Thinking the crisis
The G20 is in danger of becoming wrapped up in a futile argument between fiscal stimulators and re-
With the credit crunch the initial tempo of events was fast. In September Lehman Brothers, the fourth-largest investment bank in the US, went from solvent to bankrupt overnight. Within 72 hours the global banking system was reeling. By the third weekend of the crisis a system-wide global meltdown was under way. We quickly became used to the high tempo of crisis.
But the politicians had also responded fast – or so they convinced themselves. In the US the Troubled Assets Relief Programme was conceived on day three; by day 24 Gordon Brown’s part-nationalisation of the British banks proved an effective circuit-breaker. Soon the politicians would allow themselves to believe in a fast bounce-back theory: a V-shaped recession, over by the autumn of 2009. The velocity of modern finance would make this downturn sharp but short.
It was known in banking circles as “the blur”, and it was not completely wishful thinking. Despite the recessions that had begun in the second quarter of 2008, it was possible to believe that drastic action could contain the financial crisis, and that rapid conventional pump-priming would quicken the recovery. But the action was never drastic enough.
On the eve of the G20 London summit, it is clear the crisis was not contained; there are still concentrations of volatile matter, above all in eastern Europe, whose collapsing banks could pull western Europe’s financial system back into chaos. What is decisive, though, is the spillover into the real economy.
The implosion of the banking system has triggered high-velocity economic collapse across the globe. Japan, the great export engine, has gone into reverse. Its industrial production in January was down 31 per cent year on year; its exports were down 46 per cent. America, the celebrated “jobs machine”, has started to destroy jobs at the rate of more than half a million a month. China, the $2trn sponge for US debt, has begun to leak: experts believe it is, for the first time ever, dumping more US debt than it is buying. The International Monetary Fund now predicts that world GDP growth – reckoned to be in de facto recession at anything less than 3 per cent – will shrink by up to 1 per cent this year.
Shocking though these figures are, they do not yet begin to encompass the scale of the threat. Because what we know from history is that a slump, if allowed to develop, unfolds its misery over years, not weeks. Slumps do not respond to our desire for quick solutions. The psychological impact of a global slump on a generation raised to instant gratification will be profound.
As we approach the London summit, decisive action has, at last, been taken. New, more credible waste-dumps for toxic banking debt have been created; fiscal stimulus totalling $2.7trn has been announced. And above all, the turn to quantitative easing policies by the Bank of England and the Federal Reserve in mid-March changes the game.
But it has all been done late, hampered by lack of conviction and the absence of political consensus. At the start of the crisis it was common to hear politicians congratulate themselves for doing more in the space of weeks than Herbert Hoover and his Federal Reserve chief Andrew Mellon had been prepared to do in the space of three years after the crash of 1929.
Six months on, the balance sheet is not so favourable. The crisis got – to use a term favoured in the US military – “inside the decision cycle” of the policymakers. It forced them to react, react and react again, always reluctantly, often splitting the difference between what was necessary and what their pre-crisis ideology told them was right.
We know now that RBS needed a 95 per cent public lifeline; that Citigroup – far from being a credible bailer-out of other banks as it cast itself in October, was itself in need of a $45bn federal bailout. We know that billions of US bailout dollars were wasted on bonuses for executives at Merrill Lynch and AIG. We know that just three Republican lawmakers were prepared to vote for Barack Obama’s fiscal stimulus. We know that quantitative easing, derided in its classic form in a speech by Ben Bernanke on 13 January, was adopted by Ben Bernanke in its classic form on 18 March.
As Saddam Hussein’s generals found out, twice, executing a textbook manoeuvre is no good if you do it more slowly than an opponent who is unpredictable and lightning-fast. We will now find out if the price of leaden decision-making is a deep recession or a slump.
What is a slump? Consider this as the template: simultaneous bank failures in New York, Vienna and Berlin; impossible interbank lending rates within days; 14 per cent unemployment within months. Then iron and steel production in the US falls by 45 per cent over a five-year period, signalling the “longest cyclical contraction in US history”. That is what happened during the so-called Long Depression, which began in 1873. The downswing phase lasted until 1879 and sustained recovery was not fully registered until the early 1880s. By then the world’s great powers had turned overtly protectionist and global consumer prices had fallen by 2 per cent a year.
