Fraser Nelson

A debt-filled New Year

A debt-filled New Year
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The Spectator is out today, with a cover story that I would commend to CoffeeHousers. Failure to learn from history usually condemns a nation to repeating its mistakes. That's why we should be nervous that no one seems to have worked out what caused the crash. Little wonder: the guys doing the analysis are the same guys who failed to spot the crisis building up, so it suits everyone to blame the banks. "How was I to know," says everyone from Gordon Brown to Joe the Pundit, "that they were doing all these complex debt swap thingies? They deceived everyone, the bounders." There is another analysis – and it's our cover story, written by Johan Norberg. He has been making his case in a short film (trailer here, if you can stand Brown’s cameo) and a book (for my money, the best written about the crisis). I thought CoffeeHousers may be interested in the bones of his argument – which I flesh out, below.

His analysis is that the hangover is not the problem: the party was. Bubbles always burst. We should ask how a debt bubble was blown in the first place. "Crazy risk-taking by banks is a symptom of the easy money era. Yes, they did outrageous things – but from the tulip bubble onwards, people always do if the supply of money is not properly controlled. What did for Britain (and America) was a fatal fixation with interest rate targeting: the idea that if CPI was about 2 percent then the economy was stable. In fact, this "stability" masked an avalanche of dangerously cheap money, to needlessly counter a benign deflationary shock from China and the Far East. Prices of assets – from fine wine to houses – were soaring. But central banks, and most mainstream commentators, didn't think it was a problem. They all bought into the idea that price stability meant economic stability. The root of the crash was an intellectual error: a rotten idea. And that idea is still with us.

Here is my ten-point breakdown of Norberg's argument. All quotes are from his piece, except point 2 which is from his book. A rather technical point, but a crucial one.

1. There are eerie parallels between 2011 and 2003. “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.”

2. The error of inflation targeting. "In a dynamic economy, with constant innovation, prices often decrease. Let's assume that the real underlying costs fall by 2 per cent, due to increased efficiency. But this development could be counteracted by an increase in the money supply so that price tags in stores indicate a price increase of 1 per cent. The central bank is likely to grab the wrong end of the stick, by concluding that there is no inflation worth mentioning. This will prompt it to cut rates."

Sometimes, the world just gets more efficient – and it should mean falling prices. Norberg quotes James Grant, editor of Grant's Interest Rate Observer (which was calling the asset bubble by its name from 2003 on) in noting that "the price of a basket of good exposed to international competition had fallen by 31 per cent in the years prior to 1886, before the United States had a central bank." As Grant says: "falling prices are a natural byproduct of human ingenuity. Print money to resist the decline, and the next thing you know there's a bubble."

3. Western governments' reliance on debt now is extraordinary. The G7 countries have, on average, 50 percent more debt in 2010 than in 2007. This is an average figure: the below, using IMF data, charts how much debt they have taken on. No prizes for guessing which country raises the average:


4. David Cameron's famous baby. “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.”

5. The Russian Doll bailouts. “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?”

6. The Irish bailout will not be the last of the sovereign debt crisis. “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.”

7. A Eurozone crisis cannot fail to impact Britain. “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?”

8. In the last debt crisis, the banks fell. This time, it might be governments. "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."

9. China may be the next bubble to pop. “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.”

10. We may have tried to fix the old Ponzi scheme with a new one. “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?”

So could 2011 be the year when the second debt bubble pops? Norberg finishes off with this point:

“’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.”