Category Archives: Global Financial Crisis

THIS TIME IS NO DIFFERENT. IMF’s dire warning on global economy – Liam Dann * Why a New Multilateralism Now? – David Lipton.

Merry Christmas and happy new financial crisis.

History suggests we are due for another financial crisis and right now the world is in no shape to cope with one.

With ingenuity and international cooperation, we can make the most of new technologies and new challenges, and create a shared and sustained prosperity.


With interest rates still low, central banks simply don’t have the firepower they did in 2008 to deal with a deep recession.

The official outlook for New Zealand’s economy remains solid with GDP growth expected to stay safely north of 2.5 per cent.

But these kind of forecasts will mean little if the world heads into a serious financial crisis.

NZ Herald

Why a New Multilateralism Now

David Lipton, IMF First Deputy Managing Director

Good morning.

Thank you for the introduction.

I appreciate the invitation to speak here today. This conference is tackling issues that have a great bearing on the stability of the world economy. Having just passed the 10th anniversary of the start of the Global Financial Crisis, and now looking forward, I’d like to address what I see as this morning’s key topic: the next financial crisis.

History suggests that an economic downturn lurks somewhere over the horizon. Many are already speculating as to exactly when, where, and why it might arise. While we can’t know all that, we ought to be focusing right now on how to forestall its arrival and how to limit it to a “garden variety” recession when it arrives, meaning, how to avoid creating another systemic crisis. Over the past two years, the IMF has called on governments to put in place policies aimed at just that goal, as we have put it, “fix the roof while the sun shines.” But like many of you, I see storm clouds building, and fear the work on crisis prevention is incomplete.

Before asking what should be done, let’s analyze whether the international community has the wherewithal to respond to the next crisis, should it occur. And here I mean both individual countries, and the international organizations tasked to act as first responders. Should we be confident that the resources, policy instruments, and regulatory frameworks at our disposal will prove potent enough to counter and contain the next recession? Consider the main policy options.

Policy Options for the Next Recession

On monetary policy, much has been said about whether central banks will be able to respond to a deep or prolonged downturn. For example, past U.S. recessions have been met with 500 basis points or more of easing by the Fed. With policy rates so low at present in so many places, that response will not be available. Central banks would likely end up exploring ever more unconventional measures. But with their effectiveness uncertain, we ought to be concerned about the potency of monetary policy.

We read every day that for fiscal policy, the room for maneuver has been narrowing in many countries. Public debt has risen and, in many countries, deficits remain too high to stabilize or reduce debt. Now to be fair, we can presume that if the next slowdown creates unemployment and slack, multipliers will grow larger, likely restoring some potency to fiscal policy, even at high debt levels. But we should not expect governments to end up with the ample space to respond to a downturn that they had ten years ago. Moreover, with high sovereign debt levels, decisions to adopt stimulus may be a hard sell politically.

Given the enduring public resentments borne by the Global Financial Crisis, a recession deep enough to endanger the finances of homeowners or small businesses would likely lead to a strong political call to help relieve debt burdens. That could further stress already stretched public finances.

And if recession once again impairs banks, the recourse to bailouts is now limited in law, following financial regulatory reforms that call for bail-ins of owners and lenders. Those new systems for bail-ins remain underfunded and untested.

Finally, the impairment of key U.S. capital markets during the global financial crisis, which might have produced crippling spillovers across the globe, was robustly contained by unorthodox Fed action supported by Treasury backstop funding. That capacity is also unlikely to be readily available again.

The point is that national policy options and public financial resources may be much more constrained than in the past. The right lesson to take from that possibility is for each country to be much more careful to sustain growth, to limit vulnerabilities, and to prepare for whatever may come.

But the reality is that many countries are not pursuing policies that will bolster their growth in a sustainable fashion. The expansion actually has become less balanced across regions over the past year, and we are witnessing a buildup of vulnerabilities: higher sovereign and corporate debt, tighter financial conditions, incomplete reform efforts, and rising geopolitical tensions.

Five Key Policy Challenges

So, let me turn to five key challenges that could affect the next downturn, areas where governments face a choice to take proactive steps now, or not, and where inaction would probably make matters worse.

The first challenge is the simple and familiar admonition: “First, do no harm.” This is worthy advice for doctors and economic policymakers. Let me mention some examples.

In the case of U.S. fiscal policy over the past year, the combination of spending increases and tax cuts was intended to provide a shot of adrenalin to the U.S. economy and improve investment incentives. However, coming at a time when advanced recovery meant little need for stimulus, this choice runs the three risks of increasing the potential need for Fed tightening; raising deficits and public debt; and spending resources that might better be put aside to combat the next downturn.

Another example is the recent escalation of tariffs and trade tensions. Fortunately, the U.S. and China agreed in Buenos Aires to call a ceasefire. That was a positive development. There certainly are shortcomings in the global trading system, and countries experiencing disruption from trade have some legitimate concerns about a number of trade practices. But the only safe way to address these issues is through dialogue and cooperation.

The IMF has been advocating de-escalation and dialogue for some time. That is because the alternative is hard to contemplate. We estimate that if all of the tariffs that have been threatened are put in place, as much as three-quarters of a percent of global GDP would be lost by 2020. That would be a self-inflicted wound.

So it is vital that this ceasefire leads to a durable agreement that avoids an intensification or spread of tensions.

Now to the second challenge, which is closely tied to the trade issue: China’s emergence as an economic powerhouse. In many ways, this is one of the success stories of our era, showing that global integration can lead to rapid growth, poverty elimination, and new global supply chains lifting up other countries.

But as Winston Churchill once said of the U.S. during World War II, “the price of greatness is responsibility.”

China’s Global Role

Chinese policies that may have been globally inconsequential and thus acceptable when China joined the WTO and had a $1 trillion economy are now consequential to much of the world. That’s because China now is a globally integrated $13 trillion economy whose actions have global reverberations. If China is to continue to benefit from globalization and support the aspirations of developing countries, it will need to focus on how to limit adverse spillovers from its own policies and invest in ensuring that globalization can be sustainable.

Moreover, China would likely gain at home by addressing many of the policy issues that have been contentious, for example through stronger protections for intellectual property, which will benefit China as it becomes a world leader in technologies; reduced trade barriers, especially related to investment rules and government procurement procedures, which will produce cost-reducing and productivity enhancing competition that will benefit the Chinese people in the long run, and an acceleration of market-oriented economic reforms that will help China make more efficient use of scarce resources.

This notion of global responsibility applies to Europe as well, and this is the third challenge. Our forecasts show growth in the euro area and the UK falling short of previous projections, and modest potential growth going forward.

The future of the European economy will be shaped by the way the EU addresses its architectural and macroeconomic challenges and by Brexit. The recent EMU agreement on reforms is welcome. Going forward, the Euro area would gain by pushing further to shore up its institutional foundations.

The absence of a common fiscal policy limits Europe’s ability to share risks and respond to shocks that can radiate through its financial system. And crisis response will be constrained because too much power remains vested in national regulators and supervisors at the expense of an integrated approach across the continent.

All of this prevents Europe from playing a global role commensurate with the size and importance of the euro area economy.

The Task for Emerging Markets

The fourth challenge is in the emerging markets. For all of their extraordinary dynamism, we have seen a divergence among emerging markets over the past year: between those who have not shored up their defenses against shocks, including preparation for the normalization of interest rates in the advanced economies; and those that have taken advantage of the global recovery to address their underlying vulnerabilities.

Capital outflows over the past several months have shown how markets are judging the perceived weaknesses in individual countries. If global conditions become more complicated, these outflows could increase and become more volatile.

The fifth and final challenge is the topic you will take up this afternoon: the role of multilateral institutions.

We know that these institutions have played a crucial role in keeping the global economy on track. In the nearly 75 years since the IMF was set up, our world has undergone multiple transformations, from post-war reconstruction and the Bretton Woods system of fixed exchange rates to the era of flexible rates; the rise of emerging economies; the collapse of the Soviet Union and transition to market economies; as well as a series of financial crises: the Mexican debt crisis, the Asian Crisis, and the Global Financial Crisis.

At each stage, we at the IMF have been called upon to evolve and even remake ourselves.

Now, we see a rising tide of doubt about globalization and discontent with multilateralism in some advanced economies. Just as with the IMF, it is fair for the international community to ask for modernization in its institutions and organizations, to seek reforms to ensure that institutions serve effectively their core purposes.

This applies to groupings such as the G20, as well as international organizations.

So, it was heartening to see the G20 Leaders to call for reform of the WTO when they came together in Buenos Aires. This reform initiative, which has the potential to modernize the global trading system and restore support for cooperative approaches, should now go forward.

The policy challenges we face are clear. As I have suggested, governments have their work cut out for them and may have to contend with less potent policy tools. It is essential they do what they can now to address vulnerabilities and avoid actions that exacerbate the next downturn.

The Multilateral Response

But we should prepare for the possibility that weaker national tools may mean limited effectiveness, and thus may result in greater reliance on multilateral responses and on the global financial safety net.

The IMF’s lending capacity was increased during the global financial crisis to about one trillion dollars – a forceful response from the membership at a time of dire need. One lesson from that crisis was that the IMF went into it under-resourced; we should try to avoid that next time.

From that point of view it was encouraging that the G20 in Buenos Aires underlined its continued commitment to strengthen the safety net, with a strong and adequately financed IMF at its center. It is important that the leaders pledged to conclude the next discussion of our funding, the quota review, next year.

But the stakes are bigger than any one decision about IMF funding. IMF Managing Director Christine Lagarde has called for a “new multilateralism,” one that is dedicated to improving the lives of all this world’s citizens. That ensures that the economic benefits of globalization are shared much more broadly. That focuses on governments and institutions that are both accountable and working together for the common good. And that can take on the many transnational challenges that no one government alone, not even a few governments working together, can handle: climate change, cyber-crime, massive refugee flows, failures of governance, and corruption.

Working together, we will be better able to prevent a damaging downturn in the coming years and a dystopian future in the coming decades. With ingenuity and international cooperation, we can make the most of new technologies and new challenges, and create a shared and sustained prosperity.

Thank you.

Mike Taylor: Another financial crisis is coming… but when and where? – NZ Herald

The next crisis is lurking just below the surface and it might not take much to set it off.
As humans we have managed to solve just about every problem thrown our way, like communication, transportation, human rights, famine, plagues, and global wars.
But we are yet to solve the economic cycle.
We remain in an environment of boom and bust, misallocated capital, unintended consequences and are left always with the failings of capitalism.

NZ Herald

The End of Alchemy: Money, Banking and the Future of the Global Economy – Mervyn King.

If the economy had grown after the global financial crisis at the same rate as the number of books written about it, then we would have been back at full employment some while ago.

Modern economics has encouraged ways of thinking that make crises more probable. Economists have brought the problem upon themselves by pretending that they can forecast. No one can easily predict an unknowable future, and economists are no exception.

The fragility of our financial system stems directly from the fact that banks are the main source of money creation. Banks are man made institutions, important sources of innovation, prosperity and material progress, but also of greed, corruption and crises. For better or worse, they materially affect human welfare.

Unless we go back to the underlying causes we will never understand what happened and will be unable to prevent a repetition and help our economies truly recover.

The financial crisis of 2007-9 was merely the latest manifestation of our collective failure to manage the relationship between finance, the structure of money and banking, and a capitalist system.”

The former governor of the Bank of England on reforming global finance.

Mervyn King was governor of the Bank of England in 2003-13. In “The End of Alchemy” there is no gossip and few revelations. Instead Lord King uses his experience of the crisis as a platform from which to present economic ideas to non-specialists.

He does a good job of putting complex concepts into plain English. The discussion of the evolution of money, from Roman times to 19th-century America to today, is a useful introduction for those not quite sure what currency really is.

He explains why economies need central banks: at best, they are independent managers of the money supply and rein in the banking system. Central bankers like giving the impression that they have played such roles since time immemorial, but as Lord King points out the reality is otherwise. The Fed was created only in 1913; believe it or not, until 1994 it would not reveal to the public its interest rate decisions until weeks after the event. Even the Bank of England, founded in 1694, got the exclusive right to print banknotes, in England and Wales, only in 1844.

At times, Lord King can be refreshingly frank. He is no fan of austerity policies, saying that they have imposed “enormous costs on citizens throughout Europe”. He also reserves plenty of criticism for the economics profession. Since forecasting is so hit and miss, he thinks, the practice of giving prizes to the best forecasters “makes as much sense as it would to award the Fields Medal in mathematics to the winner of the National Lottery”.

The problem leading up to the global financial crisis, as Lord King sees it, is that commercial banks had little incentive to hold large quantities of safe, liquid assets. They knew that in a panic, the central bank would provide liquidity, no matter the quality of their balance sheets; in response they loaded up on risky investments.

The Economist

‘It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity …’ Charles Dickens, A Tale of Two Cities

The End of Alchemy, Mervyn King

The past twenty years in the modern world were indeed the best of times and the worst of times. It was a tale of two epochs in the first growth and stability, followed in the second by the worst banking crisis the industrialised world has ever witnessed. Within the space of little more than a year, between August 2007 and October 2008, what had been viewed as the age of wisdom was now seen as the age of foolishness, and belief turned into incredulity. The largest banks in the biggest financial centres in the advanced world failed, triggering a worldwide collapse of confidence and bringing about the deepest recession since the 1930s.

How did this happen? Was it a failure of individuals, institutions or ideas? The events of 2007-8 have spawned an outpouring of articles and books, as well as plays and films, about the crisis. If the economy had grown after the crisis at the same rate as the number of books written about it, then we would have been back at full employment some while ago.

Most such accounts like the media coverage and the public debate at the time focus on the symptoms and not the underlying causes. After all, those events, vivid though they remain in the memories of both participants and spectators, comprised only the latest in a long series of financial crises since our present system of money and banking became the cornerstone of modern capitalism after the Industrial Revolution in the eighteenth century. The growth of indebtedness, the failure of banks, the recession that followed, were all signs of much deeper problems in our financial and economic system.

Unless we go back to the underlying causes we will never understand what happened and will be unable to prevent a repetition and help our economies truly recover. This book looks at the big questions raised by the depressing regularity of crises in our system of money and banking. Why do they occur? Why are they so costly in terms of lost jobs and production? And what can we do to prevent them? It also examines new ideas that suggest answers.