The facts about the 1930s Depression are better known but no less scary. The US stock market halved in value over the first 15 months, much as it has done since October 2007. Then, in 1932, it fell to just over 20 per cent of its peak value; by then one in five workers was unemployed and GDP had halved. We think of the entire decade, and rightly, as “the Depression”. But the downswing lasted only until 1933. The “recovery” phase lasted right through until 1939: if you have any surviving great-grandparents, ask them how that “recovery” felt to live through to get a measure of what a slump involves.
Slumps, in short, do not obey the modern imperative for frictionless rapidity. They develop over a period of three to four years, during which a deflationary feedback loop kicks in – prices fall, wages fall, asset values fall – preventing meaningful growth for a decade. If deflation is the central economic danger in a slump, we can say, from the evidence of the 1870s and 1930s, that the break-up of the world economy is the usual result. That is why, despite the action taken, we remain at a perilous moment: the threat is not “protectionism” per se; it is the fragmentation of the world into rival “policy blocs” whose strategies, on a global scale, cancel each other out.
There have been many stunning revelations in this crisis, but one of the most profound has been the fragility of globalisation. In 1873 and 1929 the major economies of the world were, at most, interlocked. Since 1989, globalisation has created something less like a mechanism with interlocking gears and more like a nervous system with extremely receptive sensors and highly conductive neural pathways.
One case study doing the rounds in pre-G20 debates shows how ten countries participate in the manufacturing supply chain to produce parts for a single hard disk drive “manufactured” in Thailand. This “multi-step” supply chain ensures that one laptop left unsold in the Croydon branch of PC World turns into a hard economic signal in ten countries: cancel orders, lay off workers, put suppliers on credit watch and demand cash up front. This highly distributed model of production is historically new and only now undergoing its first crisis. What we know is that it transmits collapse as effectively as it transmits expansion.
World merchandise exports collapsed at an annualised rate of 40 per cent in the last two months of 2008. China, South Korea, Japan and the US have all suffered huge double-digit falls in exports on this measure. But the world record-holder was Germany, with an 80 per cent plunge. The collapse, writes the Philadelphia Federal Reserve economist Kei-Mu Yi, “has been sudden, severe and synchronised”. And it has not been driven by any kind of protectionism. Yet.
If global GDP growth has fallen back from 5 per cent to lower than zero in a year, while world exports have declined by 40 per cent, then it is fair to say that globalisation itself is now in crisis. Just as the collapse of the banking system was a function of the flaws within financial globalisation, the collapse of trade is a function of the flaws within the globalised system of production. Like investment banking, globalisation turns out to have been a very pleasant thing until it collapsed, at which point it became an accelerator of economic crisis.
And the problem is that if no coherent stance emerges from the G20 process, it is about to get worse.
It is clear in the run-up to the G20 summit what the policy rivalry consists of. America, Japan and China have blazed the trail for fiscal stimulus: the best part of a trillion dollars from the US taxpayer, $800bn from the Chinese state, Japan contributing $700bn in two bites and Brazil contributing $280bn. These four countries between them account for the vast bulk of the $2.7trn committed over the next two years.
Fiscal stimulus, a combination of tax cuts and public spending increases, carries multiplier effects. At a domestic level, you get increased bang for your buck: with public spending you can guarantee the money will be spent, not saved; you can target it beneficially; a job created means maybe a railway ticket will be bought, or a bicycle will be bought; a “green investment” stimulus renovates the railway and maybe even builds a cycle lane. And if it is done globally there is a second effect – the money pumped into country A does not drain away to country B. Indeed, if a major producer (Brazil, China or Japan) primes its pump at the same moment as a major consumer (America) there is scope for further synergy.
