Egypt or the Maori experienced before the arrival of the European.
The world is facing a failure of its monetary system. Until that is addressed, it will not resolve its economic problems; we are not going to get a world recovery until sufficient toxic assets are purged from the financial system. Therein lies the political problem. Purging toxic assets means someone has to take the loss from their face value. Sometimes they don’t have much choice, like the New Zealanders who lost their deposits in failed finance companies. Sometimes the loser is the shareholder, when their shares become valueless. However it appears that such losses wont be enough to purge all the toxic debt out of the system. So who is to take the rest of the loss?
You might say that the losses arising from the purging of the toxic assets should fall upon those who profited from it. But the capitalist system has never been particularly just, and in any case how to do it? Suppose a creator of a particular class of toxic assets received large rewards – salary and bonuses – for his innovation and energy. How might one retrospectively seize his rewards? And what about those who benefited from his spending –- should we seize the wages of the Pasifika who cleans his house? And if one excludes her, who else is to be excluded – the restaurateur who has lived plump on the diners’ bills, the dealer who sold the BMW, the real estate agent who sold the condominium in Hawaii?
An alternative is to shift the burden onto the public purse. The taxpayer is largely innocent of the creation of the toxic assets – but the principle of privatising profits and socialising losses is well established capitalist political economics. Recall the private sector panic last September when the American authorities refused to bail out Lehman Brothers. Wall Street was so outraged and terrified, that the US government found it was allowed to nationalise huge financial institutions such as the world’s biggest insurance company and two of the biggest mortgage banks.
Strictly it is not the taxpayer who pays, but future taxpayers – some of whom may not yet be born. Because any bailout bill goes onto the tax rate, there is an understandable reluctance by the authorities to be generous to holders of toxic assets.
I am sympathetic to those who want to purge the toxic assets as quickly as possible, irrespective of who bears the cost. This is not to say those involved in creating and distributing the toxic assets should not make reparations if that is practical, but getting the economy going is again is what is really important. Until the credit system is working again, the economy will not start working properly, irrespective of how much is pumped in by tax cuts and additional public spending. Fiscal injections wont jump start the economy by themselves. Think of it like jump starting your car because it has a flat battery. If there is no generator, the car will move as long as the outside current is applied. Stop that, and the engine stops. Thus a fiscal stimulus will move the economy ahead, but if the credit generator is not working, the economy will not take off under its own power. All a prolonged stimulus will do is to increase the burden of public debt, and weigh on future taxpayers – including the unborn – without any long terms benefits.
America, and many other economies (including New Zealand) are fiscally stimulating their domestic spending – pouring demand into the economy. But the monetary system generator is not working, and the economy wont take-off under its own power.
Earlier this week US Treasury Secretary Geithner announced a work-out for the 14 biggest American banks, in which their balance books will be systematically evaluated, with the promise to remedy any defects. (Remedies may include nationalisation.) But it will take time for these to fully impact on the US and World economy; both will deteriorate for much of this year.
To summarise, I have focussed on the consequences of and responses to the toxic assets, without explaining how the mess happened. That belongs to another session, and as yet there is no consensus on the relative importance of the various processes which led to them.
Even so, it is hard to give an account of the current economic shambles without providing a critique of the philosophy of unbridled financial capitalism which dominated the economic discourse since the Reagan era. There has been hardly any attempt to defend what has gone on. A year ago defenders of the old regime said the world economy would soon come right; today they are silent.
On the other hand the evolving consensus is at best fragile and far from comprehensive. That is the nature of such things. Keynes’ General Theory, one of the most important books of the twentieth century – because it has a few equations it is not generally included in the Canon – was published seven years after the Great Depression began and two years after the world economy had begun recovering from the slump. The post-Keynesian economic synthesis with its associated political and social philosophy is not likely to appear before 2015 at the earliest.
In the end we stumble on trying to discard the sillinesses of the unbridled capitalism rhetoric, trying to apply what we know to situations which are beyond our experience, and yet, with hindsight, are evident enough from the textbooks and history we have studied, albeit a lot more complex than any textbook imagined.
The New Zealand situation is but a small part of the big picture, with its own complex story which the big picture does not capture. So we turn to an economy on the margins of the world economy. But first we need a drink.
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