The end of capitalism as people knew it

After a week on holiday reading detective fiction, I’ve devoured 1931: Debt, Crisis and the Rise of Hitler by Tobias Straumann. I’d never picked out 1931 as a particularly significant year, knowing nothing about the German banking crisis that year. Yet, the book argues, what hapened “is a story of almost biblical proportions, demonstrating how quickly a situation that seems manageable at first can spin out of control.” Greek tragedy was the comparison that came to my mind: every person doing exactly what they inevitably had to, ending in disaster because of the situation.

The book, which is highly readable, starts with an economist I’d never heard of, ‘The Raven of Zurich’, Felix Somary, the Cassandra who warned of disaster staring as early as January 1930. It didn’t happen for another 18 months, with the collapse of German banks after the Credit Anstalt collapse, so Somary was mocked. But had seen the inevitable consequences of the combination of the Depression, the burden of reparations on Germany, the international imbalances that resulted from the country seeking short term foreign capital, and the efects of consequent repeated rounds of austerity on German politics.

The circumstances were of course highly specific, yet throughout the book, there are alarming parallels with the post-GFC west. Take the Smoot-Hawley tariffs, signed into law by President Hoover despite the fact that over 1000 American economists warned him against doing so. In Germany itself, the parliamentary processes of the already weak Weimar republic were increasingly debased by extremists. The latter, prominently the Nazi party, welcomed the chaos.

By mid-1931, wages and pensions had been cut, unemployment was high and rising, there was no prospect of relief from the burden of reparations or indeed further short term financing to help Germany meet those payment – and then the main banks started to topple and experienced massive bank runs. “It felt like the end of capitalism as people knew it.” Arnold Toynbee wrote that “men and women all over the world were seriously contemplating and frankly discussing that the western system of society might break down and cease to work.” In important ways they were right.

It’s a relatively short book that reads like a thriller, and – as Straumann concludes – illustrates the fundamental point that “Only when domestic electorates are prepared to accept a loss of sovereignity for the benefit of cross-border co-operation can international institutions and agreements have a chance of working effectively.” When a debt crisis makes sustained growth difficult and  leads to repeated austerity measures, electorates start to wonder what the point is.



Debt, debt, debt, debt

I’m rather late to [amazon_link id=”022627165X” target=”_blank” ]House of Debt[/amazon_link] by Atif Mian and Amir Sufi, which is recently out in paperback. It argues eloquently and persuasively that the Great Financial Crisis was not only a banking crisis but also a household debt crisis, and that the length and severity of the downturn can largely be explained by the private debt overhang. This is not the received wisdom, of course. All the policy attention has focused on the near-catastrophe of the banking meltdown, and it is terrifying even now to think how serious the economic consequences would have been if the payments systems had stopped working, as they almost did in the UK. The book acknowledges that the authorities were absolutely right to act swiftly to prevent banking meltdown, and argues that more would have been better – more in the sense of the famous ‘helicopter money’ drop advocated by Adair Turner, for one, in his recent [amazon_link id=”0691169640″ target=”_blank” ]Between Debt and the Devil.[/amazon_link]

[amazon_image id=”022627165X” link=”true” target=”_blank” size=”medium” ]House of Debt: How They (and You) Caused the Great Recession, and How We Can Prevent It from Happening Again[/amazon_image]

However, Mian and Sufi also point out that while political campaign contributions can be shown to have led the US Congress to support bank bailouts, there was next to no household debt relief. The core of their argument is that the effects of household leverage spilled over to the whole US economy, and that writing off some of the debt owed by homeowners underwater (not because of idleness or irresponsibility but because of a macro shock) would have benefited everyone. I found their argument convincing, along with the corollary that you can not fix an excess debt problem by getting people to take on more debt. The book makes a strong case for reducing the attractiveness of debt, due in large part to the tax system. They write:

“Debt instruments lead investors to focus on a very small part of the potential set of outcomes …In a world of neglected risks, financial innovation should be viewed with some degree of scepticism. If investors systematically ignore certain outcomes, financial innovation may just be secret code for bankers trying to fool investors into buying securities that look safe but are actually extremely vulnerable.” They are also critical of the extent of the bailouts for the financial sector: “The fundamental business of a bank is lending, just as the fundamental business of a furniture company is to sell furniture. Few economist believe that the government should promote the sale of bad furniture by stepping in to protect the creditors and shareholders of a poorly performing furniture company.” This understates the externalities involved in a bank failure, of course, and – as I noted – Mian and Sufi do not condemn the authorities’ response in 2008/9.