Right now the boisterous party-pooper on fiscal stimulus is Europe. The political signals could not be clearer. Angela Merkel sees “an inflationary risk” in the US fiscal stimulus. Her finance minister, Peer Steinbrück, called Gordon Brown’s strategy “crass Keynesianism”. Fiscal stimulus packages from Germany, Britain, Italy and France amount to no more than 1.5 per cent of GDP over two years. In the case of France, President Sarkozy was careful to warn the Slovak Republic, a fellow Eurozone member, that the stimulus was not intended to defend jobs there. For the great powers of Europe, fiscal stimulus, like the veal at Basil Fawlty’s restaurant, is “off”.
Like many responses in this crisis, the European stance
is traceable to a piece of neoliberal hubris. In this instance, it concerns the Maastricht Treaty. The entire single currency project, and the orthodoxy of the European Central Bank, have been founded on a commitment to low borrowing and stabilised national debt. Maastricht laid down a budget deficit of 3 per cent of GDP as the entry criterion for the euro, with debt capped at 60 per cent. (Significantly for eastern Europe, the criteria also stipulate that there should have been “no currency devaluation for two years”.)
Now the reality is this: Italy’s budget deficit will be 3.7 per cent and its government debt 110 per cent of GDP this year. Germany will move from balanced books to a deficit of 2.4 per cent of GDP and its debt will rise to 69 per cent. France is looking at a 5.6 per cent budget deficit and debt of 75 per cent. It is not just a question of percentages; the spirit and letter of Maastricht demand that these ratios be falling at the point of entry. If tested today, not one of the big three Eurozone economies would meet the criteria.
There is a rational core to the EU giants’ opposition to fiscal stimulus – that their large state sectors and welfare systems will provide “automatic stabilisers” as recession kicks in, obviating the need for extra discretionary spending along US and Chinese lines. But as their statements show, the EU leaders are against co-ordinated fiscal stimulus not just in Europe, they are against it for the world.
In eastern Europe the EU has likewise rejected calls for a holistic bailout fund, championed by Austria. It has pressured stricken countries such as Latvia to maintain their currency peg (a Maastricht criterion) with the euro. As a result of both this and stringent IMF lending conditions, badly hit economies in eastern Europe are being forced to carry out pro-cyclical spending cuts that will certainly turn recession into slump. Latvia’s fall from 10 per cent GDP growth to a projected 12 per cent shrinkage, in just over two years, will be exacerbated by cuts in public-sector wages projected to total 35 per cent. All this to retain a pegged exchange rate with the euro that even the IMF has described as unsustainable.
Because of the European stance, the short-term danger is that the G20 gets wrapped up in a futile argument between fiscal stimulators and re-regulationists. Like a fight between a shark and a lion, it is a conflict without any logical outcome.
The bigger issue to be addressed is this: what if none of the measures announced so far is enough to stave off a slide from recession to slump? What if the evaporation of global manufacturing exports is merely the harbinger of a bigger retreat to national markets and national pools of financial capital?
The slump-mongers today are as much out of fashion as the crash-mongers were before September 2008. The US economy “will” recover in 2010, Ben Bernanke told CBS in March, dismissing the possibility of depression – just as he asserted in May 2007 that “the effect of the troubles in the sub-prime sector on the broader housing market will likely be limited”.
Ironically, at the heart of the slump scenario is the very theory championed by Bernanke in his academic work, and first outlined by the Depression-era academic Irving Fisher: the “debt-deflation theory”.
Debt-deflation describes a negative feedback process whereby real incomes fall at the same time as asset values, but the value of outstanding debts does not. So normal monetary policy – cutting interest rates – does not work; and even abnormal policy – printing money to drive down the borrowing costs of the state and then the private sector – may not work.
In such conditions, as shown by the Nomura economist Richard Koo as early as May 2008, only fiscal stimulus can prevent demand, and the money supply, from shrinking. And in what Koo calls a “balance-sheet recession”, it usually takes ten years to put things right.
So what are the chances of debt-deflation actually happening? Well, at the edges of the world economy it is already under way. Latvia’s GDP shrinkage of 12 per cent, accompanied by a 35 per cent public-sector pay cut, is purposely designed to achieve deflation. Tens of thousands of people have already lost their homes. Their credit-purchased cars and more will follow.
