The great debt bubble of 2011

Have our governments averted a financial disaster – or paved the way for one?

1 January 2011

12:00 AM

1 January 2011

12:00 AM

Have our governments averted a financial disaster – or paved the way for one?

‘The worst of the storm has passed,’ declared Barack Obama at the start of last year, seeking to calm the fearful. For his part, Gordon Brown assured Britain that talk of tough years ahead was ‘simply not true’. Both men spoke of their resolve to cure their economies, and did not seem to mind using the same techniques that created the old bubble. Bank bailouts and massive stimulus efforts have indeed encouraged us to borrow, spend and speculate again. Bank interest rates have dropped to historic lows, bringing cheap credit to the housing market and the high street. The mood this year is one of cautious optimism. It would all be reassuring, were it not so eerily familiar.

In 2003, after the dotcom crash and the 11 September attacks had sent America into recession, everybody wanted the debt-fuelled consumer binge to continue. Not that they said so in terms. Euphemisms were deployed, then as now: there should be government ‘support’, a little touch of Keynes. The Nobel-winning economist Paul Krugman urged Alan Greenspan to ‘create a housing bubble to replace the Nasdaq [stock market] bubble’. The Fed chairman obliged, cutting interest rates to a new low. In Britain, base interest rates halved between 2000 and 2003. Money was as cheap as it needed to be to get everybody borrowing again, and returning to the market. House prices boomed. It looked like prosperity. Bubbles so often do.

Nothing is more dangerous than an idea when it’s the only one you have. There is a broad consensus that the financial crisis of 2007 was at least in part a result of record-low interest rates, huge deficits and large-scale credit-financed consumption. Today, governments across the world are trying to solve the crisis — by means of record-low interest rates, huge deficits and large-scale credit-financed consumption. This time, they are also using more novel means of creating easy money: bank bailouts, stimulus packages and quantitative easing. Once again, it has produced results: Christmas shopping was quite buoyant. But no one has asked how many of these Christmas shopping bills were paid with borrowed money.

For all the talk of austerity, governments everywhere plan to get through 2011 and beyond by borrowing like crazy. The world’s rich countries have increased their debt by some 50 per cent over the past three years, according to the IMF. Such statistics can too often seem meaningless, but during the British general election campaign David Cameron found a way to make them real. He unveiled a poster saying that a baby born today would owe £17,000 due to government debt. By his own estimates, that burden will rise to £21,000 within four years. Less than it would have been without the extra belt-tightening, to be sure, but a daunting figure none the less.

All governments are betting that they can keep borrowing such extraordinary sums at very low rates. But the markets may have other plans. Consider the evolution of this crisis. The crash happened because households consumed too much, sending their debts to the banks. The banks sent the debts to the governments — and, as we saw with Ireland, even governments might struggle to meet them. So they are sending their debts to the European Union. But to whom will the EU send the bills when its credit card is maxed out?


Greece and Ireland aren’t just illiquid, they are insolvent — and nothing is solved by taking new, bigger loans when they can’t pay the old ones. If Ireland or Greece default on their debt, forcing creditors to take steep losses, it might spook the markets and pull out a thread that unravels the garment.

Markets are lending billions to Spain (and Italy, Belgium, perhaps even France) because investors imagine that, while the countries themselves might be broke, someone else guarantees the investment. I am sure I was not the only one who was told by my bank that it was safe to invest in peripheral (i.e. Irish) European debt on the grounds that the EU would always step in rather than let them go bust. Sovereign bond markets panicked when Angela Merkel suggested that investors might one day have to bear some of their own losses.

If the defaults start — or if it dawns on markets that the European Financial Stability Fund doesn’t have half of what it would take to save Spain, the world’s ninth largest economy — then investors might rush for the exit. And this, for David Cameron and George Osborne, would produce some deeply unpleasant surprises. What would happen to the British banks that have lent more than $110 billion to Spain, or the French banks that lent $162 billion, or the German ones that lent $182 billion?

This year is laden with risk for Europe’s most indebted nations. The Spanish banks are already very shaky and — even in the best of circumstances — they need to borrow a sobering $111 billion this year. Anyone lending them this money might pause to reflect that their exposure to Portugal, the next wobbling domino, is almost $80 billion. To pay off old debts, they need to find new creditors. From May until June, Portugal’s government must borrow $10 billion markets to survive. During those same months, Spain needs more than $15 billion, even if it didn’t run up a single euro in deficit over the year.