In the spring of 2011, I was in Beijing to meet a senior Chinese central banker. Over dinner in the Diaoyutai State Guesthouse, where we had earlier played tennis, we talked about the lessons from history for the challenges we faced, the most important of which was how to resuscitate the world economy after the collapse of the western banking system in 2008. Bearing in mind the apocryphal answer of Premier Chou Enlai to the question of what significance one should attach to the French Revolution (it was ‘too soon to tell’), I asked my Chinese colleague what importance he now attached to the Industrial Revolution in Britain in the second half of the eighteenth century.

He thought hard. Then he replied: ‘We in China have learned a great deal from the West about how competition and a market economy support industrialisation and create higher living standards. We want to emulate that.’ Then came the sting in the tail, as he continued: ‘But I don’t think you’ve quite got the hang of money and banking yet.’ His remark was the inspiration for this book.

Since the crisis, many have been tempted to play the game of deciding who was to blame for such a disastrous outcome. But blaming individuals is counterproductive, it leads you to think that if just a few, or indeed many, of those people were punished then we would never experience a crisis again. If only it were that simple. A generation of the brightest and best were lured into banking, and especially into trading, by the promise of immense financial rewards and by the intellectual challenge of the work that created such rich returns. They were badly misled. The crisis was a failure of a system, and the ideas that underpinned it, not of individual policy makers or bankers, incompetent and greedy though some of them undoubtedly were. There was a general misunderstanding of how the world economy worked. Given the size and political influence of the banking sector, is it too late to put the genie back in the bottle? No it is never too late to ask the right questions, and in this book I try to do so.

If we don’t blame the actors, then why not the playwright? Economists have been cast by many as the villain. An abstract and increasingly mathematical discipline, economics is seen as having failed to predict the crisis. This is rather like blaming science for the occasional occurrence of a natural disaster. Yet we would blame scientists if incorrect theories made disasters more likely or created a perception that they could never occur, and one of the arguments of this book is that economics has encouraged ways of thinking that made crises more probable. Economists have brought the problem upon themselves by pretending that they can forecast. No one can easily predict an unknowable future, and economists are no exception.

Despite the criticism, modern economics provides a distinctive and useful way of thinking about the world. But no subject can stand still, and economics must change, perhaps quite radically, as a result of the searing experience of the crisis. A theory adequate for today requires us to think for ourselves, standing on the shoulders of giants of the past, not kneeling in front of them.

Economies that are capable of sending men to the moon and producing goods and services of extraordinary complexity and innovation seem to struggle with the more mundane challenge of handling money and banking. The frequency, and certainly severity, of crises has, if anything, increased rather than decreased over time.

In the heat of the crisis in October 2008, nation states took over responsibility for all the obligations and debts of the global banking system. In terms of its balance sheet, the banking system had been virtually nationalised but without collective control over its operations. That government rescue cannot conveniently be forgotten. When push came to shove, the very sector that had espoused the merits of market discipline was allowed to carry on only by dint of taxpayer support. The creditworthiness of the state was put on the line, and in some cases, such as Iceland and Ireland, lost. God may have created the universe, but we mortals created paper money and risky banks. They are man made institutions, important sources of innovation, prosperity and material progress, but also of greed, corruption and crises. For better or worse, they materially affect human welfare.

For much of modern history, and for good reason, money and banking have been seen as the magical elements that liberated us from a stagnant feudal system and permitted the emergence of dynamic markets capable of making the long-term investments necessary to support a growing economy. The idea that paper money could replace intrinsically valuable gold and precious metals, and that banks could take secure short-term deposits and transform them into long-term risky investments, came into its own with the Industrial Revolution in the eighteenth century. It was both revolutionary and immensely seductive. It was in fact financial alchemy, the creation of extraordinary financial powers that defy reality and common sense. Pursuit of this monetary elixir has brought a series of economic disasters from hyperinflations to banking collapses.

Why have money and banking, the alchemists of a market economy, turned into its Achilles heel?

The purpose of this book is to answer that question. It sets out to explain why the economic failures of a modern capitalist economy stem from our system of money and banking, the consequences for the economy as a whole, and how we can end the alchemy. Our ideas about money and banking are just as much a product of our age as the way we conduct our politics and imagine our past.

The twentieth century experience of depression, hyperinflation and war changed both the world and the way economists thought about it. Before the Great Depression of the early 1930s, central banks and governments saw their role as stabilising the financial system and balancing the budget. After the Great Depression, attention turned to policies aimed at maintaining full employment. But post-war confidence that Keynesian ideas, the use of public spending to expand total demand in the economy, would prevent us from repeating the errors of the past was to prove touchingly naive. The use of expansionary policies during the 1960s, exacerbated by the Vietnam War, led to the Great Inflation of the 1970s, accompanied by slow growth and rising unemployment, the combination known as ‘stagflation’.

The direct consequence was that central banks were reborn as independent institutions committed to price stability. So successful was this that in the 1990s not only did inflation fall to levels unseen for a generation, but central banks and their governors were hailed for inaugurating an era of economic growth with low inflation, the Great Stability or Great Moderation. Politicians worshipped at the altar of finance, bringing gifts in the form of lax regulation and receiving support, and sometimes campaign contributions, in return. Then came the fall: the initial signs that some banks were losing access to markets for short-term borrowing in 2007, the collapse of the industrialised world’s banking system in 2008, the Great Recession that followed, and increasingly desperate attempts by policy-makers to engineer a recovery. Today the world economy remains in a depressed state. Enthusiasm for policy stimulus is back in fashion, and the wheel has turned full circle.

The recession is hurting people who were not responsible for our present predicament, and they are, naturally, angry. There is a need to channel that anger into a careful analysis of what went wrong and a determination to put things right. The economy is behaving in ways that we did not expect, and new ideas will be needed if we are to prevent a repetition of the Great Recession and restore prosperity.

Many accounts and memoirs of the crisis have already been published. Their titles are numerous, but they share the same invisible subtitle: ‘how I saved the world’. So although in the interests of transparency I should make clear that I was an actor in the drama, Governor of the Bank of England for ten years between 2003 and 2013, during both the Great Stability, the banking crisis itself, the Great Recession that followed, and the start of the recovery, this is not a memoir of the crisis with revelations about private conversations and behind the scenes clashes. Of course, those happened as in any walk of life. But who said what to whom and when can safely, and properly, be left to dispassionate and disinterested historians who can sift and weigh the evidence available to them after sufficient time has elapsed and all the relevant official and unofficial papers have been made available.

Instant memoirs, whether of politicians or officials, are usually partial and self-serving. I see little purpose in trying to set the record straight when any account that I gave would naturally also seem self-serving. My own record of events and the accompanying Bank papers will be made available to historians when the twenty-year rule permits their release.

This book is about economic ideas. My time at the Bank of England showed that ideas, for good or ill, do influence governments and their policies. The adoption of inflation targeting in the early 1990s and the granting of independence to the Bank of England in 1997 are prime examples. Economists brought intellectual rigour to economic policy and especially to central banking. But my experience at the Bank also revealed the inadequacies of the ‘models’, whether verbal descriptions or mathematical equations, used by economists to explain swings in total spending and production. In particular, such models say nothing about the importance of money and banks and the panoply of financial markets that feature prominently in newspapers and on our television screens.

Is there a fundamental weakness in the intellectual economic framework underpinning contemporary thinking?

An exploration of some of these basic issues does not require a technical exposition, and I have stayed away from one. Of course, economists use mathematical and statistical methods to understand a complex world, they would be remiss if they did not. Economics is an intellectual discipline that requires propositions to be not merely plausible but subject to the rigour of a logical proof. And yet there is no mathematics in this book. It is written in (I hope) plain English and draws on examples from real life. Although I would like my fellow economists to read the book in the hope that they will take forward some of the ideas presented here, it is aimed at the reader with no formal training in economics but an interest in the issues.

In the course of this book, I will explain the fundamental causes of the crisis and how the world economy lost its balance; how money emerged in earlier societies and the role it plays today; why the fragility of our financial system stems directly from the fact that banks are the main source of money creation; why central banks need to change the way they respond to crises; why politics and money go hand in hand; why the world will probably face another crisis unless nations pursue different policies; and, most important of all, how we can end the alchemy of our present system of money and banking.

By alchemy I mean the belief that all paper money can be turned into an intrinsically valuable commodity, such as gold, on demand and that money kept in banks can be taken out whenever depositors ask for it. The truth is that money, in all forms, depends on trust in its issuer. Confidence in paper money rests on the ability and willingness of governments not to abuse their power to print money. Bank deposits are backed by long-term risky loans that cannot quickly be converted into money. For centuries, alchemy has been the basis of our system of money and banking. As this book shows, we can end the alchemy without losing the enormous benefits that money and banking contribute to a capitalist economy.

Four concepts are used extensively in the book: disequilibrium, radical uncertainty, the prisoner’s dilemma and trust. These concepts will be familiar to many, although the context in which I use them may not. Their significance will become clear as the argument unfolds, but a brief definition and explanation may be helpful at the outset.

Disequilibrium is the absence of a state of balance between the forces acting on a system. As applied to economics, disequilibrium is a position that is unsustainable, meaning that at some point a large change in the pattern of spending and production will take place as the economy moves to a new equilibrium. The word accurately describes the evolution of the world economy since the fall of the Berlin Wall, which I discuss in Chapter 1.

Radical uncertainty refers to uncertainty so profound that it is impossible to represent the future in terms of a knowable and exhaustive list of outcomes to which we can attach probabilities. Economists conventionally assume that ‘rational’ people can construct such probabilities. But when businesses invest, they are not rolling dice with known and finite outcomes on the faces; rather they face a future in which the possibilities are both limitless and impossible to imagine. Almost all the things that define modern life, and which we now take for granted, such as cars, aeroplanes, computers and antibiotics, were once unimaginable. The essential challenge facing everyone living in a capitalist economy is the inability to conceive of what the future may hold. The failure to incorporate radical uncertainty into economic theories was one of the factors responsible for the misjudgements that led to the crisis.

The prisoner’s dilemma may be defined as the difficulty of achieving the best outcome when there are obstacles to cooperation. Imagine two prisoners who have been arrested and kept apart from each other. Both are offered the same deal: if they agree to incriminate the other they will receive a light sentence, but if they refuse to do so they will receive a severe sentence if the other incriminates them. If neither incriminates the other, then both are acquitted. Clearly, the best outcome is for both to remain silent. But if they cannot cooperate the choice is more difficult. The only way to guarantee the avoidance of a severe sentence is to incriminate the other. And if both do so, the outcome is that both receive a light sentence. But this non-cooperative outcome is inferior to the cooperative outcome. The difficulty of cooperating with each other creates a prisoner’s dilemma. Such problems are central to understanding how the economy behaves as a whole (the field known as macroeconomics) and to thinking through both how we got into the crisis and how we can now move towards a sustainable recovery. Many examples will appear in the following pages. Finding a resolution to the prisoner’s dilemma problem in a capitalist economy is central to understanding and improving our fortunes.

Trust is the ingredient that makes a market economy work. How could we drive, eat, or even buy and sell, unless we trusted other people? Everyday life would be impossible without trust: we give our credit card details to strangers and eat in restaurants that we have never visited before. Of course, trust is supplemented with regulation, fraud is a crime and there are controls of the conditions in restaurant kitchens but an economy works more efficiently with trust than without. Trust is part of the answer to the prisoner’s dilemma. It is central to the role of money and banks, and to the institutions that manage our economy. Long ago, Confucius emphasised the crucial role of trust in the authorities: ‘Three things are necessary for government: weapons, food and trust. If a ruler cannot hold on to all three, he should give up weapons first and food next. Trust should be guarded to the end: without trust we cannot stand.’

Those four ideas run through the book and help us to understand the origin of the alchemy of money and banking and how we can reduce or even eliminate that alchemy.

When I left the Bank of England in 2013, I decided to explore the flaws in both the theory and practice of money and banking, and how they relate to the economy as a whole. I was led deeper and deeper into basic questions about economics. I came to believe that fundamental changes are needed in the way we think about macroeconomics, as well as in the way central banks manage their economies.

A key role of a market economy is to link the present and the future, and to coordinate decisions about spending and production not only today but tomorrow and in the years thereafter. Families will save if the interest rate is high enough to overcome their natural impatience to spend today rather than tomorrow. Companies will invest in productive capital if the prospective rate of return exceeds the cost of attracting finance. And economic growth requires saving and investment to add to the stock of productive capital and so increase the potential output of the economy in the future. In a healthy growing economy all three rates, the interest rate on saving, the rate of return on investment, and the rate of growth are well above zero. Today, however, we are stuck with extraordinarily low interest rates, which discourage saving, the source of future demand and, if maintained indefinitely, will pull down rates of return on investment, diverting resources into unprofitable projects. Both effects will drag down future growth rates. We are already some way down that road. It seems that our market economy today is not providing an effective link between the present and the future.

I believe there are two reasons for this failure. First, there is an inherent problem in linking a known present with an unknowable future. Radical uncertainty presents a market economy with an impossible challenge how are we to create markets in goods and services that we cannot at present imagine? Money and banking are part of the response of a market economy to that challenge. Second, the conventional wisdom of economists about how governments and central banks should stabilise the economy gives insufficient weight to the importance of radical uncertainty in generating an occasional large disequilibrium. Crises do not come out of thin air but are the result of the unavoidable mistakes made by people struggling to cope with an unknowable future. Both issues have profound implications and will be explored at greater length in subsequent chapters.

Inevitably, my views reflect the two halves of my career. The first was as an academic, a student in Cambridge, England, and a Kennedy scholar at Harvard in the other Cambridge, followed by teaching positions on both sides of the Atlantic. I experienced at first hand the evolution of macroeconomics from literary exposition where propositions seemed plausible but never completely convincing, into a mathematical discipline where propositions were logically convincing but never completely plausible. Only during the crisis of 2007-9 did I look back and understand the nature of the tensions between the surviving disciples of John Maynard Keynes who taught me in the 1960s, primarily Richard Kahn and Joan Robinson, and the influx of mathematicians and scientists into the subject that fuelled the rapid expansion of university economics departments in the same period. The old school ‘Keynesians’ were mistaken in their view that all wisdom was to be found in the work of one great man, and as a result their influence waned. The new arrivals brought mathematical discipline to a subject that prided itself on its rigour. But the informal analysis of disequilibrium of economies, radical uncertainty, and trust as a solution to the prisoner’s dilemma was lost in the enthusiasm for the idea that rational individuals would lead the economy to an efficient equilibrium. It is time to take those concepts more seriously.