In January 2008, the IMF’s economists ran their computer model to test the probability of debt-deflation. It concluded that 13 countries “display ‘moderate’ risk of deflation based on 2009 projections, among them Germany, Italy and France. The United States is on the border to high risk. Only Japan
exhibits clearly high risk.” However, it added: “Importantly, over 11 per cent of the model runs over the next three years failed to solve: these simulations, which assume [already] announced fiscal policies, have an ever-increasing deflationary spiral with rising real interest rates that prevent the economy from recovering.”
Cautiously, and with many caveats, the IMF’s staff had quietly put a figure on the possibility of a global debt-deflation spiral: there is an 11 per cent chance it will happen, based on the growth and inflation figures we knew about in January, offset by the stimulus packages announced by then.
On the basis of this, and the rapid decline in inflation towards zero expected in the latter half of this year, the veteran UBS economist George Magnus sounded the alarm: “There is no question that we face a deep and enduring recession.
We may even be on the cusp of a depression . . . One factor that would almost guarantee such an outcome would be if deflation in broad price measures continued for more than a few months, becoming embedded for a sustained period.”
Magnus is one of a small band of economists who predicted the financial meltdown. Like Nomura’s Koo, he is concerned that the sheer scale of household indebtedness and low saving in the developed world may cancel out even the effects of the unconventional policies (fiscal stimulus and quantitative easing) that have been so slowly adopted over the past six months.
So, if the slump-mongers are right, it is decision time at the G20. Any agreement shorn of detail and firm commitment may be judged harshly in the years to come.
What nobody involved in the G20 process has yet admitted fully is that the growth model inaugurated in the early 1990s is finished. In the Anglo-Saxon countries, we have experienced that growth model as debt-fuelled consumption and a house-price boom. In China and India it has been lived as the rise of industrial-export sweatshops. In the port cities of the world, which became backwaters during the crisis years of the 1970s and 1980s, it has been experienced as mile-long, sky-obscuring walls of containers.
At the heart of the model was a profound global imbalance: Asia produced, America consumed; Asia lent, America and the Anglo-Saxon countries borrowed; western governments operated on near-permanent overdrafts and Asian governments, together with the oil producers, ran up colossal surpluses.
To any rational mind, these imbalances look unsustainable, but they provided a win-win solution for the politicians of the world. China and India got export-led growth; the west got a high-consumption economy fuelled by debt instead of wages. Voters were kept happy, even in countries where the absence of democracy makes voting pointless. Today it is this deal, as well as the banking system, that is in the process of collapse.
But, judging by their actions, policymakers are determined to revive it. The psychology and subtext are easy to read: in America, the route back to the debt-fuelled boom means avoiding a government stake in distressed banks until you really have to take it; in Europe, back to Maastricht and business as usual means avoiding huge discretionary stimulus; in China, the route back to export-led growth means ignoring pleas to stimulate domestic consumption and address inequalities.
The challenge for the G20 leaders is to imagine a world beyond this and to act as if it were possible.
In the run-up to the summit there have been all kinds of semi-official “Imagineering” sessions, some of which have sprinted quickly to the issue of climate change and the so-called Green New Deal, swerving neatly around the pressing issue of anti-crisis measures in the here and now.
But the G20 will not be judged by its ability to do blue-sky thinking. It will be judged by its ability to deliver common
action in four areas: global co-ordinated fiscal stimulus; a bailout of the emerging and developing economies that is free of crazily pro-cyclical conditions; decisive cauterisation of the banking crisis – with, as Mervyn King indicates, “whatever proportion of equity stake turns out to be necessary” (that is to say, full nationalisation if required); and last, some formal and believable commitment to global regulation.
It was Malcolm X who coined the phrase “By any means necessary”. And, in the weeks between the British move to quantitative easing and the G20, it has become clear that this is the new attitude, in Washington and London at least.
But the thing about Malcolm was that, having said things, he then did things. The G20 has to shorten the time span between saying and doing, and act ruthlessly and in combination, striking deep into the heart of the deflationary beast that threatens the world. If the slump Cassandras are right, we won’t get many other chances after this.
Paul Mason is the economics editor of BBC Newsnight. His book “Meltdown: the End of the Age of Greed” is published on 27 April by Verso (£9.99)