Given where we are, they advocate instead a range of measures to reduce debt dependence in future, including levelling the tax code as between debt and equity, and encouraging the use of more equity-like financial instruments, including in lending for home purchase. They cite approvingly Bob Shiller’s suggestions for instruments to insure against macro risks (in his book [amazon_link id=”B00C791JJI” target=”_blank” ]Finance and the Good Society[/amazon_link]) and [amazon_link id=”B00HZ634AU” target=”_blank” ]Admati and Hellwig'[/amazon_link]s advocacy for far higher levels of equity as opposed to be debt to be required on banks’ balance sheets. These kinds of arguments are slowly making headway in both economics and in policy circles. But slowly. Meanwhile, what is terrifiying is the evidence of a re-inflating of the debt bubble in some economies, including the UK. Can we really be ready to risk going around the same hamster wheel again, just because the financial sector lobbies so effectively?

Debt, no brainers and no-nos

Yesterday I attended the launch of a new CEPR (free) e-book, A New Start for the Eurozone: Dealing with Debt. Written by some of Europe’s most distinguished macroeconomists, it notes that a return to sustainability requires a reduction in the legacy debt burden. It proposes using the seigniorage revenues from the Euro to finance a one-time debt buyback for the most indebted Eurozone countries, reducing their debt-GDP ratios to a sustainable level. This would be combined with a stronger regulatory structure to prevent future debt build-ups (and mitigate the unavoidable moral hazard involved in the first step), and the creation of a safe asset, a synthetic European bond.

A New Start for the EurozoneThis is very far from my area of expertise, so it sounds a promising package of measures but I’m not in a good position to evaluate its details. Among the audience at the launch, the questions centred almost entirely on political economy questions: how could European governments be persuaded to do anything now the markets are calm? how would the new measures sit within the existing institutional framework? could northern Europe (Germany) be persuaded to allow the seigniorage revenues to be used in this way?

In short, an economic no-brainer – that the debt legacy has to be tackled – is a political no-no. The fact that the economic hurdles are huge but the barriers to reform are political was brought home by Gillian Tett’s Financial Times column this morning. She writes: “On the eastern side of the Atlantic, policy makers are now at pains to suggest that a Greek default, or even a eurozone exit, would not be disastrous; at last week’s International Monetary Fund meetings German officials argued that the chance of a Greek exit had already been priced into the markets, and that shocks could be contained.”

She argues – and I agree – that the Eurozone could yet go very pear shaped, and the dangers of renewed systemic financial crisis are non-zero. At least if the pessimistic view is correct, the political economy of reform along the CEPR or other lines will become more favourable.

The debt overhang

Larry Summers today reviews in the FT [amazon_link id=”022608194X” target=”_blank” ]House of Debt [/amazon_link]by Atif Mian and Amir Sufi, praising it highly – except in one respect. Amusingly, he starts out by emphasising that it is the most important economics book of 2014, based on unchallengeable data and clearly written. Still, (not so) subtle side-swipes at [amazon_link id=”067443000X” target=”_blank” ]Capital in the 21st Century [/amazon_link]aside, Summers’ acceptance of the argument in [amazon_link id=”022608194X” target=”_blank” ]House of Debt[/amazon_link] is significant, given his key role in responding to the financial crisis. The book argues that the roots of the crisis lie not in the banking or shadow banking system but in household over-leverage, drawing on a line of argument dating back to [amazon_link id=”1469947080″ target=”_blank” ]Irving Fisher[/amazon_link] and running more recently through [amazon_link id=”0470824948″ target=”_blank” ]Richard Koo’s work on Japan[/amazon_link].

[amazon_image id=”022608194X” link=”true” target=”_blank” size=”medium” ]House of Debt: How They (and You) Caused the Great Recession, and How We Can Prevent it from Happening Again[/amazon_image]

Where Summers disagrees with the book concerns the authors’ interpretation of the policy response, criticising the authorities’ failure to tackle the mortgage overhang more directly with sweeping relief for over-indebted households. Summers writes: “Obviously, as the director of President Barack Obama’s National Economic Council in 2009 and 2010, I am an interested party here. It seems to me that Mian and Sufi are naive on policy.”

There is support for Summers’ point that implementation of more extensive mortgage debt relief simply could not get through Congress in one of the essays I’ve just read in [amazon_link id=”0231160755″ target=”_blank” ]The Best Business Writing 2013[/amazon_link], The Great American Foreclosure Story by ProPublica’s Paul Kiel. In general, I think economists – even those with a tremendous interest in policy issues – fail to take into account the sheer difficulty of implementing anything in a modern democratic polity, where politics meets complexity. Just glance at [amazon_link id=”1780742665″ target=”_blank” ]The Blunders of Our Governments[/amazon_link] by Anthony King and Ivor Crewe….

[amazon_image id=”1780742665″ link=”true” target=”_blank” size=”medium” ]The Blunders of Our Governments[/amazon_image]

[amazon_link id=”022608194X” target=”_blank” ]House of Debt[/amazon_link] sounds like an essential read on the crisis. I wonder if any economists are doing similar empirical work on household indebtedness in the European economies?

How can there be a borrower from hell?

The joy of a four-day weekend – as well as cooking and gardening, I’ve read a thoroughly enjoyable economic history book with great relevance for the present debate on sovereign borrowing. It’s [amazon_link id=”0691151490″ target=”_blank” ]Lending to the Borrower from Hell: Debt, Taxes and Default in the Age of Philip II [/amazon_link]by Mauricio Drelichman and Hans-Joachim Voth.