The second half of my career comprised twenty-two years at the Bank of England, the oldest continuously functioning central bank in the world, from 1991 to 2013, as Chief Economist, Deputy Governor and then Governor. That certainly gave me a chance to see how money could be managed. I learned, and argued publicly, that this is done best not by relying on gifted individuals to weave their magic, but by designing and building institutions that can be run by people who are merely professionally competent. Of course individuals matter and can make a difference, especially in a crisis. But the power of markets, the expression of hundreds of thousands of investors around the world is a match for any individual, central banker or politician, who fancies his ability to resist economic arithmetic. As one of President Clinton’s advisers remarked, ‘I used to think if there was reincarnation, I wanted to come back as the president or the Pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody.’ Nothing has diminished the force of that remark since it was made over twenty years ago.

In 2012, I gave the first radio broadcast in peacetime by a Governor of the Bank of England since Montagu Norman delivered a talk on the BBC in March 1939, only months before the outbreak of the Second World War. As Norman left Broadcasting House, he was mobbed by British Social Credits Party demonstrators carrying flags and slogan-boards bearing the words: CONSCRIPT THE BANKERS FIRST! Feelings also ran high in 2012. The consequences of the events of 2007-9 are still unfolding, and anger about their effects on ordinary citizens is not diminishing. That disaster was a long time in the making, and will be just as long in the resolving.

But the cost of lost output and employment from our continuing failure to manage money and banking and prevent crises is too high for us to wait for another crisis to occur before we act to protect future generations.

Charles Dickens’ novel A Tale of Two Cities has not only a very famous opening sentence but an equally famous closing sentence. As Sydney Carton sacrifices himself to the guillotine in the place of another, he reflects: ‘It is a far, far better thing that I do, than I have ever done …’ If we can find a way to end the alchemy of the system of money and banking we have inherited then, at least in the sphere of economics, it will indeed be a far, far better thing than we have ever done.

One

THE GOOD, THE BAD AND THE UGLY

‘I think that Capitalism, wisely managed, can probably be made more efficient for attaining economic ends than any alternative system yet in sight.’ John Maynard Keynes, The End of Laissez-faire (1926)

‘The experience of being disastrously wrong is salutary; no economist should be spared it, and few are.’ John Kenneth Galbraith, A Life in Our Times (1982)

History is what happened before you were born. That is why it is so hard to learn lessons from history: the mistakes were made by the previous generation. As a student in the 1960s, I knew why the 1930s were such a bad time. Outdated economic ideas guided the decisions of governments and central banks, while the key individuals were revealed in contemporary photographs as fuddy-duddies who wore whiskers and hats and were ignorant of modern economics. A younger generation, in academia and government, trained in modern economics, would ensure that the Great Depression of the 1930s would never be repeated.

In the 1960s, everything seemed possible. Old ideas and conventions were jettisoned, and a new world beckoned. In economics, an influx of mathematicians, engineers and physicists brought a new scientific approach to what the nineteenth-century philosopher and writer Thomas Carlyle christened the ‘dismal science’. It promised not just a better understanding of our economy, but an improved economic performance.

The subsequent fifty years were a mixed experience. Over that period, national income in the advanced world more than doubled, and in the so-called developing world hundreds of millions of people were lifted out of extreme poverty. And yet runaway inflation in the 1970s was followed in 2007-9 by the biggest financial crisis the world has ever seen. How do we make sense of it all? Was the post-war period a success or a failure?

The origins of economic growth

The history of capitalism is one of growth and rising living standards interrupted by financial crises, most of which have emanated from our mismanagement of money and banking. My Chinese colleague spoke an important, indeed profound, truth.

The financial crisis of 2007-9 (hereafter ‘the crisis’) was not the fault of particular individuals or economic policies. Rather, it was merely the latest manifestation of our collective failure to manage the relationship between finance, the structure of money and banking, and a capitalist system.

Failure to appreciate this explains why most accounts of the crisis focus on the symptoms and not the underlying causes of what went wrong. The fact that we have not yet got the hang of it does not mean that a capitalist economy is doomed to instability and failure. It means that we need to think harder about how to make it work.

Over many years, a capitalist economy has proved the most successful route to escape poverty and achieve prosperity.

Capitalism, as I use the term here, is an economic system in which private owners of capital hire wage earners to work in their businesses and pay for investment by raising finance from banks and financial markets.

The West has built the institutions to support a capitalist system, the rule of law to enforce private contracts and protect property rights, intellectual freedom to innovate and publish new ideas, anti-trust regulation to promote competition and break up monopolies, and collectively financed services and networks, such as education, water, electricity and telecommunications, which provide the infrastructure to support a thriving market economy. Those institutions create a balance between freedom and restraint, and between unfettered competition and regulation. It is a subtle balance that has emerged and evolved over time. And it has transformed our standard of living. Growth at a rate of 2.5 per cent a year, close to the average experienced in North America and Europe since the Second World War, raises real total national income twelvefold over one century, a truly revolutionary outcome.

Over the past two centuries, we have come to take economic growth for granted. Writing in the middle of that extraordinary period of economic change in the mid-eighteenth century, the Scottish philosopher and political economist, Adam Smith, identified the source of the breakout from relative economic stagnation, an era during which productivity (output per head) was broadly constant and any increase resulted from discoveries of new land or other natural resources, to a prolonged period of continuous growth of productivity: specialisation. It was possible for individuals to specialise in particular tasks, the division of labour, and by working with capital equipment to raise their productivity by many times the level achieved by a jack-of-all-trades. To illustrate his argument, Smith employed his now famous example of a pin factory:

A workman could scarce, perhaps, with his utmost industry, make one pin in a day, and certainly could not make twenty. But in the way in which this business is now carried on, not only the whole work is a peculiar trade, but it is divided into a number of branches. One man draws out the wire, another straights it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head The important business of making a pin is, in this manner, divided into about eighteen distinct operations, which, in some manufactories, are all performed by distinct hands.

The factory Smith was describing employed ten men and made over 48,000 pins in a day.

The application of technical knowhow to more and more tasks increased specialisation and raised productivity. Specialisation went hand in hand with an even greater need for both a means to exchange the fruits of one’s labour for an ever wider variety of goods produced by other specialists, money, and a way to finance the purchase of the capital equipment that made specialisation possible, banks.

As each person in the workforce became more specialised, more machinery and capital investment was required to support them, and the role of money and banks increased. After a millennium of roughly constant output per person, from the middle of the eighteenth century productivity started, slowly but surely, to rise. Capitalism was, quite literally, producing the goods. Historians will continue to debate why the Industrial Revolution occurred in Britain, population growth, plentiful supplies of coal and iron, supportive institutions, religious beliefs and other factors all feature in recent accounts.

But the evolution of money and banking was a necessary condition for the Revolution to take off.

Almost a century later, with the experience of industrialisation and a massive shift of labour from the land to urban factories, socialist writers saw things differently. For Karl Marx and Friedrich Engels the future was clear. Capitalism was a temporary staging post along the journey from feudalism to socialism. In their Communist Manifesto of 1848, they put forward their idea of ‘scientific socialism’ with its deterministic view that capitalism would ultimately collapse and be replaced by socialism or communism. Later, in the first volume of Das Kapital (1867), Marx elaborated (at great length) on this thesis and predicted that the owners of capital would become ever richer while excessive capital accumulation would lead to a falling rate of profit, reducing the incentive to invest and leaving the working class immersed in misery. The British industrial working class in the nineteenth century did indeed suffer miserable working conditions, as graphically described by Charles Dickens in his novels. But no sooner had the ink dried on Marx’s famous work than the British economy entered a long period of rising real wages (money wages adjusted for the cost of living). Even the two world wars and the intervening Great Depression in the 1930s could not halt rising productivity and real wages, and broadly stable rates of profit. Economic growth and improving living standards became the norm.

But if capitalism did not collapse under the weight of its own internal contradictions, neither did it provide economic security. During the twentieth century, the extremes of hyperinflations and depressions eroded both living standards and the accumulated wealth of citizens in many capitalist economies, especially during the Great Depression in the 1930s, when mass unemployment sparked renewed interest in the possibilities of communism and central planning, especially in Europe. The British economist John Maynard Keynes promoted the idea that government intervention to bolster total spending in the economy could restore full employment, without the need to resort to fully fledged socialism.

After the Second World War, there was a widespread belief that government planning had won the war and could be the means to win the peace. In Britain, as late as 1964 the newly elected Labour government announced a ‘National Plan’. Inspired by a rather naive version of Keynesian ideas, it focused on policies to boost the demand for goods and services rather than the ability of the economy to produce them. As the former outstripped the latter, the result was inflation. On the other side of the Atlantic, the growing cost of the Vietnam War in the late 1960s also led to higher inflation.

Rising inflation put pressure on the internationally agreed framework within which countries had traded with each other since the Bretton Woods Agreement of 1944, named after the conference held in the New Hampshire town in July of that year. Designed to allow a war-damaged Europe slowly to rebuild its economy and reintegrate into the world trading system, the agreement created an international monetary system under which countries set their own interest rates but fixed their exchange rates among themselves. For this to be possible, movements of capital between countries had to be severely restricted otherwise capital would move to where interest rates were highest, making it impossible to maintain either differences in those rates or fixed exchange rates. Exchange controls were ubiquitous, and countries imposed limits on investments in foreign currency. As a student, I remember that no British traveller in the 1960s could take abroad with them more than £50 a year to spend.

The new international institutions, the International Monetary Fund (IMF) and the World Bank, would use funds provided by its members to finance temporary shortages of foreign currency and the investment needed to replace the factories and infrastructure destroyed during the Second World War. Implicit in this framework was the belief that countries would have similar and low rates of inflation. Any loss of competitiveness in one country, as a result of higher inflation than in its trading partners, was assumed to be temporary and would be met by a deflationary policy to restore competitiveness while borrowing from the IMF to finance a short-term trade deficit. But in the late 1960s differences in inflation across countries, especially between the United States and Germany, appeared to be more than temporary, and led to the breakdown of the Bretton Woods system in 1970-1. By the early 1970s, the major economies had moved to a system of ‘floating’ exchange rates, in which currency values are determined by private sector supply and demand in the markets for foreign exchange.

Inevitably, the early days of floating exchange rates reduced the discipline on countries to pursue low inflation. When the two oil shocks of the 1970s, in 1973, when an embargo by Arab countries led to a quadrupling of prices, and 1979, when prices doubled after disruption to supply following the Iranian Revolution hit the western world, the result was the Great Inflation, with annual inflation reaching 13 per cent in the United States and 27 per cent in the United Kingdom.

Economic experiments

From the late 1970s onwards, the western world then embarked on what we can now see were three bold experiments to manage money, exchange rates and the banking system better. The first was to give central banks much greater independence in order to bring down and stabilise inflation, subsequently enshrined in the policy of inflation targeting, the goal of national price stability. The second was to allow capital to move freely between countries and encourage a shift to fixed exchange rates both within Europe, culminating in the creation of a monetary union, and in a substantial proportion of the most rapidly growing part of the world economy, particularly China, which fixed its exchange rates against the US dollar, the goal of exchange rate stability. And the third experiment was to remove regulations limiting the activities of the banking and financial system to promote competition and allow banks both to diversify into new products and regions and to expand in size, with the aim of bringing stability to a banking system often threatened in the past by risks that were concentrated either geographically or by line of business, the goal of financial stability.

These three simultaneous experiments might now be best described as having three consequences the Good, the Bad and the Ugly. The Good was a period between about 1990 and 2007 of unprecedented stability of both output and inflation the Great Stability. Monetary policy around the world changed radically. Inflation targeting and central bank independence spread to more than thirty countries. And there were significant changes in the dynamics of inflation, which on average became markedly lower, less variable and less persistent.

The Bad was the rise in debt levels. Eliminating exchange rate flexibility in Europe and the emerging markets led to growing trade surpluses and deficits. Some countries saved a great deal while others had to borrow to finance their external deficit. The willingness of the former to save outweighed the willingness of the latter to spend, and so long-term interest rates in the integrated world capital market began to fall. The price of an asset, whether a house, shares in a company or any other claim on the future, is the value today of future expected returns (rents, the value of housing services from living in your own home, or dividends). To calculate that price one must convert future into current values by discounting them at an interest rate. The immediate effect of a fall in interest rates is to raise the prices of assets across the board. So as long-term interest rates in the world fell, the value of assets especially of houses rose. And as the values of assets increased, so did the amounts that had to be borrowed to enable people to buy them. Between 1986 and 2006, household debt rose from just under 70 per cent of total household income to almost 120 per cent in the United States and from 90 per cent to around 140 per cent in the United Kingdom.

The Ugly was the development of an extremely fragile banking system. In the USA, Federal banking regulators’ increasingly lax interpretation of the provisions to separate commercial and investment banking introduced in the 1933 Banking Act (often known as Glass-Steagall, the senator and representative respectively who led the passage of the legislation) reached its inevitable conclusion with the Gramm-Leach-Bliley Act of 1999, which swept away any remaining restrictions on the activities of banks. In the UK, the so-called Big Bang of 1986, which started as a measure to introduce competition into the Stock Exchange, led to takeovers of small stockbroking firms and mergers between commercial banks and securities houses. Banks diversified and expanded rapidly after deregulation. In continental Europe so-called universal banks had long been the norm. The assets of large international banks doubled in the five years before 2008. Trading of new and highly complex financial products among banks meant that they became so closely interconnected that a problem in one would spread rapidly to others, magnifying rather than spreading risk.

