The recent Great Recession, Eurozone crisis and Great Depression have been devastating in terms of human welfare, employment and economic growth. Although there has been a number of explanations for these miseries, I will try to explain here, what happened and why, in a general context, according to my humble understanding. My perspective will be non-canonical, as I do not think that current macroeconomic theory (DSGE-models) can give any meaningful insight into the roots and reasons behind these hazardous business cycles. Moreover, I will not delve into the structural flaws of the Eurozone; rather, I will try to explain the general features of any real monetary economy.
First of all, what needs to be understood from the very beginning is that generally any economy is a non-equilibrium system. This means that even though an economy has a general equilibrium configuration, the system might never reach it. Demand and supply might never balance each other. This has been well known since the 1960’s. Herbert Scarf was a pioneer in this field. So the intellectual foundations for neoclassical economic theory are rather shaky in the sense that we know virtually nothing about the adjustment process towards equilibrium, at least in analytical terms. The system might be in chaotic motion without ever reaching a stable state. In the jargon, we say that the dynamical system is not stable.
As the current DSGE-literature is based on the idea of a stable equilibrium, we cannot really be sure that the DSGE-paradigm is a very good model of reality, at least when it comes to understanding how the economic machine actually works. DSGE-models basically ignore banks, money creation and nominal issues in such a way that I am really dubious whether they are of any use. They might be even harmful, as they might prohibit us from seeing when a credit cycle is about to peak.
I think that macroeconomics should go partly back to the 1930’s, back to Keynes, Schumpeter, Wicksell and especially Irving Fisher. I think Fisher’s theory of debt deflation is possibly the most ontologically correct description of credit cycles. I will explain its main features in just a minute. More recently, stock-flow consistent modeling by Wynne Godley is also of high relevance. I think Hyman Minsky has provided good insight and Ray Dalio has smart thinking as well, from the hedge fund Bridgewaters.
The blueprint of the machine
The modern economic machine works like any advanced machine. It has a lot of interdependent moving parts. The lubricant and fuel of the machine is debt/money. The definition of money is a matter of taste, but for the reasons of simplicity, we might understand money as commercial bank deposits. This is because we need bank account balances to settle our day-to-day purchases, be it a pint of beer, a factory machine for a company, a car or an apartment, not to mention day to day groceries. Also, if somebody saves money in pension/investment funds, the savings go into somebody’s bank account. So the speak of “idle bank accounts” is not really intellectually coherent. We could also consider extending the definition of money to various overdraft facilities and credit cards, but for simplicity I will consider only bank deposits, i.e. ~liability base of commercial banks.
Given this definition of money, we should note that money can be created and annihilated on an on-going basis. Money is created by commercial banks when they grant bank loans and extend credit. So when a bank buys a bond from a primary issue or extends a loan to a company or a mortgage, it finances this loan by crediting the customers’ bank accounts. It therefore creates money out of thin air, ex nihilo. Of course the bank might need to refinance its deposits by borrowing from the interbank market, or attracting deposits from payment systems transactions, issuing bonds or borrowing from the central bank, but the initial money itself that is circulating in the payment system is created by banks themselves. In the beginning of times, God did not create the stock of deposits that are lent over and over again. So the money multiplier story in economics 101 text books is best to be forgotten. Likewise, when somebody pays its dues to a bank, the balance sheet of the bank shrinks and money is destroyed (the bank account is debited).
According to Irving Fisher and some others alike, the credit crash begins from the state of over-indebtedness, so economic units have too much debt. Remember that we are talking about debt in gross terms as someone’s debt is always some others’ asset. Too much debt then logically implies too much assets. Too large balance sheet. Possibly too much leverage. We need to understand why there is too much debt and how it accumulates.
As long as the music is playing, you’ve got to get up and dance. We’re still dancing.
The credit cycle begins when firms and households are in a good mood. Firms have a positive expectation of future profits for some reason and the investment analysts’ calculations show a large positive net present value for projects. The firms will then start investing. They borrow money from the banking system, directly or indirectly, and this will cause the balance sheet of the banking sector to go up. There will be lots of new assets and lots of new liabilities. The credit standards are easy and lax, as the banks themselves also see the future as bright, and the incurred losses on current loan portfolios are small and manageable. The value of collateral goes up as well and induces more lending. Let’s do some volume business!
The newly created money is first on the bank accounts of the firms. Then the firms hire lots of new people to build up new factories and so forth. Remember that even capital goods are partly the result of labor force input. This hiring binge creates positive atmosphere in the labor market and the labor force gets new money from the firms. This creates even more economic activity, as the labor force will be inclined to buy new cars, new apartments and new leisure commodities. All these purchases can be partly financed by fresh new money, new mortgages, new car loans and credit card loans. The balance sheet of the banking sector goes up further as the original investment loans for the companies are not paid back yet.