In this regard, 2011 looks horribly like 2008. Yet again, banks are treading water, hoping that they can continue to borrow — and trying to lay their hands on as much capital as possible to cover their losses. Yet their risk is the same as last time. We have seen how jittery world markets can become, and how calamitous the consequences can be. It only took one big bank collapse — Lehman Brothers — to scare the markets so much that they avoided lending to anybody. Then, it was banks that fell like dominoes. Next time, it might be governments.

Barack Obama’s ‘stimulus’ programme (named after its intentions, not its results) is predicated on his belief that America will be able to borrow as much as it likes because of the dollar’s status as the world’s reserve currency. Yet as the US continues its quantitative easing — that is, printing money — the dollar might cease to look like such a safe investment. Perceptions can change rapidly, especially for the United States, which has to renew around half of its almighty national debt every year. In the past six months, the US Treasury has had to increase the interest paid on its ten-year IOU notes to 3.5 per cent — a full percentage point higher than in the summer. If Uncle Sam’s cost of borrowing keeps rising at this rate (Spain is shelling out 5.5 per cent, and Ireland 8.5 per cent), the US deficit will start to look like a black hole.

At this point, it is traditional to say: thank God for those roaring economics in East Asia, India and Brazil. But how real is their remarkable growth? Look closely, and even this may be in part a result of artificial stimulus. India’s and Brazil’s growth is financed by short-term capital from abroad: money that could disappear overnight. Easy money always ends up somewhere. The last time it was in property, this time it is in emerging markets (and often in the property markets of emerging markets).

China’s wealth and prospects dazzle the debt-laden West. ‘Money, money everywhere,’ the Beijing economist Patrick Chovanec said in a recent survey of China. ‘Awash in luxury cars, condos and expensive jewellery, the Chinese are enjoying what looks to be an unstoppable boom.’ The prices of high-end properties in some of the wealthiest cities have almost doubled in two years. High street prices are also creeping up, prompting the government to tighten policy.

In fact, this is not the result of better prospects but of a monetary shock. Aside from the foreign ca
pital inflows, China had its own stimulus package, as big as America’s. Beijing has printed yuan and pushed banks and local governments to spend like drunken Keynesians. Absurdly, China’s money supply is now larger than America’s, even though its economy is a third of the size. We can see the results of this stimulus in stock market prices and in new roads, bridges and housing complexes all over the country.

Not that anyone wants to travel on those roads or live in those buildings. In August, China’s largest energy company reported that an extraordinary 65.4 million residences have not consumed any electricity in the last six months — a fairly big clue that they lie empty. There are now entire ghost towns, like new Ordos in northern China, where tens of thousands of buildings erected from scratch stand empty. And yet property prices in Ordos have doubled over three years. It’s not popular demand, it’s pure speculation. In some quarters, China is being spoken of as the last, best hope for the world economy. But it might be the next bubble to pop.

In the original Superman film, the hero rescues Lois Lane as she falls from a skyscraper. ‘Don’t worry, ma’am, I got you,’ he says, midair. ‘You got me? Who’s got you?’ she replies. This is the question that no one is asking now. If China is lending to us, who is lending to China? If the governments are saving the banks, then who will save the governments? If the European Union is offering a safety net, who would be there to bail out the EU? There are other questions not being asked: which country, in recent economic history, has successfully borrowed its way out of a debt crisis? Why should it work now? And how can we justify saddling the next generation with such debt?

‘The problem with socialism,’ Lady Thatcher once said, ‘is that eventually you run out of other people’s money.’ This time, it is worse: we are running out of our children’s money, and our grandchildren’s money. We are assuming we will have a never-ending supply of borrowed money, and we have no backup plan if this supply chokes up. Things may feel safe at the moment. We can still borrow easily from international markets. So could Lehman Brothers on 12 September 2008 — the day before the bank imploded.

I am an optimist by nature. Every generation tends to make terrible mistakes, and yet we have still managed to create the richest civilization ever — so the odds are that we’ll work our way out of this financial crisis too. In the long run. But our reliance on debt can only make that long run even longer.

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Show comments
  • Larry Motuz

    The article cites Krugman as urging Greenspan to create a new bubble. Please correct.

    “This, probably accidentally, misquotes Krugman, who was citing someone else.

    Go to the original NYT article: “Dubya’s Double Dip?” at http://www.nytimes.com/2002/08/02/opinion/dubya-s-double-dip.html?pagewanted=2”

  • Johan Norberg

    Dear Larry,

    Yes, Krugman was referring to (not exactly quoting) McCulley’s view, but he did it to say that McCulley is right. It is obvious from the context (and from his recommendations to Fed) that this is Krugman’s own view as well:

    “To fight this recession the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. And to do that, as Paul McCulley of Pimco put it, Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble.”