Banks relied less and less on their own resources to finance lending and became more and more dependent on borrowing. The equity capital of banks, the funds provided by the shareholders of the bank accounted for a declining proportion of overall funding. Leverage, the ratio of total assets (or liabilities) to the equity capital of a bank, rose to extraordinary levels. On the eve of the crisis, the leverage ratio for many banks was 30 or more, and for some investment banks it was between 40 and 50. A few banks had ratios even higher than that. With a leverage ratio of even 25 it would take a fall of only 4 per cent in the average value of a bank’s assets to wipe out the whole of the shareholders’ equity and leave it unable to service its debts.

By 2008, the Ugly led the Bad to overwhelm the Good. The crisis, one might say catastrophe of the events that began to unfold under the gaze of a disbelieving world in 2007, was the failure of all three experiments. Greater stability of output and inflation, although desirable in itself, concealed the build-up of a major disequilibrium in the composition of spending. Some countries were saving too little and borrowing too much to be able to sustain their path of spending in the future, while others saved and lent so much that their consumption was pushed below a sustainable path. Total saving in the world was so high that interest rates, after allowing for inflation, fell to levels incompatible in the long run with a profitable growing market economy. Falling interest rates led to rising asset values and increases in the debt taken out against those more valuable assets. Fixed exchange rates exacerbated the burden of the debts, and in Europe the creation of monetary union in 1999 sapped the strength of many of its economies, as they became increasingly uncompetitive. Large, highly leveraged banks proved unstable and were vulnerable to even a modest loss of confidence, resulting in contagion to other banks and the collapse of the system in 2008.

At their outset the ill-fated nature of the three experiments was not yet visible. On the contrary, during the 1990s the elimination of high and variable inflation, which had undermined market economies in the 1970s, led to a welcome period of macroeconomic stability. The Great Stability, or the Great Moderation as it was dubbed in the United States, was seen, as in many ways it was, as a success for monetary policy. But it was unsustainable. Policy-makers were conscious of problems inherent in the first two experiments, but seemed powerless to do anything about them. At international gatherings, such as those of the IMF, policy-makers would wring their hands about the ‘global imbalances’ but no one country had any incentive to do anything about it. If a country had, on its own, tried to swim against the tide of falling interest rates, it would have experienced an economic slowdown and rising unemployment without any material impact on either the global economy or the banking system. Even then the prisoner’s dilemma was beginning to rear its ugly head.

Nor was it obvious how the unsustainable position of the world economy would come to an end. I remember attending a seminar of economists and policy-makers at the IMF as early as 2002 where the consensus was that there would eventually be a sharp fall in the value of the US dollar, which would produce a change in spending patterns. But long before that could happen, the third experiment ended with the banking crisis of September and October 2008. The shock that some of the biggest and most successful commercial banks in North America and Europe either failed, or were seriously crippled, led to a collapse of confidence which produced the largest fall in world trade since the 1930s. Something had gone seriously wrong.

Opinions differ as to the cause of the crisis. Some see it as a financial panic in which fundamentally sound financial institutions were left short of cash as confidence in the credit-worthiness of banks suddenly changed and professional investors stopped lending to them, a liquidity crisis. Others see it as the inevitable outcome of bad lending decisions by banks, a solvency crisis, in which the true value of banks’ assets had fallen by enough to wipe out most of their equity capital, meaning that they might be unable to repay their debts. But almost all accounts of the recent crisis are about the symptoms, the rise and fall of housing markets, the explosion of debt and the excesses of the banking system rather than the underlying causes of the events that overwhelmed the economies of the industrialised world in 2008. Some even imagine that the crisis was solely an affair of the US financial sector. But unless the events of 2008 are seen in their global economic context, it is hard to make sense of what happened and of the deeper malaise in the world economy.

The story of what happened can be explained in little more than a few pages, everything you need to know but were afraid to ask about the causes of the recent crisis. So here goes.

The story of the crisis

By the start of the twenty-first century it seemed that economic prosperity and democracy went hand in hand. Modern capitalism spawned growing prosperity based on growing trade, free markets and competition, and global banks. In 2008 the system collapsed. To understand why the crisis was so big, and came as such a surprise, we should start at the key turning point, the fall of the Berlin Wall in 1989. At the time it was thought to represent the end of communism, indeed the end of the appeal of socialism and central planning.

For some it was the end of history. For most, it represented a victory for free market economics. Contrary to the prediction of Marx, capitalism had displaced communism. Yet who would have believed that the fall of the Wall was not just the end of communism but the beginning of the biggest crisis in capitalism since the Great Depression?

What has happened over the past quarter of a century to bring about this remarkable change of fortune in the position of capitalist economies?

After the demise of the socialist model of a planned economy, China, countries of the former Soviet Union and India embraced the international trading system, adding millions of workers each year to the pool of labour around the world producing tradeable, especially manufactured, goods. In China alone, over 70 million manufacturing jobs were created during the twenty-first century, far exceeding the 42 million working in manufacturing in 2012 in the United States and Europe combined. The pool of labour supplying the world trading system more than trebled in size. Advanced economies benefited from an influx of cheap consumer goods at the expense of employment in the manufacturing sector.

The aim of the emerging economies was to follow Japan and Korea in pursuing an export-led growth strategy. To stimulate exports, their exchange rates were held down by fixing them at a low level against the US dollar. The strategy worked, especially in the case of China. Its share in world exports rose from 2 per cent to 12 per cent between 1990 and 2013. China and other Asian economies ran large trade surpluses. In other words, they were producing more than they were spending and saving more than they were investing at home. The desire to save was very strong. In the absence of a social safety net, households in China chose to save large proportions of their income to provide self-insurance in the event of unemployment or ill-health, and to finance retirement consumption. Such a high level of saving was exacerbated by the policy from 1980 of limiting most families to one child, making it difficult for parents to rely on their children to provide for them in retirement.

Asian economies in general also saved more in order to accumulate large holdings of dollars as insurance in case their banking system ran short of foreign currency, as happened to Korea and other countries in the Asian financial crisis of the 1990s.

*

from

The End of Alchemy: Money, Banking and the Future of the Global Economy

by Mervyn King

get it at Amazon.com

Why the Only Answer is to Break Up the Biggest Wall Street Banks – Robert Reich * Twenty Years after the Fall of the Berlin Wall: Rethinking the Role of Money and Markets in the Global Economy – W. Lee Hoskins and Walker F. Todd.

If you took the greed out of Wall Street all you’d have left is pavement.

Trump would rather stir up public rage against foreigners than address the true abuses of power inside America.

Why should banks ever be permitted to use peoples’ bank deposits insured by the federal government to place risky bets on the banks’ own behalf?

Government managed intervention in financial markets around the world and unpredictable monetary policy continue to encourage inappropriate risk taking.

What, if anything, should those who do not want to be serfs or slaves do about this situation?

Congress needs to prohibit regulators from bailing out failed banks, other types of financial institutions, and nonfinancial institutions (or foreign banking systems), be they large or small.

On Wednesday, Federal bank regulators proposed to allow Wall Street more freedom to make riskier bets with federally insured bank deposits such as the money in your checking and savings accounts.

The proposal waters down the so-called “Volcker Rule” (named after former Fed chair Paul Volcker, who proposed it). The Volcker Rule was part of the Dodd-Frank Act, passed after the near meltdown of Wall Street in 2008 in order to prevent future near meltdowns.

The Volcker Rule was itself a watered down version of the 1930s Glass Steagall Act, enacted in response to the Great Crash of 1929. Glass Steagall forced banks to choose between being commercial banks, taking in regular deposits and lending them out, or being investment banks that traded on their own capital.

Glass-Steagall’s key principle was to keep risky assets away from insured deposits. It worked well for more than half century. Then Wall Street saw opportunities to make lots of money by betting on stocks, bonds, and derivatives (bets on bets) and in 1999 persuaded Bill Clinton and a Republican congress to repeal it.

Nine years later, Wall Street had to be bailed out, and millions of Americans lost their savings, their jobs, and their homes.

Why didn’t America simply reinstate Glass Steagall after the last financial crisis? Because too much money was at stake. Wall Street was intent on keeping the door open to making bets with commercial deposits. So instead of Glass Steagall, we got the Volcker Rule almost 300 pages of regulatory mumbo jumbo, riddled with exemptions and loopholes.

Now those loopholes and exemptions are about to get even bigger, until they swallow up the Volcker Rule altogether. If the latest proposal goes through, we’ll be nearly back to where we were before the crash of 2008.

Why should banks ever be permitted to use peoples’ bank deposits insured by the federal government to place risky bets on the banks’ own behalf? Bankers say the tougher regulatory standards put them at a disadvantage relative to their overseas competitors.

Baloney. Since the 2008 Bnancial crisis, Europe has been more aggressive than the United States in clamping down on banks headquartered there. Britain is requiring its banks to have higher capital reserves than are so far contemplated in the United States.

The real reason Wall Street has spent huge sums trying to water down the Volcker Rule is that far vaster sums can be made if the Rule is out of the way. If you took the greed out of Wall Street all you’d have left is pavement.

As a result of consolidations brought on by the Wall Street bailout, the biggest banks today are bigger and have more clout than ever. They and their clients know with certainty they will be bailed out if they get into trouble, which gives them a financial advantage over smaller competitors whose capital doesn’t come with such a guarantee. So they’re becoming even more powerful.

The only answer is to break up the giant banks. The Sherman Antitrust Act of 1890 was designed not only to improve economic efficiency by reducing the market power of economic giants like the railroads and oil companies but also to prevent companies from becoming so large that their political power would undermine democracy.

The sad lesson of Dodd-Frank and the Volcker Rule is that Wall Street is too powerful to allow effective regulation of it. America should have learned that lesson in 2008 as the Street brought the rest of the economy and much of the world to its knees.

If Trump were a true populist on the side of the people rather than powerful financial interests, he’d lead the way, as did Teddy Roosevelt starting in 1901.

But Trump is a fake populist. After all, he appointed the bank regulators who are now again deregulating Wall Street. Trump would rather stir up public rage against foreigners than address the true abuses of power inside America.

So we may have to wait until we have a true progressive populist president. Or until Wall Street nearly implodes again robbing millions more of their savings, jobs, and homes. And the public once again demands action.

Twenty Years after the Fall of the Berlin Wall: Rethinking the Role of Money and Markets in the Global Economy

W. Lee Hoskins, Pacific Research Institute

Walker F. Todd, Middle Tennessee State University

June 2018

Many of the hopes arising from the 1989 fall of the Berlin Wall were still unrealized in 2010 and remain so today, especially in monetary policy and financial supervision. The major players that helped bring on the 2008 financial crisis still exist, with rising levels of moral hazard, including Fannie Mae, Freddie Mac, the too big to fail banks, and even AIG. In monetary policy, the Federal Reserve has only just begun to reduce its vastly increased balance sheet, while the European Central Bank has yet to begin.

The Dodd Frank Act of 2010 imposed new conditions but did not contract the greatly expanded federal safety net and failed to reduce the substantial increase in moral hazard. The larger budget deficits since 2008 were simply decisions to spend at higher levels instead of rational responses to the crisis. Only an increased reliance on market discipline in financial services, avoidance of Federal Reserve market interventions to rescue financial players while doing little or nothing for households and firms, and elimination of the Treasury’s backdoor borrowings that conceal the real costs of increasing budget deficits, can enable the American public to achieve the meaningful improvements in living standards that were reasonably expected when the Berlin Wall fell.

My comments focus on the continuing failure of regulations to limit disruptions in financial markets and the concomitant increase in moral hazard, as well as the purely discretionary monetary policy conducted by the Federal Reserve. State managed intervention in financial markets and a disruptive monetary policy combined to impose large costs on the economy. Yet Congress is likely to reward the Fed with more power and continues to rely on regulatory intervention. Lawmakers and regulators do not follow thoughtful economic advice that focuses on market solutions because it is rarely in their self interest to do so. Only a citizenry, educated about the values of free markets, private enterprise, and a stable monetary order, can roll back the tide of government intervention by exercising its power at the ballot box.

THEN

The Berlin Wall fell on November 9, 1989. The United States was embroiled in a financial disruption involving commercial banks and savings and loan associations. When it was over, some 1,400 banks and over 1,000 savings and loan associations failed at a then estimated present value cost of $150 billion dollars to taxpayers. Two pieces of legislation were passed to deal with the problem. The Financial Institutions Reform Recovery and Enforcement Act was enacted in August 1989, followed by the Federal Deposit Insurance Corporation Improvement Act in December 1991.

These statutes were enacted to deal with the worst collapse of financial institutions since the 1930s (at the time). They relied on more regulation, more capital, and more diligent regulators. Yet it was clear that this set of regulations would fare no better than the mountain of regulations already on the books. Loopholes would develop, and regulators would forbear. At the time, those of us who were hopeful about reform thought that the regulators would heed the message from Congress, especially the House of Representatives. The too big to fail doctrine, in which the regulators colluded throughout the 1980s, was declared against public policy by the words of the 1991 statute.

Representatives of large banks (lobbyists), however, acting through the regulators and the Treasury Department, managed to have the “systemic risk exception” codified. That exception has been invoked several times now since early 2008. Simultaneously, Senator Christopher Dodd, acting on behalf of lobbyists for the Securities Industry Association, introduced an amendment of Section 13(3) of the Federal Reserve Act that appeared to enable the Fed to make emergency loans to securities firms and other nonbanks, a power that had not been used since 1936. In the next session of Congress, the lobbyists began their multi decade rout of the forces of reform by enacting the Riegle-Neel Act of 1993.

The Founding Fathers of the Republic might have been misguided, but they were persuaded profoundly that a system of checks and balances, including preservation of the capacity of minority forces (which they called “factions”) to push back against excess on the part of other forces, was essential to preserve the forms and processes of a constitutional Republic. They clearly did not contemplate that one force or faction always would win all the battles for decades on end. Those who wanted to game the system did, in fact, win all the legislative and regulatory battles from 1992 forward. The outcome of their victories is plain for all to see after 2008.

What, if anything, should those who do not want to be serfs or slaves do about this situation?

Classical constitutional theory, which is at odds with utilitarian economic theories of efficiency on this point, says, “Make sure that those who would resist the gamers retain the capacity to push back effectively within the legitimate processes of the system.” It is not necessarily more efficient, and certainly not constitutional, to argue that nothing should stand in the way of those who advocate more and bigger games at public risk or public expense.