As increased spending creates even more employment in construction and household goods and car industry, the people working for those companies will get boosted opportunities to borrow new money for their consumption. There is a virtuous self-reinforcing cycle that boosts economic growth, employment, revenues and prices. New money is created more than old debts are being paid back. Balance sheets of various sectors expand. Inflation picks up.
Banks will not have any trouble at extending new loans as the level of loan losses stays low and financial assets gain in value, thus boosting the capital base of the banking system. Net interest income stays positive and stable as well. Remember that basically the only constraint for bank lending is the availability of demand, sufficient collateral, and most importantly, banks’ capital base.
After some point, the credit hybris goes too far. Banks will ease lending standards as the data supports lowered credit risk and banks accept even speculative finance needs, i.e. debtors pay only their annual interest expenses without paying back some of the principal. The leverage of the banking sector becomes too large and there is too little capital for unexpected losses. Notice that also the households are too much leveraged as are the firms (banks’ loan assets are households’ and firms’ liabilities, if we assume no external sector and no public sector for simplicity). Banks might know that their lending is reckless, but alas, business requires that you’ve gotta dance while the music’s still playing.
The excess lending/money creation has of course inflated the economy as whole and inflation is fast as are the valuations of financial assets (some of the new money goes into purchasing financial assets in the secondary markets). Because CPI-indices do not take totally and comprehensively asset reflation/bubbles into account, the monetary policy acts too late and there is ample time to develop a good old fashioned unsustainable credit binge. This is the end of the first part of the cycle.
When the music stops, in terms of liquidity, things will be complicated.
The second part what some people call the “Minsky moment” starts when some shock ignites the system and makes it collapse like a house of cards. For example, markets might just realize that the banks have lent too much money for people who cannot bear the cost of higher interest rates and this might spike a sell-off in bank shares, bonds and ABS –markets. As the loan books start to rot and funding costs of the banking sector goes up, the banks will stop extending new loans and they will start to sell off assets in panic like everybody else in the financial markets. Shrinking balance sheet by selling eg. bonds in your trading book improves your capital and liquidity position. Re-valuation of the assets (fair-value accounting) and eventual loan losses will cause the bank capital go down further and people start really speculating on the solvency of the banking system. The interbank and repo markets dry up. Banks will stop new lending altogether and seek help from central banks and government. A wide sell –off continues, stocks go down as does everything else except the safest government bonds.
The credit freeze is symmetric compared to the credit binge in the sense that the process will amplify itself and there will be a self-reinforcing loop. As lending stops, the inability to refinance maturing debt and interest expenses will cause further defaults and will erode bank capital further. Insolvency procedures will kick in, igniting further sell-offs. As there will be no new net lending, consumption and aggregate demand will fall, which together will wipe out revenues of the firms as a whole. As revenues go down, investments stops and firms will start kicking people out. Unemployment will go up rapidly.
As a result, we have a large contraction in national product, very high unemployment, and low gross investment and bank failures. The system is on a brink of financial self-destruction. This is what happened in 2008-2009.
The public sector will suffer, albeit with a delay. As the GDP collapses, the tax income collapses as well. The public expenditure goes up as automatic stabilizers kick in. Unemployment benefits and other social costs along with lowered tax income will cause large public deficits to accumulate and a rapidly increasing government debt. The fiscal effect however stabilizes the situation at the same time, as increased government spending stimulates aggregate demand.
As the banking sector is the heart of the financial system, bank failures and closings are not realistic as a general option, when it comes to systemically important banks (SIBs). Even though there are legal attempts to make the system more towards “pro-market” instead of “pro-business”, empirical data tells us a story where usually governments tend to bail out banks by injecting capital into the banks and by guaranteeing the bank liabilities (deposit insurance, external financing insurance). These operations cause usually the gross stock of government debt to increase further. This is the end of the second stage of the credit cycle.
After the collapse there is relapse. However, this takes time as most of the balance sheets in the economy are still too large to bear. Now the economy, ceteris paribus, faces a long period of low growth and deflation. Producing economic units, i.e. households, governments and firms will invest and spend only what is essential as they will want to use their income to pay off their debt and nobody is willing to lend them more for extra spending/investing. What we have is a fairly long deleveraging period, what Richard Koo calls “balance sheet recession”.
Ultimately, as time goes by and people and firms get their debts to acceptable levels, the system reaches its low in the credit cycle and the relapse phase begins. This usually however means a long journey of suffering, as deleveraging is a deflationary process (paying one’s debt destroys money in the system) and the deflationary process tends to press down profits and employment.
