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Friday, October
22, 2011 Financial
Black Holes and Economic Stagnation: An Explanation “Financial
markets are driving the world towards another Great Depression with
incalculable political consequences. The authorities, particularly in Europe,
have lost control of the situation. They need to regain control and they need
to do so now.” George Soros, international financier, ( Does the
Euro Have a Future?, New York Review of Books, September 15,
2011.) “The [financial] crisis was not a failure
of the free market system and the answer is not to try to reinvent that
system. ...Government intervention is not a cure-all." President George W. Bush, Thursday
November 13, 2008 "There
is no cause to worry. The high tide of prosperity will continue." Andrew W. Mellon, President Herbert Hoover's Secretary of the
Treasury. September 1929 "I
believe that banking institutions are more dangerous to our liberties than
standing armies. Already they have raised up a monied aristocracy that has
set the government at defiance. The issuing power (of money) should be taken away from
the banks and restored to the people to whom it properly belongs." Thomas Jefferson (1743-1826), 3rd U.S. President. Presently, one has the
net impression that today's governments, both in Europe and in the United
States, have their fingers plugging the holes in the financial dike, but fear
that that the entire dam could collapse in the not too distant future with
dire economic consequences. Let's see if we can make sense of it all. Let's say to
begin that most financial crises
are the direct result of
unsustainable debt
levels relative
to income that need to be wrung out of the economic system. It has happened
in the past (notably in 1873, in 1907 and in 1931, for example), and numerous
times in developing countries, and it will undoubtedly happen again in the
future. The process is more often than not always the same: some large banks, corporations, consumers
or governments take on too much risky debt that becomes unsustainable when
economic conditions change, thus launching the entire economy into a
devastating process of debt deflation.
Sometimes, it may take decades to overcome such a debt deflation and it
usually creates an environment of economic stagnation
when aggregate demand
collapses. What makes the current financial crisis so troublesome is not only
that debt levels are historically high for some countries, but also because
the usual instruments and procedures to reduce the debt burden, while doing
the least damage to the real economy, have been rendered inoperative, due to
a large extent, to the poisonous so-called financial
“innovations” that have taken place since 1999 in the general
climate of wholesale financial
deregulation. As a consequence, financial debt in many countries creates a sort of
financial black hole that siphons off money income and prevents it from being
re-circulated back into the economy. This creates a serious deficiency
of demand (when consumers spend less, when corporations postpone
investments and when governments adopt austerity programs) that translates
into low output growth, economic stagnation and high unemployment. In this short article, I will try to identify some of these financial
“black holes” that starve the economy of the necessary funds to
prosper. I will also attempt to explain why this financial crisis may turn
out to be much more serious than previous ones and why governments should
take drastic measures to avoid a devastating economic
depression. —I have done this in the past, again, in 2006, and again, in 2007, and again and again in 2010, but
obviously some politicians, both in Europe and in North America, don't seem
to get. Instead, they seem to think that fiscal austerity and lower taxes is
all that takes to stimulate the economy and lower unemployment. They cannot
be more wrong in the current context. Such policies in an open economy are
going to make things worse, much worse if they are applied over time. Here is why. Many governments had the imprudence of piling up debt upon debt over
the last thirty years, but especially over the last ten years. There are four
main causes for such a public binge of debt in many countries. -First, in Europe, the creation
of the Euro zone in 1999 induced some imprudent
member countries to go deep into debt by taking advantage of the credibility
of the euro and by issuing bonds in euros at favorable interest rates. There
was, indeed, a widely held belief on the part of lenders and borrowers alike
that the new monetary union provided an implicit guarantee of stability to
the safety of the loans. -Secondly, lenders were induced
to lend large sums at low interest rates because borrowers could avail
themselves of a newly created financial instrument, the Credit Default Swaps
(CDS) that allowed them to
take a low cost insurance against an eventual default on their bonds. (By the
way, the financial crises on both sides of the Atlantic are closely linked
due to the fact that some large U.S. banks are heavily exposed to the
European sovereign debt crisis as sellers of credit default swaps.) -Thirdly, the persistent large
trade imbalances in the world meant that some countries, such as mainland
China (which joined the World
Trade Organization in December 2001), piled up tremendous external trade
surpluses and their excess funds became available to foreign borrowers.