For decades before the 2016 election, a large section of the public was asking for a choice other than, “Decide whose boots you want to lick.” At least at the beginning, around 2010, the Tea Parties essentially were saying, “We don’t want to lick bankers’ boots.” The Republican leaders, unfortunately, essentially began to say, “When you lick, we’ll make them taste better.” The Democrat leaders of that day gave lip service to part of the public’s pleas (they enacted the Consumer Financial Protection Board [CFPB]), but they did not really want to turn aside bankers’ financial offerings as campaign contributions either (they structured the CFPB so as to leave it vulnerable to constitutional challenge).

The only good news was that government authorities still had the backbone as late as the early 1990s to let large financial institutions fail and to punish their shareholders, counterparties, and creditors.

Of course, most of the institutions that failed were relatively small. Three months after the Berlin Wall went down, Drexel Burnham, a large investment bank that served as the lynchpin for the junk bond market, was allowed to fail with the blessings of the Treasury and the Federal Reserve’s Board of Governors. At the March 1990 Federal Open Market Committee (FOMC) meeting, Peter Stemlight of the New York Fed (FRBNY) remarked on how smoothly the markets handled the Drexel bankruptcy. Yet too big to fail policy already began for large commercial banks, beginning with Franklin National Bank of New York in 1974 and culminating with the failure of Continental Illinois in 1984. The moral hazard problem associated with bank bailouts became well known.

Many academics and at least two Federal Reserve Bank presidents argued in the early 1990s for limiting federal deposit insurance and pricing it for the risk of the institution, as well as reducing the rest of the federal safety net, in particular dumping the too big to fail policy. The essence of financial exchange is creditor and counterparty scrutiny, knowing one’s customer and bearing the costs and benefits of doing so. Government intervention that shields depositors, creditors, and counterparties from losses weakens the market restraint on inappropriate risk taking. By the mid 1990s, the federal safety net no longer was reduced; instead, more regulation and more empowered (but more spineless) regulators was the congressional solution.

This choice by Congress in the 1990s proved to be a bad one, for in fewer than two decades we arrived at another “worst banking crisis since the 1930s.”

When the Berlin Wall fell, central banks were focusing on lower inflation rates and exchange rate stability. At the December 1989 FOMC meeting, the Board’s staff presented a model simulation of the cost of reaching zero inflation by 1995 from the then prevalent 4.5 percent inflation rate. The Committee had not agreed on a target inflation rate, but most members seemed to prefer something between zero and 2 percent.

At the same FOMC meeting, Sam Cross of the FRBNY reported that the German mark (this was in pre euro days) had soared against the dollar and that there was some speculation in the market that the Fed might intervene. The Fed already had intervened to the tune of $20 billion, and the Treasury, using its Exchange Stabilization Fund and the Fed’s warehousing facility, also held that same amount of foreign currency from interventions. This warehousing facility (the Fed lent the Treasury dollars in exchange for its foreign currencies) was simply a way for the Treasury to evade Congressional appropriations. In short, it was and still is a way for the Fed to fund the Treasury directly. While the warehouse is dormant now, it is still on the statute books and could be used again. The Fed’s former sterilized interventions in currency markets produced nothing but uncertainty.

During the 1990s the Fed did manage to lower the inflation rate. It did so with no monetary rules or targets, nothing but pure discretion. But the Fed developed a pattern of lowering interest rates at every potential downturn in GDP and every dislocation in financial markets. This practice encouraged investors to take on riskier assets, knowing that the Fed would bail them out with lower interest rates should a problem occur.

This practice came to be known as the “Greenspan put,” and monetary policy began to produce moral hazard on a grand scale.

NOW

Today we bear the fruits of state managed intervention and seat of the pants monetary policy. Many of the interventions from the 1930s are still with us, the Federal Housing Administration, Fannie Mae, and Freddie Mac, to name just a few, and they all played a major role in the housing bubble and its collapse in 2008.

Many new housing and mortgage programs were put in place during the recent troubles, and they will probably be around for the next financial disruption. Financial Services committee chairmen Dodd and Frank chose to travel the road of more regulation despite the fact that a mountain of regulation on the books failed to prevent the 1980s savings and loan and banking debacles, as well as the latest meltdown in financial markets. The integrated nature of global financial markets means that our problems quickly can become theirs. Governments around the globe are also going down the regulation road, despite the post 2007 failure of the Basel bank regulatory agreements and their own homegrown regulations.

Meanwhile, government guarantees and insurance programs for financial assets, along with bank bailouts, have produced, arguably, the largest increase in moral hazard in the history of financial markets. The Fed’s zero interest rate policy lasted so long (2008-15) that it encouraged excessive risk taking, certainly riding the yield curve for banks (funding short and lending long). Unless reversed, these policies will plant the seeds for the next bubble. A major consequence of these policies has been a surge in the already troubling problem of growing federal debt. Public debt levels abroad also have increased as a result of these failed policies.

The bailouts by the Federal Reserve doubled its balance sheet (emergency lending) with dubious assets, but also made it more of a development bank than a modern central bank. The bailouts of Bear Stearns and AIG put the Fed in the business of making fiscal policy, a function that belongs to Congress.

The Fed’s purchase of $1.7 trillion of mortgage backed securities was pure credit allocation that favored one sector of the economy over another.

Will Congress learn that if the Fed can allocate credit for the mortgage market, it also can do so for the municipal securities market or small business loans? Credit allocation also is something that Congress does, usually unsuccessfully, as with Fannie Mae and Freddie Mac before 2008, which were predicted to cost taxpayers upward of $400 billion, ignoring subsequent recoveries, before the housing bust ran its course (Morgenson and Rosner 2011).

The terrible decision to bail out the creditors of Bear Stearns set a precedent that did much damage. Other banks with troubled portfolios did not feel the urgency to clean themselves up. Creditors did not run on troubled institutions because they believed that they would be bailed out. Buyers of other troubled banks expected the Fed to be an investor for $30 billion, as it was with Bear Steams, and sellers expected to receive $10 a share instead of nothing, the same as Bear’s stockholders. This market expectation was not met with the failure of Lehman Brothers in September 2008, which is one very big reason why potential buyers of Lehman walked away.

Monetary policy at the Fed for nearly a decade now [2010] has been to hold short term rates near zero until the unemployment rate falls. Because unemployment is a lagging indicator, the Fed ran the risks of rising inflation and inflation expectations. Because the Fed essentially operated as an arm of the Treasury, its credibility as an inflation fighter fell into doubt.

Unwinding the balance sheet is going to be tricky because of the mortgage backed securities that dominate the Fed’s balance sheet. As interest rates rise, these long term assets will fall in value, leaving the Fed with large losses. The Fed needs to sell these assets now before it raises rates, as some in the Fed have argued. A governance issue for the Fed as it anticipates raising interest rates is which body within the Fed makes the decision on changes in excess reserve interest rates. Congress gave the power to the Board of Governors, not the FOMC, which makes monetary policy decisions. These decisions need to be linked (i.e., the same entity, preferably the FOMC, needs to decide on both monetary policy and excess reserve interest rates) if monetary policy is to have any chance of success.

In sum, today we have a greatly expanded federal safety net, a substantial increase in moral hazard, and a surge in federal debt that can be attributed only partially to the recession. A higher inflation rate must seem appealing to many in Washington. Much the same can be said for the majority of our friends abroad. The universal response so far is a call for more regulation, more capital and more far seeing regulators. The lessons from past banking busts go unlearned.

Government managed intervention in financial markets around the world and unpredictable monetary policy continue to encourage inappropriate risk taking.

TOMORROW

The principled economic position is to have government remove itself from intervening in financial markets and move to some form of a commodity standard for money or perhaps a regime of competitive money supplies. Over time, creditors, counterparties, and depositors would seek out prudent banks with high capital ratios. Weaker banks would adjust or fail. Some institutions might drop limited liability corporate charters and put stockholders at risk for capital calls. Existing clearing houses would provide risk sharing arrangements and thus would play a much stronger role in supervising the practices of participating banks. There would be no central bank to feed bubbles and busts.

Market disruptions still would occur, but they would be fewer, smaller, and quickly self correcting. The day the public and politicians are ready to accept such a system is probably some time off, perhaps after the bankruptcy of some major governments.

In the meantime, doing what is politically achievable, guided by the principled economic position, is about our best hope. Start by debunking the notion that only the government can prevent systemic risk. There is no bank that is too big to fail. That idea exists in the minds of regulators and politicians. If the failure of a large, insolvent bank causes runs on solvent institutions, then a lender of last resort lends freely at penalty rates against sound collateral until the run stops.

The second source of systemic risk is related to the effects of a bank failure on the payment system. The fear is that the failure of a large bank could cause failure of other banks connected to the payment system. Participants in clearing houses routinely limit their risk to individual counterparties so that the loss for each bank would be small. Also, risk sharing arrangements are in place in many clearing houses.

Congress needs to prohibit regulators from bailing out failed banks, other types of financial institutions, and nonfinancial institutions (or foreign banking systems), be they large or small.

Federal guarantees and deposit insurance need to be scaled back drastically. Mandatory closure rules are needed and should be enforced by bankruptcy judges and not a gaggle of regulators. Federal Reserve emergency lending powers should be removed [Section 13(3)]. This would prevent future bailouts of any company, banking or otherwise, by the Fed. The Fed also needs to have its warehousing relationship with the Treasury closed permanently. It is a nonstatutory arrangement that has been used since the 1960s for foreign exchange holdings of the Treasury, but it could be used for any Treasury asset for as long as this facility exists. All of these arrangements amount to backdoor Treasury borrowing. In the conduct of monetary policy, arrangements that provide backdoor funding for Treasury intervention in financial markets are particularly objectionable.

The Fed’s monetary policy should have a single objective, domestic price level stability. No more chasing after short term fluctuations in the real economy with a Section 13(3) fire extinguisher or after financial market disruptions with the fire hose of large changes in interest rates.

The Fed’s policy independence should not be unconditional. It should be expected to achieve its monetary policy objective in a defined amount of time and should face a penalty for failure, such as replacing members of the FOMC (preferably those whose policy choices led to or exacerbated the failure).

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Pushing even the modest reforms proposed here through Congress will prove difficult without an educated public changing the political calculus at the ballot box. In the United States, an already restless public became even more so after 2008 regarding the size of government, the amount of debt (both foreign and domestic) that it is creating, and its intrusions into the private sector, particularly bank bailouts perceived as doing little or nothing to alleviate pressures on households and most firms.

The midterm elections of 2010 (the first Tea Party election) offered the first opportunity for the public to send a message to politicians that it was in their self interest to reduce the role of the state in our lives and in our economic affairs. The failure of the governing elites of both major parties to restrain the intrusive government that they had created led to the election of 2016, when the populist revolt erupted in both parties (Sanders for the Democrats and Trump for the Republicans). Those wishing for a different outcome in 2018 or 2020 need to explain what they propose to do about the factors causing public restlessness already in 2010.

Could New Zealand’s economy survive a China crisis? – Liam Dann.

“The scenarios chosen are almost certain not to accurately reflect any future shock or combination of shocks that occurs.”

In July 2018 China’s economy falters sending shockwaves through the global banking sector. Commodity prices plunge and the world faces its first global financial crisis since the meltdown of 2008.

What happens next is pretty ugly for most New Zealanders, job losses, soaring mortgage rates, falling house prices and a sharp recession.

As a forecast it would be unnecessarily gloomy, although not implausible.

But the grim situation painted by NZ Treasury is not meant to be a prediction it is a model designed to offer a stress test of our economy under extreme conditions.

A Chinese financial crisis is one of three ”large but plausible shocks” modelled by Treasury in its 2018 Investment Statement, along with a major Wellington earthquake and an outbreak of foot and mouth disease.

So what happens next in the event of a Chinese economic meltdown?

The first thing that New Zealand would see is a dramatic fall in demand for our exports. The terms of trade drops 20 per cent. The value of the Kiwi dollar plunges 13 per cent.

For most New Zealanders that means the cost of imported goods, like iPhones, and overseas travel spikes.

But that’s not the really ugly bit.

Disruption to global debt markets would push local funding costs up by 3 per cent, Treasury says.

In other words interest rates would soar, bad news for homeowners who aren’t on fixed rates.

Treasury’s model sees this flowing through to sharp fails in property prices and on the sharemarket.

In fact they estimate the cost of the revaluation if assets and liabilities at $30 billion.

Nearly $20b of that would be due to a 40 per cent crash on the stock exchange both here and around the world, devastating news for KiwiSavers.

For homeowners the immediate price fall would be about 10 per cent, as we saw in the last GFC, survivable for most unless you are under pressure to sell.

But similar falls in commercial property and farm prices would put additional stress on the economy.

Meanwhile, the uncertain outlook would drive a decline in consumer and business confidence. Both retail spending and business investment would fall. Then firms would start cutting jobs.

Some 60,000 jobs would be lost in 2019, with unemployment spiking to 7.4 per cent the highest level since 1999. it is currently 4.4 percent.

The Reserve Bank (RBNZ) would attempt to ride to the rescue of course.

You could expect to see the RBNZ cut rates by half a per cent in its September review to 1.25 per cent, Treasury estimates.

The RBNZ would likely keep cutting over the next six months until the official cash rate was at, or near, zero.

From here the news gets a little better. And as we saw during the 2008 GFC the economy has the strength and flexibility to bounce back.

The rate cuts couldn’t prevent a recession in the March quarter of 2019.

But while demand for goods exports remains low, the depreciation in the dollar, means the annual value stays on target.

“Record low interest rates and an improvement in the economic outlook leads to a pickup in business confidence, driving a strong increase in business investment,” Treasury says.

Life would still be tough for workers.

“Employment growth and consumer spending remain soft throughout.”

In the final wash-up the financial downturn would cost the Crown $157b across five years.

Net debt would rise to 33 per cent of GDP after five years 15 per cent higher than 2017 forecasts.

But ultimately the economy would pass the test.

Treasury notes that these stress tests are designed to assess whether severe but plausible shocks could have impacts that are beyond the financial capacity to absorb, thus putting the provision of public services at risk.

“The scenarios chosen are almost certain not to accurately reflect any future shock or combination of shocks that occurs.”

GUNS & BOMBS. Donald Trump’s hair-raising level of debt could bring us all crashing down – Ambrose Evans-Pritchard.