Play it again, Sam?
Now we have come through the whole credit cycle. The cycle begins with a spark in investments and this creates more money in the system. More money means more profits and more jobs and more lending until the system reaches its Minsky moment. Then the system turns and selling starts, deleveraging and debt deflation follows. Without government intervention this can take fairly long. Ultimately, as the leverage system-wide goes sufficiently low, the system is ready for another build-up of credit. What kicks off the relapse is difficult to say, it has to do something with a sufficiently low level of leverage. One can bear more risk, if there is sufficient capital. And taking risk at the level of the system will again induce the self-reinforcing virtuous credit binge.
In this way, the economy reminds me of a non-linear oscillator, where pathological behavior takes place during the cycle. It is evident that the economic system is far from equilibrium. Maybe the economy is oscillating chaotically around some steady state.
The real question is then, what can we do about it?
We surely want to avoid economic swings like 2008? To me it seems that the key to stabilization is monetary policy, microprudential policy and macroprudential policy. Fiscal policy is too political and slow, although making public investments during the debt deflation could alleviate the suffering.
It seems clear that the credit cycle has to do with reckless lending and borrowing. Therefore we would need to a have a better rules based system when it comes to interest rates policy. Inflation targeting does not seem to suffice. Maybe one could improve by considering nominal GDP targeting. Bank regulation and macroprudential policies are of essence as well. First of all, banks need to hold a sufficient amount of capital to cover unexpected losses. Also excess leverage should be prohibited. Basel III, new trading book rules, RWA-floors and leverage ratio are steps into the right direction. In my opinion, however, they are not sufficient. Banks have an incentive to maximize their return on equity, and they tend to argue that they have too much capital. The cost of equity should however normally somehow reflect the risks of the bank, when considering ratios like risks per equity. Also, one should consider risk-adjusted returns on equity, not to mention the negative externalities of banking crises.
On the macroprudential side, we would need to lean against the wind when the credit binge is building up. Supervisors and central banks should monitor closely especially loan-to-value- and loan to income –ratios and demand extra capital if the rate of credit expansion is too high. We do have countercyclical capital buffers, but the implementation is yet to be seen.
Loan loss provisioning and impairment rules are of utmost importance as well. During the last crisis, too little was provisioned and too late. Maybe IFRS 9 will fix all this but I have my doubts. During good times the expected life time losses will be small.
What about fiscal policy? My take is that during the balance sheet recession the government should use fiscal policy proactively. As everybody else is deleveraging, the public sector should lean against the wind and invest in repairs and infrastructure. After all, we are living in a consumption -based economy. Somebody needs to spend in order to keep the music playing. In the Eurozone this is more difficult than in the US for example.
Various tax incentives could be introduced to reduce the bias towards debt financing. Cost of equity should be made tax deductible.
However, the most important role is saved for central monetary authority. The most important variable that is volatile throughout the credit cycle is the amount of credit extended per unit time. Therefore what the central banks should target is a steady expansion of the amount of credit. Too little credit is bad, too much credit is bad. If one takes a look at the data of various monetary aggregates, it is clear that central banks had too loose monetary policy before the crash of 2008. In the US at least, whereas in the Eurozone things are more complicated. Controlling the credit supply is of course difficult and because of the Keynesian liquidity trap it might take really unconventional measures like outright monetary financing of households or something of this sort. In more normal times the adjustment of the main refinancing rates should however be sufficient.
My hypothesis is that too narrow focus on consumer price index and the belief in “Great Moderation” caused mainly the last catastrophe. There was too much extension of credit. Of course it was partly supported by the excess savings in Asia. But ultimately the financial system collapsed because banks had lent recklessly. The credit risk then contaminated the whole system through the ABS -market and the interbank market.
When it comes to regulators, the problem is that policy makers are educated in various economic departments and the lack of sufficient understanding of macroeconomic processes lead to a situation where knowbody halted the game. Therefore, given how much suffering credit crashes cause to people, we should invest in macroeconomic research. And not in just the usual empirical macro, but we should really try to model a real working economy with all its money and credit flows throughout the economy. I recently read about stock-flow consistent modeling of macroeconomics and I found it really appealing. Rather it than stock-flow inconsistent modeling. Computer simulations might be useful as well.
It might nevertheless be the case that we are doomed to live forever in this credit cycle. The economy is a highly non-linear system, and controlling it might prove to be too difficult altogether. Not to mention that stopping the music while people are dancing is not politically popular. We are now in the very beginning of a new credit cycle, so cheers!