[amazon_image id=”0691151490″ link=”true” target=”_blank” size=”medium” ]Lending to the Borrower from Hell: Debt, Taxes, and Default in the Age of Philip II (The Princeton Economic History of the Western World)[/amazon_image]

Part of my enjoyment was that I studied this period for my history A level (and almost read history at university before economics captured me), and so was absorbed in 16th and 17th century Europe during those impressionable teenage years. It’s extraordinary that so many Europeans know so little about it now – certainly, British schoolchildren jump from the Tudors straight to World War II and the Cold War. For a sense of how turbulent and decisive a period it was, the novel [amazon_link id=”0099439832″ target=”_blank” ]Q[/amazon_link] by the Italian collective Luther Blissett is hard to beat; I have the Wu Ming “sequel”, [amazon_link id=”1781681678″ target=”_blank” ]Altai[/amazon_link], on my in-pile now.

[amazon_image id=”1781681678″ link=”true” target=”_blank” size=”medium” ]Altai: A Novel[/amazon_image]

However, even if you don’t share my specific interest in the period, this is an essential book for economists interested in sovereign debt – and which of us is not at the moment? It fills in some important detail about an episode in debt history that features in the data set of the monumental [amazon_link id=”0691152640″ target=”_blank” ]This Time is Different[/amazon_link]. A large part of the achievement of the authors is the collection of a highly impressive data set on the debt issuance, repayments, revenues and expenses of Philip II of Spain, based on obviously extensive archival research as well as secondary sources.This was, of course, the period when New World silver started to reach the coffers of the Castilian crown in large quantities. [amazon_link id=”0691151490″ target=”_blank” ]The Borrower from Hell[/amazon_link] underlines the concept of resource curse.

[amazon_image id=”0691152640″ link=”true” target=”_blank” size=”medium” ]This Time Is Different: Eight Centuries of Financial Folly[/amazon_image]

Philip II has the reputation of being the Borrower from Hell because of the frequency with which he defaulted – there was a payment suspension more often than one year in every five during his reign. As the authors point out, the [amazon_link id=”0691152640″ target=”_blank” ]Reinhart-Rogoff data set[/amazon_link] shows 20% of countries in default on average in every year since 1800, so the reputation may be unfair; but the scale of the borrowing was large and Philip II defaulted a record-breaking 13 times in succession: “No country in recorded history has defaulted more times.”

So the question is why he got the opportunity to do so; why did bankers continue lending to him? How can there be a ‘borrower from hell’? The book carries out an IMF-type sustainability exercise on the historical data set and concludes that the debt burden was sustainable although there were liquidity crises due to events – usually a military loss. It also argues that the structure of the lending meant there was a kind of balance of power between king and lenders. The form the lending took was syndicated loans provided by a relatively small and tight-knit group of families; 130 people from 63 families lent Philip money over the years but 3 families accounted for 40% of all loans and 10 families for 70%. The banking network was stable and dominated the available funds. So whereas two hundred years earlier Philip IV of France had executed those who lent him money (Jews, Lombards, Templars) when he couldn’t pay, Philip II of Spain had a long relationship with his financiers. The ‘absolutism’ of the 16th and 17th centuries was in fact constrained, a useful fiction for both monarch and elites.

The data indicate that despite the defaults, holidays and renegotiations, the average return on the loans was highly favourable. The book argues that the lending was understood to be contingent and that a renegotiation would ensue if events turned out badly for the king. The negotiations were typically speedy, as was the return to lending. The bankers were sharing the risk with Philip, their return amply compensating them for it. It sounds not unlike Robert Shiller’s proposal for event-dependent sovereign loans in his book [amazon_link id=”0691120110″ target=”_blank” ]The New Financial Order[/amazon_link].

[amazon_image id=”0691120110″ link=”true” target=”_blank” size=”medium” ]The New Financial Order: Risk in the 21st Century[/amazon_image]

[amazon_link id=”0691151490″ target=”_blank” ]Lending to the Borrower from Hell[/amazon_link] is a useful reminder that, not only is sovereign lending wholly intertwined with the state, it can perform a useful rather than a solely destructive function. The book does not indulge in drawing lessons for modern finance, but it’s hard to escape the conclusion that the structure of modern financial markets deserves close scrutiny in evaluating lessons from the crisis. And that the balance of power between, say, the Greek government and Wall Street banks has been made completely clear by the terms of Greece’s “rescue”.

As for the resource curse, Drelichman and Voth conclude with a discussion of the reasons for later Spanish economic decline: “The inability to raise state capacity must ultimately be traced back to a resource windfall – silver. It kept the Crown fiscally sound without the need to strike a bargain that would have helped build a stronger, more capable state in the long run.”

A final note: this is a tremendously well-written book, a pleasure to read.