If there is such a thing as a capital crime in economics, it is Donald Trump’s exorbitant fiscal stimulus at the top of the cycle.

The effects are entirely pernicious. Such deficit spending at this juncture can only provoke a ferocious monetary response, threatening to bring the global expansion to a shuddering and climactic end sooner rather than later, and with particular violence.

Twin reports by the International Monetary Fund sketch a chain reaction of dangerous consequences for world finance.

The policy if, you can call it that, puts the US on an untenable debt trajectory. It smacks of Latin American caudillo populism, a Peronist contagion that threatens to destroy the moral foundations of the Great Republic.

The IMF’s Fiscal Monitor estimates that the US budget deficit will spike to 5.3 per cent of GDP this year and 5.9 per cent in 2019. This is happening at a stage of the economic cycle when swelling tax revenues should be reducing net borrowing to zero.

The deficit will still be 5 per cent in 2023. By then the ratio of public debt will have ballooned to 117 per cent (it was 61 per cent in 2007). Franklin Roosevelt defeated fascism with a total war economy at lower ratios.

The IMF does not take into account the near certainty of a global downturn at some point over the next five years. A deep recession would push the deficit into double digits, and send the debt ratio spiralling towards 140 per cent in short order.

There is no justification for Trump’s stimulus. The output gap has already closed. The fiscal “multiplier” is less than one. The US unemployment rate is approaching a 48-year low. The New York Fed’s “underlying inflation gauge” surged to 3.14 per cent in March, the highest since 2005.

As an aside, the IMF’s Fiscal Monitor noted that the lion’s share of Trump’s tax cuts go to the rich. The poorest two quintiles enjoy crumbs at first, but are ultimately left worse off.

He has betrayed the very descamisados who elected him. It is worth thumbing through the IMF’s Global Financial Stability Report for a glimpse of the gothic horror story that lies ahead of us.

”Term premiums could suddenly decompress, risk premiums could rise, and global financial conditions could tighten sharply. Although no major disruptions were reported during the episode of volatility in early February, market participants should not take too much comfort,” it said.

The report is a forensic study of hair-raising excess. The US stock market has broken with historic valuations and risen to 155 per cent of GDP, up from 95 per cent even in 2011. Margin debt on Wall Street the bellwether of speculation has rocketed to US$550 billion.

The Fund warned of “late-stage credit cycle dynamics” all too like 2007, and behaviour “reminiscent of past episodes of investor excesses? Leveraged loans in the US have doubled to USSl trillion since the pre-Lehman peak. There is a risk that defaults could spin out of control, leading to a complete “shutdown of the market”, with grave economic implications.

The shadiest “Cov-lite” loans made up 75 per cent of new loan issuance last year, with a deteriorating quality of covenant protection. This is a sure sign that debt markets are throwing caution to the wind. ”Embedded leverage” through derivatives has become endemic. US and European bond funds have raised their derivative leverage ratio from 215 per cent to 268 per cent of assets since 2014, with gross exposure reaching ”worrisome” levels. And so it goes on.

There are two elephants in the room. One is well-understood: the world is leveraged to the hilt.

“The combination of excessive public and private debt levels can be dangerous in the event of a downturn because it would prolong the ensuing recession,” said the Fund. It calculates that the global debt ratio has risen by 12 per cent of GDP since the last peak. The Bank for International Settlements thinks it is at least 40 per cent of GDP higher.

The point remains the same. Every region of the global economy has been drawn into the morass by the leakage effects of zero rates and quantitative easing, compounded by unrestricted capital flows.

The world is therefore ever more sensitive to rising borrowing costs. It lacks the fiscal buffers to cope with a shock. Countries may be forced into contractionary “pro-cyclical” policies, the fate of Greece, Spain, Portugal and Italy in the EMU austerity tragedy. It may soon happen on a global scale.

The IMF says the interest rate burden as a share of tax revenues has doubled over the last 10 years for poorer countries, leaving them acutely vulnerable to “rollover” risks if liquidity dries up.

Private debt ratios in emerging markets have jumped from 60 per cent to 120 per cent in a decade.

The second elephant is global dollar debt. This is less understood. Offshore dollar debt has risen fourfold to US$16t since the early 2000s, or USS30t when equivalent derivatives are included. “The international dollar banking system faces a structural liquidity mismatch,” said the Fund.

The world has a vast “short position” on the dollar. This is harmless in good times but prone to a sudden margin call akin to late 2008 as the Fed raises rates and drains dollar liquidity.

Much of this lending is carried out by European and Japanese banks using short term instruments such as commercial paper and interbank deposits, leaving them “structurally vulnerable to liquidity risks”. French banks have shockingly low dollar liquidity ratios.

The IMF says markets should not be beguiled by the current calm in the currency swap markets, used to hedge this edifice of dollar lending. The so-called “cross-currency basis” can move suddenly. “Swap markets may not be a reliable backstop in periods of stress,” it said.

The Fund warned that banks may find that they cannot roll over short term dollarfunding currently taken for granted. “Banks could then act as an amplifier of market strains. Funding pressure could induce banks to shrink dollar lending to non-US borrowers. Ultimately, there is a risk that banks could default on their dollar obligations,” it said.

So there you have it. While the IMF is coy, the awful truth is that the world is just as vulnerable to a financial crisis as it was in 2007. The scale is now larger. The authorities have fewer safety buffers, and far less ammunition to fight a depression.

This time China cannot come to the rescue. It is itself the epicentre of risk.

The detonator for the denouement is selfevidently Fed tightening and should it ever happen a surging dollar.

Trump may have thought he was being clever in thinking that fiscal prime pumping this year and next would greatly help his re-election chances.

He may instead have brought forward global forces that he does not begin to understand, and guaranteed a frightening crisis under his own watch.

Ten Years after Bear Stearns, U.S. Financial Stability is again in Danger – Katharina Pistor * Waiting for the Chinese Bear Stearns – Daniela Gabor.

Banks are pushing for deregulation and roll backs of Dodd-Frank’s regular check-ups on their financial health. We should be worried.

Katharina Pistor

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The great financial crisis with its peak in the fall of 2008 was not inevitable; it could and should have been prevented. Had it been, the economy would not have lost trillions of dollars, millions of Americans would have been spared eviction and unemployment, and the U.S.’s vibrant financial sector would have remained intact.

But few saw a crisis of these proportions coming: Almost no one raised red flags when the first mortgage originators filed for bankruptcy, or when a roster of medium-sized banks experienced liquidity shortage. Even when margin calls began putting pressure even on larger financial firms, and credit lines that had been put in place to provide only short-term, stopgap measures were running hot, almost no one sounded alarms.

Every incident was eyed in isolation even as, slowly but surely, stress built in the system as a whole, as it always does in finance, from the weaker, less resilient periphery of mortgage originators to the very core of storied investment banks whose ultimate fall threatened to bring down the entire system.

The 16th of March of this year marked the 10-year anniversary of the marriage between Bear Stearns and JP Morgan Chase, which was arranged and co-financed by the Federal Reserve. It was by no means the beginning of the crisis; rather, it marked the beginning of the end. It was the final stage in which financial firms at the core were still able to keep their heads above water; however, fearing for their own survival, they would extend another lifeline to fellow banks only with government help.

By September, it took a massive government bailout to prevent a financial meltdown.

Of course, the government could have stepped aside and allowed the banking and finance system to selfdestruct. Members of Congress who voted against the Troubled Asset Relief Program (TARP) Act at the time certainly thought it should.

Allowing it to implode would have created a much cleaner slate for rebuilding finance on sound footing just as the collapse of the financial system in the 1930s had. On the downside, no one could say for sure whether the system would recover and what it would cost to get there. Fearing the abyss, the Fed, the Treasury and Congress stepped in and did what it took (to paraphrase then-Fed Chairman Ben Bernanke) to stabilize the financial system which has since returned to making huge profits.

No good deed goes unpunished.

Instead of a new foundation for sound finance, all we got for this massive public intervention was the same old system, merely patched up with rules and regulations to make it more resilient.

Among the most far-reaching of the reform measures was a new set of essentially preventive care measures for the financial sector: annual check-ups for banks beyond a certain size, strategies for designing tests that would make it harder for financial intermediaries to game them, and additional discretionary powers for regulators to impose additional prudential measures on banks in the name of system stability. Given the massive regulatory failure in spotting early signs of trouble and preventing the 2008 crisis, that looked like the least Congress could do to keep Americans safe from financial instability.

Yet, Republicans, along with a breakaway bloc of Democratic senators, have begun to strip away much of the preventive measures in the post-crisis regulatory legislation, known as Dodd-Frank. Following lobbying by the financial industry, the US. Senate just voted to proceed with considering a new bill, which provides that only banks with consolidated assets worth $100 billion or more (up from $50 billion) will be subject to regular stress tests conducted by the Fed; but these checkups will be “periodic” rather than annual, and they will include only two rather than three stress scenarios. Similarly, in the new design, company-run internal stress tests are required now only for firms with more than $50 billion in assets (up from $10 billion). They, too, can dispense with annual checks: periodic ones will do.

This massive act of deregulation will not be accompanied by greater discretion for the Fed to impose supervisory measures on select companies. On the contrary, the Fed’s discretionary powers have been circumscribed in the bill.

Thresholds are always arbitrary; it is simply impossible to find an optimal point that imposes just enough costs on banks and financial institutions to ensure financial stability. But with these new changes, financial stability has been placed on the back burner. Instead we are presented with back-of-the-envelope calculations about the positive effects scaling back regulation will have on credit expansion, and therefore on growth. It’s a dangerous game, least because this calculation does not include the costs of future crises that result from reckless credit expansion.

If financial stability were the goal, as it should be, we might want to do away with asset thresholds altogether and instead empower regulators to diagnose and treat threats to financial instability wherever they find them. No doubt, the financial industry would reject such a move, because it craves regulatory “certainty”, the very reason its lobbyists pushed for the thresholds in the first place. But we should not fool ourselves: Limiting financial preventive care to large banks at the core of the system deprives regulators of the tools they need to diagnose a crisis in the making, and leaves us exactly where we were in the run-up to the last one.

Waiting for the Chinese Bear Stearns

Daniela Gabor
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Unregulated, speculative lending markets nearly brought down the global financial system 10 years ago. Now, Western banks are exporting this failed model to the developing world.

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What a difference a decade makes’, mused Mark Carney, the head of the Financial Stability Board (FSB), in a recent speech. Carney was measuring, and applauding, regulatory progress since shadow banking brought Bear Stearns down in March 2008 and Lehman Brothers six months later, and since 2013, when he warned that shadow banking in developing and emerging countries (DECS) was the threat to global financial stability. A lot has changed since.

Shadow banking is no longer used pejoratively. The IMF recently noted that DEC shadow banking ‘might yield greater efficiencies and risk sharing capacity. In scholarly and policy literature, DEC shadow banking is portrayed as an activity confined by national borders, connected closely to banks that move activities in the shadows, circumventing regulation or financial repression, complementary to traditional banks that underserve (SME) entrepreneurs, be it because of market imperfections or the priorities of the developmental state (China).

Another C is relevant for China: constructed by the Chinese state as a quasi-fiscal lever. After Lehman, China’s fiscal stimulus involved encouraging local governments to tap shadow credit, often from large state-owned banks through local Government Financing Vehicles; Yet systemic risks pale in comparison to those that gave us the Bear Sterns and Lehman moments, since (a) complex securitization and wholesale funding markets are (still) absent and (b) DECS have preserved autonomy to design regulatory regimes proportional to the risks posed by shadow banks important to economic development. At worst, DECs may have to backstop shadow credit creation, just like high-income countries did after Lehman’s collapse.

The ‘viable alternative’ story has one shortcoming. It stops short of theorizing shadow banking as a phenomenon intricately linked to financial globalization. In so doing, it misses out a recent development.

The global agenda of reforming shadow banking has morphed into a project of constructing resilient market-based finance that seeks to organize DEC financial systems around securities markets. The project re-invigorates a pre-crisis plan designed by G8 countries, led by Germany’s central bank, the Bundesbank, together with the World Bank and the IMF, to promote local currency bond markets, a plan that G20 countries endorsed in 2011. As one Bundesbank official put it then: “more developed domestic bond markets enhance national and global financial stability. Therefore, it is not surprising that this is a topic which generates an exceptional high international consensus and interest even beyond the G20.”

Deeper local securities markets, it is argued, would (a) reduce DEC dependency on short-term foreign currency debt by (b) tapping into growing demand from foreign institutional investors and their asset managers while (c) expanding the investor base to domestic institutional investors that could act as a buffer, increasing DEC’s capacity to absorb large capital inflows without capital controls; and (d) reduce global imbalances, since large DECs (for example, China and other Asian countries) would no longer need to recycle savings in US. financial markets. Everyone wins if DECs develop missing (securities) markets.

Despite paying lip service to the potential fragility of capital flows into DEC securities markets, this is a project of policy-engineered financial globalization.

The key to understanding this is in the plumbing. Plumbing, for building and securities markets, holds little to excite the imagination. Until it goes wrong.

The plumbing of securities markets refers to the money markets where securities can be financed. According to the International Monetary Fund (IMF) and the World Bank: “the money market is the starting point to developing… fixed income (i.e. securities) markets.” The institutions refer to a special segment, known as the repo market. Repo is the “plumbing” that circulates securities between asset managers, institutional investors, market-making banks and leveraged investors, “greasing” securities’ liquidity (ease of trading). It allows financial institutions to borrow against securities collateral and to lend securities to those betting on a change in price.

This is why international institutions, from the FSB to the IMF and World Bank, have insisted that DECS seeking to build resilient market-based finance need to (re)model their repo plumbing according to a ‘Western’ blueprint.

The official policy advice coincides with the View of securities markets’ lobbies, as expressed, for instance, by the Asia Securities Industry and Financial Markets Association, in the 2013 India Bond Market Roadmap and the 2017 China’s Capital Markets: Navigating the Road Ahead.

The advice ignores economist Hyman Minsky’s insights on fragile plumbing (and the lesson of the Bear Sterns and Lehman moments). Minsky was deeply interested in the plumbing of financial markets, where he looked for signs of evolutionary changes that would make monetary policy less effective while sowing the seeds of fragile finance.