  • Steve Tierney

    Very much what I’ve been saying for a few years now. Nobody listens.

  • Larry Motuz

    Dear Johan,

    My reading is different from yours–but then I’m a multihanded economist. I believe Mr. Krugman began his article by stating that the equity market bubble had been caused by the Fed’s low interest rate policy, and that more of the same was about to happen from the Fed.

    Of course, I could be wrong. If so, sorry.


  • Laurent

    Dear Mr Norberg,

    I think you are intentionally misreading the Krugman piece from 2002. Clearly Krugman agrees with Mcculley that a Greenspan housing bubble would head off a double dip. But you cannot possibly argue he is *advocating* a housing bubble. He is in fact predicting a double dip recession (incorrectly, as it happened). In general this is an analytical piece by him, not one of advocacy. This failed cheap shot at Krugman undermines the rest of your article (I am sure I am not the only person who did not read another word of it . . .)

  • A. MacAulay

    “But to whom will the EU send the bills when its credit card is maxed out?” Why, Germany of course! Which is why the Kanzlerin has the German people behind her when she attempts to stall this nonsense before it happens.

  • maddy1

    Will the UK and the USA ever be able to pay off their debts? Lets start afresh by defaulting on the Chinese like they did to the world in 1921.

  • Wm Peden

    An excellent article. Thank you for writing it so well. I really appreciate your common sense analysis.

  • JohnAnt

    I’ve read Krugman’s article. It is clear (to me at least) that he does not call for the housing bubble whose advocacy he ascribes to Greenspan – on the contrary, he goes on to be rather scathing about Greenspan’s ‘crystal ball’. But Krugman is partly to blame for any misinterpretation of his stance, by writing in a misleading ‘as if’ semi-ironic style without proper attention to the subjunctive mood of reported or alleged speech.
    The context of what Krugman said was [I quote]:
    “The basic point is that the recession of 2001 wasn’t a typical postwar slump, brought on when an inflation-fighting Fed raises interest rates and easily ended by a snapback in housing and consumer spending when the Fed brings rates back down again. This was a prewar-style recession, a morning after brought on by irrational exuberance. To fight this recession the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. And to do that, as Paul McCulley of Pimco put it, Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble.
    Judging by Mr. Greenspan’s remarkably cheerful recent testimony, he still thinks he can pull that off. But the Fed chairman’s crystal ball has been cloudy lately; remember how he urged Congress to cut taxes to head off the risk of excessive budget surpluses? And a sober look at recent data is not encouraging…The administration needs a recovery because, with deficits exploding, the only way it can justify that tax cut is by pretending that it was just what the economy needed. Mr. Greenspan needs one to avoid awkward questions about his own role in creating the stock market bubble.
    But wishful thinking aside, I just don’t understand the grounds for optimism. Who, exactly, is about to start spending a lot more?”
    Even those of us whose first language is English have some difficulty in understanding American polit-economese. Suggesting that any misunderstanding by Mr Norberg might be ‘intentional’ is extremely inflammatory. We need cool and co-operative heads and above all, cool and clear prose.

  • Johan Norberg

    Dear Larry and JohnAnt,

    Above we have the exact words, Krugman hopes that Greenspan can engineer a housing bubble – but he is not certain that Greenspan can pull it off. And if you think he is being ironic, I urge you to consider that this is precisely the policy Krugman advocated at the time – lower interest rates to get people to spend more on housing and everything else.

    And if you demand more proof that this is what Krugman really thought, here it is, from four different interviews/articles with and by Krugman in 2001:

    “economic policy should encourage other spending to offset the temporary slump in business investment. Low interest rates, which promote spending on housing and other durable goods, are the main answer.”

    “Business investment is not going to be the driving force in this recovery. It has to come from things like housing”

    “…there are always those who say that lower interest rates will not help. They overlook that low interest rates act in several ways. For instance, more housing is built, which expands the building sector.”

    “Will the Fed cut interest rates enough? Will long-term rates fall enough to get the consumer, get the housing sector there in time? We don’t know”


    As you can see, Krugman’s only reservation is that he does not think Fed was bold enough in inflating the housing bubble.

  • Hmmm

    As Baron Rothschild would say: “Buy when there’s blood in the streets” and he, who didn’t seem to be a “left-wing monger” knew it very well.

  • alaoui .morocco

    your article is a real lesson of the world economic crisis and the chairs of the universities must teachs to the students .none can give whene he have nothing to give.thanks mister.

  • revolution

    Yes but Gordon the clown Brown stopped all this boom and bust didn;t he?