“The Way Forward” – Who Paid for the Study?

by Elliott R. Morss

Editor’s note: This is the first of two related articles.  The second is here.

A friend whose judgment I respect said the just-published study on US economic policies moving forward by Alpert, Hockett, and Roubini, was a MUST READ. This was confirmed by Joe Nocera, the NYT financial writer who said: “Its analysis of our problems is sobering. Its proposed solutions are far more ambitious than anything being talked about in Washington.” So I read it. Their omission of what caused the world’s economic problems and what should be done about it is so glaring that I wonder who paid for the study.

Summary of Study

The authors do an excellent job of detailing today’s global economic problems:

• High unemployment and the threat of renewed recession.
• The possibility that the European sovereign debt problem will spiral into a full-fledged global banking crisis.
• The hoped-for demand boost from emerging market countries is fading as policies to control inflation and credit-creation kick in.

Albert, Hockett and Roubini (AHR) conclude:

“Even if a return to negative growth rates is somehow avoided, there will remain a real and present danger that Europe and the United States alike fall into an indefinitely lengthy period of negligible growth, high unemployment and deflation, much as Japan has experienced over the past 20 years….”

Their solutions – “3 Pillars”:

• Pillar 1 – a $1.2 trillion five-to-seven year public investment program;
• Pillar 2 – a national debt-restructuring program focusing on “banking and real-estate sectors in particular;
• Pillar 3 – global reforms.

I have absolutely no problem with “Pillar 1”. For some time, I have argued further monetary stimuli will add little and an additional fiscal stimulus program is needed. And of course, I am not alone in making this argument. More on the other two “Pillars” later.

Diagnosis

AHR say the world got into this mess as the result of 2 related factors:

• The “worst credit-fueled asset-price bubble and burst since the late 1920s”;
• “The steady entry into the world economy of successive waves of new export-oriented economies, beginning with Japan and the Asian tigers in the 1980s and peaking with China in the early 2000s, with more than two billion newly employable workers. The integration of these high-savings, lower wage economies into the global economy, occurring as it did against the backdrop of dramatic productivity gains rooted in new information technologies and the globalization of corporate supply chains, decisively shifted the balance of global supply and demand. In consequence, the world economy now is beset by excess supplies of labor, capital, and productive capacity”.

1. The Asset Price Bubble

Few would disagree with AHR on pointing to the Asset Bubble as a key ingredient leading to the global recession. But AHR argue that a main source of the bubble were the massive capital inflows into the US from emerging market countries that kept US interest rates artificially low and the US dollar artificially strong. I have looked carefully the role of capital inflows and see little reason to attribute much of asset price bubble to them.

But this gets us to the major omission in the AHR study as to both the cause and ultimate solution to the global economic woes. What causes a bubble? Someone buying to the point that the price is ridiculously high. In short, irrational, excessive buying. What do the US mortgage bubble and the European sovereign debt bubble have in common? They both involved a risky asset that banks bought in excess.

Why did US banks buy up so many mortgages knowing there is a real estate cycle that goes down as well as up? Why were European banks buying Greek debt back in 2007 knowing from published data what horrible shape the government accounts were in? The answer in both cases is the same. The banks saw a way to make money:

• buy up these risky assets;
• package them;
• in some cases insure them, and
• sell them off for a commission.

In the US, this went on until one day, the bubble burst and there was no market for asset-backed securities. The result was a bank collapse that caused a worldwide panic. And as I have reported, this panic resulted in stock market and real estate losses of $50 trillion (to put this in context, 2008 GDP $61 trillion). And the “wealth effect” of those losses led to the reduction in spending worldwide that launched the global recession.

And what has just happened in Europe? Banks created a bubble in sovereign debt. They bought too much of it, packaged it, insured it, and sold it off. The bubble has already burst, and another global panic has only been averted by massive purchases of sovereign debt “vehicles” by the European central bank and others.

Large bubbles only occur when there are buyers of an overpriced asset. Banks were the buyers of mortgages and government debt. Their continued buying of these assets contributed significantly to the bubbles. And when they burst, it appears there is more concern about bank survival than anything else. Why is this? Because we don’t want to lose our deposits: let the odd private equity firm/hedge fund collapse, but we don’t want to lose our deposits. We have seen panic recently, but that panic would pale relative to a major run on our depository institutions.

2. Excess Labor

I am in agreement with AHR’s diagnosis point: “the world economy now is beset by excess supplies of labor, capital, and productive capacity.”

Policy Prescriptions

1. Banks

Inasmuch as AHR did not mention private banks in their diagnosis of the problem, it is understandable that they did not mention more bank regulation in their policy recommendations. I believe this is a fundamental shortcoming to their study. And it seems that this point is so obvious to make me wonder who paid for their study – the American Bankers Association?

As I have written, the primary job of depository banks is to protect depositors. It is not to engage in risky trading to justify high salaries for bank senior executives. John Lounsbury has supported consideration of some banking activities being operated as public utilities. I agree. Deposits should be risk free, and this is certainly not the case today.

In addition, any depository bank insured by government should be required to manage its own loans and not allowed to trade for its own account. The US Congress had right back in 1933 when it passed the Glass-Steagall Act that removed investment banking from depository institutions. Remember Paul Volcker? He told Obama the same thing but was shunted aside by the bankers’ lobby (Summers and Geithner) in the President’s Administration.

Some might still believe new bank regulations will solve the problem. Have you talked to a bank regulator recently? I have. They are totally confused: I quote from a piece by Michael Rapoport on what is happening in Europe:

“The problems for investors in evaluating European banks first arose during the summer, when the banks made different choices in how they valued Greek government debt, as a financial crisis made it clear that the bonds wouldn’t be repaid in full. Some banks valued the debt at its market price, about half of its face value, and took an impairment charge against earnings to write down the other half. But others declared there was no viable, active market for the debt, so they used their own models to value it, as accounting rules allow in such circumstances.

“The debt isn’t the only thing impaired here,” said Lynn Turner, a former chief accountant for the Securities and Exchange Commission. “The regulators and auditors are impaired as bad if not worse.”

Forget the Basel Accords. They are a joke. They have not protected us in the past, and they will not protect us in the future.

2. Excess Labor, etc.

I am concerned that with labor saving technology being developed at a rapid pace, AHR’s policy prescriptions here fall short. I do not believe an aggregate demand stimulus of any size will be adequate to return the world to full employment. And as Juliet Schor has pointed out, there are real costs in producing too much. Instead, we need to create incentives for people to work less. Yes. I am serious: rather than increasing the age for Social Security eligibility, it should be reduced.

Final Thoughts

While AHR has done an excellent job of portraying just how serious the global economic problems are, I was shocked to find they did not view banks as primary culprits warranting greater regulation. And I also wonder just how much we can expect to get from additional aggregate demand stimuli.

Their points on capital flows are interesting as are their proposals for global reforms. These will be covered in a follow-up article.

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About the Author

Elliott Morss has a broad background in international finance and economics. He holds a Ph.D.in Political Economy from The Johns Hopkins University and has taught at the University of Michigan, Harvard, Boston University, Brandeis and the University of Palermo in Buenos Aires. During his career he worked in the Fiscal Affairs Department at the IMF with assignments in more than 45 countries. In addition, Elliott was a principle in a firm that became the largest contractor to USAID (United States Agency for International Development) and co-founded (and was president) of the Asia-Pacific Group with investments in Cambodia, China and Myanmar. He has co-authored seven books and published more than 50 professional journal articles. Elliott writes at his blog Morss Global Finance