Fragility, he warned, arises where: ‘the viability of loans mainly made because of collateral, however, depends upon the expected market value of the assets that are pledged. An emphasis by bankers on the collateral value and the expected values of assets is conducive to the emergence of a fragile financial structure’

Western or classic repo plumbing does precisely that. It orients (shadow) bankers towards the daily market value of collateral. For both borrower and lender, the daily market value of the security collateral is critical: the borrower does not want to leave more collateral with the lender than the cash it has borrowed, and vice-versa. This is why repo plumbing enables aggressive leverage during good times, when securities prices go up, the borrower gets cash/securities back, and can borrow more against them to buy more securities, drive their price up etc. Conversely, when securities prices fall, borrowers have to find, on a daily basis, more cash or more collateral.

Shadow bankers live with daily anxieties. One day, they may find that the repo supporting their securities portfolios is no longer there, as Bear Stearns did. Then they have to firesale collateral, driving securities’ prices down, creating more funding problems for other shadow bankers until they fold, as Lehman Brothers did.

It was such destabilizing processes that prompted the FSB to identify repos as systemic shadow markets that need tight regulation in 2011. Since then, regulatory ambitions to make the plumbing more resilient have been watered down significantly, as the global policy community turned to the project of constructing market-based finance.

Paradoxically, when the Bundesbank advises DECS to make (shadow) bankers more sensitive to the daily dynamic of securities markets, it ignores its own history. Two decades ago, finance lobbies pressured the Bundesbank to relax its strong grip on German repo markets. The Bundesbank resisted because it believed only tight control would safeguard financial stability and monetary policy effectiveness. Eventually, the Bundesbank abandoned this Minsky-like stance because it worried other Euro-area securities would be more attractive for global investors.

Since the 1980s, the policy engineering of liquid securities markets has been a project of promoting shadow plumbing, first in Europe and the US, now in DECs. Take China. Since 2009, Chinese securities markets have grown rapidly to become the third largest in the world, behind the US and Japan. Such rapid growth reflects policies to re-organize Chinese shadow banking into market-based finance, driven by a broader renminbi (RMB, China’s currency) internationalization strategy that views deep local securities markets as a critical pillar. The repo plumbing of Chinese securities markets expanded equally fast, to around US$ 8 trillion by June 2017. Chinese plumbing is now roughly similar in volumes to European and US repo markets, when in 2010 it was only a fifth of those markets. Since then, Chinese (shadow) banks increased repo funding from 10% to 30% of total funding.

Yet China’s repo is fundamentally different. Legal and market practice there does not force the Chinese (shadow) banker to care about, or to make profit from, daily changes in securities prices. Without daily collateral valuation practices, the “archaic” regime makes for patient (shadow) bankers and more resilient plumbing. This is the case in most DEC countries.

The pressure is on China to open repo markets to foreign investors and to abandon “archaic” rules if it wants RMB internationalization. While China may be able to resist such pressures, it is difficult to see how other DECs will. The global push for market-based finance prepares the terrain for organizing international development interventions via securities markets, as suggested by the growing popularity of green bonds, bond markets for infrastructure, impact investment and digital financial inclusion approaches to poverty reduction. After all, the new mantra is “development’s future is finance, not foreign aid.”

In sum, the shadow-banking-into-resilient-market based-finance agenda seeks to define the terms on which DEC countries join the global supply of securities. It silently threatens the monetary power of DEC countries to manage capital flows and the effects of global financial cycles, a hard-fought victory to weaken the political clout of what Jagdish Bhagwati termed the “Wall Street-Treasury complex” that successfully pressured DECs to open their capital accounts.

This policy-engineered financial globalization seeks a clean break from “the engineered industrialization” that involved capital controls, bank credit guided by the priorities of industrial strategies and competitive exchange rate management.

Instead, it seeks to accelerate the global diffusion of the architecture of US. securities markets and their plumbing, despite well-documented fragilities and contested social efficiency.

Questions of sustainability, credit creation and growth should not be left to securities markets. Carefully designed developmental states, historical experience suggests, work better.

How Economics Survived the Economic Crisis – Robert Skidelsky * Good enough for government work? Macroeconomics since the crisis – Paul Krugman.

Unlike the Great Depression of the 1930s, which produced Keynesian economics, and the stagflation of the 1970s, which gave rise to Milton Friedman’s monetarism, the Great Recession has elicited no such response from the economics profession. Why?

The tenth anniversary of the start of the Great Recession was the occasion for an elegant essay by the Nobel laureate economist Paul Krugman, who noted how little the debate about the causes and consequences of the crisis have changed over the last decade. Whereas the Great Depression of the 1930s produced Keynesian economics, and the stagilation of the 1970s produced Milton Friedman’s monetarism, the Great Recession has produced no similar intellectual shift.

This is deeply depressing to young students of economics, who hoped for a suitably challenging response from the profession.

Why has there been none?

Krugman’s answer is typically ingenious: the old macroeconomics was, as the saying goes, “good enough for government work.” It prevented another Great Depression. So students should lock up their dreams and learn their lessons.

A decade ago, two schools of macroeconomists contended for primacy: the New Classical or the “freshwater” School, descended from Milton Friedman and Robert Lucas and headquartered at the University of Chicago, and the New Keynesian, or “saltwater,” School, descended from John Maynard Keynes, and based at MIT and Harvard.

Freshwater-types believed that budgets deficits were always bad, whereas the saltwater camp believed that deficits were beneficial in a slump. Krugman is a New Keynesian, and his essay was intended to show that the Great Recession vindicated standard New Keynesian models.

But there are serious problems with Krugman’s narrative. For starters, there is his answer to Queen Elizabeth II’s nowfamous question: “Why did no one see it coming?” Krugman’s cheerful response is that the New Keynesians were looking the other way. Theirs was a failure not of theory, but of “data collection.” They had “overlooked” crucial institutional changes in the financial system. While this was regrettable, it raised no “deep conceptual issue” that is, it didn’t demand that they reconsider their theory.

Faced with the crisis itself, the New Keynesians had risen to the challenge. They dusted off their old sticky-price models from the 1950s and 1960s, which told them three things. First, very large budget deficits would not drive up near zero interest rates. Second, even large increases in the monetary base would not lead to high inflation, or even to corresponding increases in broader monetary aggregates. And, third, there would be a positive national income multiplier, almost surely greater than one, from changes in government spending and taxation.

These propositions made the case for budget deficits in the aftermath of the collapse of 2008. Policies based on them were implemented and worked “remarkably well.” The success of New Keynesian policy had the ironic effect of allowing “the more inflexible members of our profession [the New Classicals from Chicago] to ignore events in a way they couldn’t in past episodes.” So neither school, sect might be the better word, was challenged to re-think first principles.

This clever history of pre- and post-crash economics leaves key questions unanswered.

First, if New Keynesian economics was “good enough,” why didn’t New Keynesian economists urge precautions against the collapse of 2007-2008? After all, they did not rule out the possibility of such a collapse a priori.

Krugman admits to a gap in “evidence collection.” But the choice of evidence is theory-driven. In my view, New Keynesian economists turned a blind eye to instabilities building up in the banking system, because their models told them that financial institutions could accurately price risk. So there was a “deep conceptual issue” involved in New Keynesian analysis: its failure to explain how banks might come to “underprice risk worldwide,” as Alan Greenspan put it.

Second, Krugman fails to explain why the Keynesian policies vindicated in 2008-2009 were so rapidly reversed and replaced by fiscal austerity. Why didn’t policymakers stick to their stodgy fixed-price models until they had done their work? Why abandon them in 2009, when Western economies were still 4-5% below their precrash levels?

The answer I would give is that when Keynes was briefly exhumed for six months in 2008-2009, it was for political, not intellectual, reasons. Because the New Keynesian models did not offer a sufficient basis for maintaining Keynesian policies once the economic emergency had been overcome, they were quickly abandoned.

Krugman comes close to acknowledging this: New Keynesians, he writes, “start with rational behavior and market equilibrium as a baseline, and try to get economic dysfunction by tweaking that baseline at the edges.” Such tweaks enable New Keynesian models to generate temporary real effects from nominal shocks, and thus justify quite radical intervention in times of emergency. But no tweaks can create a strong enough case to justify sustained interventionist policy.

The problem for New Keynesian macroeconomists is that they fail to acknowledge radical uncertainty in their models, leaving them without any theory of what to do in good times in order to avoid the bad times. Their focus on nominal wage and price rigidities implies that if these factors were absent, equilibrium would readily be achieved. They regard the financial sector as neutral, not as fundamental (capitalism’s “ephor,” as Joseph Schumpeter put it).

Without acknowledgement of uncertainty, saltwater economics is bound to collapse into its freshwater counterpart. New Keynesian “tweaking” will create limited political space for intervention, but not nearly enough to do a proper job. So Krugman’s argument, while provocative, is certainly not conclusive. Macroeconomics still needs to come up with a big new idea.

*

Robert Skidelsky, Professor Emeritus of Political Economy at Warwick University and a fellow of the British Academy in history and economics, is a member of the British House of Lords. The author of a three-volume biography of John Maynard Keynes.

Project Syndicate

Oxford Review of Economic Policy, 2018

Good enough for government work? Macroeconomics since the crisis

Paul Krugman

Abstract:

This paper argues that when the financial crisis came policy-makers relied on some version of the Hicksian sticky-price IS-LM as their default model; these models were ”good enough for government work’.

While there have been many incremental changes suggested to the DSGE model. there has been no single ‘big new idea” because the even simpler lS-LM type models were what worked well. In particular, the policy responses based on lS-LM were appropriate.

Specifically, these models generated the insights that large budget deficits would not drive up interest rates and, while the economy remained at the zero lower bound, that very large increases in monetary base wouldn’t be inflationary, and that the multiplier on government spending was greater than 1.

The one big exception to this satisfactory understanding was in price behaviour. A large output gap was expected to lead to a large fall in inflation, but did not. If new research is necessary. it is on pricing behaviour. While there was a failure to forecast the crisis, it did not come down to a lack of understanding of possible mechanisms, or of a lack of data, but rather through a lack of attention to the right data.

I. Introduction

It’s somewhat startling, at least for those of us who bloviate about economics for a living, to realize just how much time has passed since the 2008 financial crisis. Indeed, the crisis and aftermath are starting to take on the status of an iconic historical episode, like the stagflation of the 1970s or the Great Depression itself, rather than that of freshly remembered experience. Younger colleagues sometimes ask me what it was like during the golden age of economics blogging, mainly concerned with macroeconomic debates, which they think of as an era that ended years ago.

Yet there is an odd, interesting difference, both among economists and with a wider audience, between the intellectual legacies of those previous episodes and what seems to be the state of macroeconomics now.

Each of those previous episodes of crisis was followed both by a major rethinking of macroeconomics and, eventually, by a clear victor in some of the fundamental debates. Thus, the Great Depression brought on Keynesian economies, which became the subject of fierce dispute, and everyone knew how those disputes turned out: Keynes, or Keynes as interpreted by and filtered through Hicks and Samuelson, won the argument.

In somewhat the same way, stagflation brought on the Friedman Phelps natural rate hypothesis, yes, both men wrote their seminal papers before the 1970s, but the bad news brought their work to the top of the agenda. And everyone knew, up to a point anyway, how the debate over that hypothesis ended up: basically everyone accepted the natural rate idea, abandoning the notion of a long-run trade-off between inflation and unemployment. True, the profession then split into freshwater and saltwater camps over the effectiveness or lack thereof of short-run stabilization policies, a development that I think presaged some of what has happened since 2008. But I’ll get back to that.

For now, let me instead just focus on how different the economics profession response to the post-2008 crisis has been from the responses to depression and stagflation. For this time there hasn’t been a big new idea, let alone one that has taken the profession by storm. Yes, there are lots of proclamations about things researchers should or must do differently, many of them represented in this issue of the Oxford Review. We need to put finance into the heart of the models! We need to incorporate heterogeneous agents! We need to incorporate more behavioural economics! And so on.

But while many of these ideas are very interesting, none of them seems to have emerged as the idea we need to grapple with. The intellectual impact of the crisis just seems far more muted than the scale of crisis might have led one to expect. Why?

Well, I’m going to offer what I suspect will be a controversial answer: namely, macroeconomics hasn’t changed that much because it was. in two senses, what my father’s generation used to call ‘good enough for government work”. On one side, the basic models used by macroeconomists who either practise or comment frequently on policy have actually worked quite well, indeed remarkably well. On the other, the policy response to the crisis, while severely lacking in many ways, was sufficient to avert utter disaster, which in turn allowed the more inflexible members of our profession to ignore events in a way they couldn‘t in past episodes.

In what follows I start with the lessons of the financial crisis and Great Recession, which economists obviously failed to predict. I then move on to the aftermath, the era of fiscal austerity and unorthodox monetary policy, in which I’ll argue that basic macroeconomics, at least in one version, performed extremely well. I follow up with some puzzles that remain. Finally, I turn to the policy response and its implications for the economics profession.

II. The Queen’s question

When all hell broke loose in financial markets, Queen Elizabeth II famously asked why nobody saw it coming. This was a good question but maybe not as devastating as many still seem to think.

Obviously, very few economists predicted the crisis of 2008-9; those who did, with few exceptions I can think of, also predicted multiple other crises that didn’t happen. And this failure to see what was coming can’t be brushed aside as inconsequential.

There are, however, two different ways a forecasting failure of this magnitude can happen, which have very different intellectual implications. Consider an example from a different field, meteorology. In 1987 the Met Office dismissed warnings that a severe hurricane might strike Britain; shortly afterwards, the Great Storm of 1987 arrived, wreaking widespread destruction. Meteorologists could have drawn the lesson that their fundamental understanding of weather was fatally flawed which they would presumably have done if their models had insisted that no such storm was even possible. Instead, they concluded that while the models needed refinement, the problem mainly involved data collection that the network of weather stations, buoys, etc. had been inadequate, leaving them unaware of just how bad things were looking.

How does the global financial crisis compare in this respect? To be fair, the DSGE models that occupied a lot of shelf space in journals really had no room for anything like this crisis. But macroeconomists focused on international experience, one of the hats I personally wear, were very aware that crises triggered by loss of financial confidence do happen, and can be very severe. The Asian financial crisis of 1997-9, in particular, inspired not just a realization that severe l930s-type downturns remain possible in the modern world, but a substantial amount of modelling of how such things can happen.