Indeed, large international banks found it most profitable to channel these
newly created funds to willing sovereign borrowers around the world. -Fourthly, some central banks,
especially the American Greenspan
Fed, thought they were
obliged to provide an environment of easy money after the events of September
11, 2001 in the U.S., and they kept interest rates unduly low for too long,
thus providing an additional inducement to eager borrowers to go deeper into
debt. Indeed, the housing bubble in the United States that led to
the subprime
mortgage crisis was a creation of the Greenspan Fed with the
encouragement of the Bush-Cheney administration. A first conclusion, therefore, is that many institutional factors and
policies contributed into encouraging some governments (and also some consumers
and investors) to take on more debt than was prudent, often to finance
unproductive spending such as military spending. Today, for example, there
are dozens of countries whose gross
general government debt stands above 100 percent of their gross domestic product
(GDP). Moreover, when a high proportion of this debt is foreign-owned, money to service
such debt flows out and this, of course, creates a drag on the domestic
economy. Servicing an unproductive foreign debt is one of the financial
“black holes” I have in mind here. But what's even more important, the financial and banking systems
have evolved in such a way over the last ten years or so that it has become
very difficult, if not technically impossible, to solve a sovereign debt
crisis through the traditional means used in the past. How come? Because debt restructuring (a fancy term for
reducing the capital owed by a debtor through debt write-downs that reflect
actual market values and/or the extension of a debt's maturity and/or a
lowering of interest rates) has been made most difficult by the fact that
banks and other lenders have been “insured” against a debt
default and are thus expecting to receive 100 percent of a loan and interests,
no matter how risky their loans have turn out to be and how low their current
value. In the past, when a government faced a debt crisis, it usually did
two things: 1- It petitioned its lenders for a restructuration of its debts
if the latter wished to avoid a complete default; and, 2- it would devalue
its currency to boost its economy's competitiveness and stimulate its economy
after an unavoidable capital outflow. For a country like Greece, a member of the
European Union (EU) that is heavily in
debt, these two options to alleviate its crushing debt burden are not easily
available: -it cannot coerce large international banks and other lenders to
voluntarily take a loss on its so-called “insured“ debt, and, -it
cannot devalue the euro which is a common currency to sixteen other
countries. The principal venue left is to keep borrowing at high costs from
other members of the euro zone, the so-called the European
financial stability fund, (N.B.: this is equivalent to borrowing from Peter to pay Paul!), and
to impose a draconian fiscal austerity program on an economy that has been
declining at more than five percent over the last two years. The paradox is that the more austerity the government applies, the
more the economy contracts and the higher is its fiscal deficit and its needs
to borrow even more. This is a self-reinforcing spiral down. —That's
really a true recipe to produce an economic depression. And, if many
governments elsewhere follow the same foolish route for too long, this could
lead to a worldwide economic depression. There are two other major financial black holes that act to starve
the economy of needed funds. First, in the United States, it is the $1.5 trillion
in excess reserves that banks hold at
the Fed and find to their advantage not to lend to the economy. Some of that
money came from American taxpayers when the Bush-Cheney administration put
forward its TARP program to salvage
large banks from bankruptcy in the fall of 2008. (N. B.: Part of it came also
from the general public and from holders of U.S. dollars around the world
when the Fed pushed short term interest rates to close to zero.) Secondly,
also in the United States, it is another $1.5 trillion
in cash
that large U.S. corporations hold abroad in their subsidiary companies while
parking it in tax havens where there are no taxes at all. They refuse to
repatriate these funds for fear of paying taxes at home on their foreign
earnings. (N. B.: The U.S. corporate income tax
is imposed on all income no matter the country in which it was generated.
However, the code allows for U.S. taxes to be deferred as long as the foreign
earnings are kept abroad.) Conclusion So, don't look elsewhere to understand why there is so
much economic stagnation around and why unemployment remains so high. It is
because of all these financial black holes that suck money from the economy
without putting it back. The correct policies would be to close these
financial black holes, and the quicker the better. (The alternative would be even more massive government
deficits!) —But don't hold your breath before such appropriate
policies are implemented. Too many politicians have been bought lock, stock
and barrel by the same interests that profit greatly from the existence of
these financial black holes. Dr. Rodrigue
Tremblay, an economist,
is the author of the book “The
Code for Global Ethics, Ten Humanist Principles”, Please visit the book site at: www.TheCodeForGlobalEthics.com/ Posted,
Friday, October 22, 2011, at 5:30 am Or click Here. Send contact, comments or commercial reproduction
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