So the coming of the crisis didn’t reveal a fundamental conceptual gap. Did it reveal serious gaps in data collection? My answer would be, sort of, in the following sense: crucial data weren’t so much lacking as overlooked.

This was most obvious on the financial side. The panic and disruption of financial markets that began in 2007 and peaked after the fall of Lehman came as a huge surprise, but one can hardly accuse economists of having been unaware of the possibility of bank runs. lf most of us considered such runs unlikely or impossible in modern advanced economies, the problem was not conceptual but empirical: failure to take on board the extent to which institutional changes had made conventional monetary data inadequate.

This is clearly true for the United States, where data on shadow banking on the repo market, asset-backed commercial paper, etc. were available but mostly ignored. In a less obvious way, European economists failed to pay sufficient intention to the growth of interbank lending as a source of finance. In both cases the institutional changes undermined the existing financial safety net, especially deposit insurance. But this wasn’t a deep conceptual issue: when the crisis struck, I’m sure I wasn’t the only economist whose reaction was not ‘How can this be happening?” but rather to yell at oneself, ‘Diamond Dybvig, you idiot!’

(The Diamond-Dybvig model is an influential model of bank runs and related financial crises. The model shows how banks’ mix of illiquid assets (such as business or mortgage loans) and liquid liabilities (deposits which may be withdrawn at any time) may give rise to selffulfilling panics among depositors.)

In a more subtle way, economists were also under-informed about the surge in housing prices that we now know represented a huge bubble, whose bursting was at the heart of the Great Recession. In this case, rising home prices were an unmistakable story. But most economists who looked at these prices focused on broad aggregates say, national average home prices in the United States. And these aggregates, while up substantially, were still in a range that could seemingly be rationalized by appealing to factors like low interest rates. The trouble, it turned out, was that these aggregates masked the reality, because they averaged home prices in locations with elastic housing supply (say, Houston or Atlanta) with those in which supply was inelastic (Florida or Spain); looking at the latter clearly showed increases that could not be easily rationalized.

Let me add a third form of data that were available but largely ignored: it’s fairly remarkable that more wasn’t made of the sharp rise in household debt, which should have suggested something unsustainable about the growth of the 2001-7 era. And in the aftermath of the crisis macroeconomists, myself included (Eggertsson and Krugman, 2012) began taking private-sector leverage seriously in a way they should arguably have been doing before.

So did economists ignore warning signs they should have heeded? Yes. One way to summarize their (our) failure is that they ignored evidence that the private sector was engaged in financial overreach on multiple fronts, with financial institutions too vulnerable, housing prices in a bubble, and household debt unsustainable. But did this failure of observation indicate the need for a fundamental revision of how we do macroeconomics? That’s much less clear.

First, was the failure of prediction a consequence of failures in the economic framework that can be fixed by adopting a radically different framework? It’s true that a significant wing of both macroeconomists and financial economists were in the thrall of the efficient markets hypothesis, believing that financial overreach simply cannot happen or at any rate that it can only be discovered after the fact, because markets know what they are doing better than any observer. But many macroeconomists, especially in policy institutions, knew better than to trust markets to always get it right especially those who had studied or been involved with the Asian crisis of the 1990s. Yet they (we) also missed some or all of the signs of overreach. Why?

My answer may seem unsatisfying, but I believe it to be true: for the most part what happened was a demonstration of the old line that predictions are hard, especially about the future. It’s a complicated world out there, and one’s ability to track potential threats is limited. Almost nobody saw the Asian crisis coming, either. For that matter, how many people worried about political disruption of oil supplies before 1973? And so on. At any given time there tends to be a set of conventional indicators everyone looks at, determined less by fundamental theory than by recent events, and big, surprise crises almost by definition happen due to factors not on that list. If you like, it’s as if meteorologists with limited resources concentrated those resources in places that had helped track previous storms, leading to the occasional surprise when a storm comes from an unusual direction.

A different question is whether, now that we know whence the 2008 crisis came, it points to a need for deep changes in macroeconomic thinking. As I’ve already noted, bank runs have been fairly well understood for a long time; we just failed to note the changing definition of banks. The bursting of the housing bubble, with its effects on residential investment and wealth, was conceptually just a negative shock to aggregate demand.

The role of household leverage and forced deleveraging is a bigger break from conventional macroeconomics, even as done by saltwater economists who never bought into efficient markets and were aware of the risk of financial crises. That said, despite the impressive empirical work of Mian and Sufi (2011) and my own intellectual investment in the subject, I don’t think we can consider incorporating debt and leverage a fundamental new idea, as opposed to a refinement at the margin.

It’s true that introducing a role for household debt in spending behaviour makes the short-run equilibrium of the economy dependent on a stock variable, the level of debt. But this implicit role of stock variables in short-run outcomes isn‘t new: after all, nobody has ever questioned the notion that investment flows depend in part on the existing capital stock, and I’m not aware that many macroeconomists consider this a difficult conceptual issue.

And I’m not even fully convinced that household debt played that large a role in the crisis. Did household spending fall that much more than one would have expected from the simple wealth effects of the housing bust?

My bottom line is that the failure of nearly all macroeconomists, even of the saltwater camp, to predict the 2008 crisis was similar in type to the Met Office failure in 1987, a failure of observation rather than a fundamental failure of concept. Neither the financial crisis nor the Great Recession that followed required a rethinking of basic ideas.

III. Not believing in (confidence) fairies

Once the Great Recession had happened, the advanced world found itself in a situation not seen since the 1930s, except in Japan, with policy interest rates close to zero everywhere. This raised the practical question of how governments and central banks should and would respond, of which more later.

For economists, it raised the question of what to expect as a result of those policy responses. And the predictions they made were, in a sense, out-of-sample tests of their theoretical framework: economists weren’t trying to reproduce the historical time-series behaviour of aggregates given historical policy regimes, they were trying to predict the effects of policies that hadn’t been applied in modern times in a situation that hadn’t occurred in modern times.

In making these predictions, the deep divide in macroeconomics came into play, making a mockery of those who imagined that time had narrowed the gap between saltwater and freshwater schools. But let me put the freshwater school on one side, again pending later discussion, and talk about the performance of the macroeconomists, many of them trained at MIT or Harvard in the 1970s, who had never abandoned their belief that activist policy can be effective in dealing with short-run fluctuations. I would include in this group Ben Bernanke, Olivier Blanchard, Christina Romer, Mario Draghi, and Larry Summers, among those close to actual policy, and a variety of academics and commentators, such as Simon Wren-Lewis, Martin Wolf, and, of course, yours truly, in supporting roles.

I think it’s fair to say that everyone in this group came into the crisis with some version of Hicksian sticky-price IS-LM as their default, back-of-the-envelope macroeconomic model. Many were at least somewhat willing to work with DSGE models, maybe even considering such models superior for many purposes. But when faced with what amounted to a regime change from normal conditions to an economy where policy interest rates couldn’t fall, they took as their starting point what the Hicksian approach predicted about policy in a liquidity trap. That is, they did not rush to develop new theories, they pretty much stuck with their existing models.

These existing models made at least three strong predictions that were very much at odds with what many inhuential figures in the political and business worlds (backed by a few economists) were saying.

First. Hicksian macroeconomics said that very large budget deficits, which one might normally have expected to drive interest rates sharply higher, would not have that effect near the zero lower bound.

Second, the same approach predicted that even very large increases in the monetary base would not lead to high inflation, or even to corresponding increases in broader monetary aggregates.

Third, this approach predicted a positive multiplier, almost surely greater than 1, on changes in government spending and taxation.

These were not common-sense propositions. Non-economists were quite sure that the huge budget deficits the US ran in 2009-10 would bring on an attack by the ‘bond vigilantes’. Many financial commentators and political figures warned that the Fed’s expansion of its balance sheet would ‘debase the dollar’ and cause high inflation. And many political and policy figures rejected the Keynesian proposition that spending more would expand the economy, spending less lead to contraction.

In fact, if you‘re looking for a post-2008 equivalent to the kinds of debate that raged in the 1930s and again in the 1970s, a conflict between old ideas based on pre-crisis thinking, and new ideas inspired by the crisis, your best candidate would be fiscal policy. The old guard clung to the traditional Keynesian notion of a government spending multiplier somewhat limited by automatic stabilizers, but still greater than 1. The new economic thinking that achieved actual real-world influence during the crisis and aftermath-as opposed, let’s be honest, to the kind of thinking found in this issue mostly involved rejecting the Keynesian multiplier in favour of the doctrine of expansionary austerity, the argument that cutting public spending would crowd in large amounts of private spending by increasing confidence (Alesina and Ardagna, 2010). (The claim that bad things happen when public debt crosses a critical threshold also played an important real-world role, but was less a doctrine than a claimed empirical observation.)

So here, at least, there was something like a classic crisis-inspired confrontation between tired old ideas and a radical new doctrine. Sad to say, however, as an empirical matter the old ideas were proved right, at least insofar as anything in economics can be settled by experience, while the new ideas crashed and burned. Interest rates stayed low despite huge deficits. Massive expansion in the monetary base did not lead to infiation. And the experience of austerity in the euro area, coupled with the natural experiments created by some of the interregional aspects of the Obama stimulus, ended up strongly supporting a conventional, Keynesian view of fiscal policy, Even the magnitude of the multiplier now looks to be around 1.5, which was the number conventional wisdom suggested in advance of the crisis.

So the crisis and aftermath did indeed produce a confrontation between innovative new ideas and traditional views largely rooted in the 1930s. But the movie failed to follow the Hollywood script: the stodgy old ideas led to broadly accurate predictions, were indeed validated to a remarkable degree, while the new ideas proved embarrassingly wrong. Macroeconomics didn’t change radically in response to crisis because old-fashioned models, confronted with a new situation, did just fine.

IV. The case of the missing deflation

I’ve just argued that the lack of a major rethinking of macroeconomics in the aftermath of crisis was reasonable, given that conventional, off-the-shelf macroeconomics performed very well. But this optimistic assessment needs to be qualified in one important respect: while the demand side of economy did just about what economists trained at MIT in the 1970s thought it would, the supply side didn’t.

As I said, the experience of stagflation effectively convinced the whole profession of the validity of the natural-rate hypothesis. Almost everyone agreed that there was no long-run inflation unemployment trade-off. The great saltwater freshwater divide was, instead, about whether there were usable short-run trade-offs.

But if the natural-rate hypothesis was correct, sustained high unemployment should have led not just to low inflation but to continually declining inflation, and eventually deflation. You can see a bit of this in some of the most severely depressed economies, notably Greece. But deflation fears generally failed to materialize.

Put slightly differently, even saltwater, activist-minded macroeconomists came into the crisis as ‘accelerationists’: they expected to see a downward-sloping relationship between unemployment and the rate of change of inflation. What we’ve seen instead is, at best, something like the 1960s version of the Phillips curve, a downward-sloping relationship between unemployment and the level of inflation and even that relationship appears weak.

Obviously this empirical failure has not gone unnoticed. Broadly, those attempting to explain price behaviour since 2008 have gone in two directions. One side, e.g. Blanchard (2016), invokes ‘anchored’ inflation expectations: the claim that after a long period of low, stable inflation, price-setters throughout the economy became insensitive to recent inflation history, and continued to build 2 per cent or so inflation into their decisions even after a number of years of falling below that target. The other side. e.g. Daly and Hobijn (2014), harking back to Tobin (1972) and Akerlof er a1. (1996), invokes downward nominal wage rigidity to argue that the natural rate hypothesis loses validity at low inflation rates.

In a deep sense, I’d argue that these two explanations have more in common than they may seem to at first sight. The anchored-expectations story may preserve the outward form of an accelerationist Phillips curve, but it assumes that the process of expectations formation changes, for reasons not fully explained, at low inflation rates. The nominal rigidity story assumes that there is a form of money illusion. opposition to outright nominal wage cuts, that is also not fully explained but becomes significant at low overall inflation rates.

Both stories also seem to suggest the need for aggressive expansionary policy when inflation is below target: otherwise there’s the risk that expectations may become unanchored on the downward side, or simply that the economy will suffer persistent, unnecessary slack because the downward rigidity of wages is binding for too many workers.

Finally. I would argue that it is important to admit that both stories are ex post explanations of macroeconomic behaviour that was not widely predicted in advance of the post-2008 era. Pre-2008, the general view even on the saltwater side was that stable inflation was a sufficient indicator of an economy operating at potential output, that any persistent negative output gap would lead to steadily declining inflation and eventually outright deflation. This view was, in fact, a key part of the intellectual case for inflation targeting as the basis of monetary policy. If inflation will remain stable at, say, 1 per cent even in a persistently depressed economy. it’s all too easy to see how policymakers might give themselves high marks even while in reality failing at their job.

But while this is a subjective impression, I haven’t done a statistical analysis of recent literature, it does seem that surprisingly few calls for a major reconstruction of macroeconomics focus on the area in which old-fashioned macroeconomics did, in fact, perform badly post-crisis.

There have, for example, been many calls for making the financial sector and financial frictions much more integral to our models than they are, which is a reasonable thing to argue. But their absence from DSGE models wasn’t the source of any major predictive failures. Has there been any comparable chorus of demands that we rethink the inflation process, and reconsider the natural rate hypothesis? Of course there have been some papers along those lines, but none that have really resonated with the profession.

Why not? As someone who came of academic age just as the saltwater freshwater divide was opening up, I think I can offer a still-relevant insight: understanding wage and price-setting is hard, basically just not amenable to the tools we as economists have in our kit. We start with rational behaviour and market equilibrium as a baseline, and try to get economic dysfunction by tweaking that baseline at the edges; this approach has generated big insights in many areas, but wages and prices isn’t one of them.

Consider the paths followed by the two schools of macroeconomics.

Freshwater theory began with the assumption that wage and price-setters were rational maximizers, but with imperfect information, and that this lack of information explained the apparent real effects of nominal shocks. But this approach became obviously untenable by the early 1980s, when inflation declined only gradually despite mass unemployment. Now what?

One possible route would have been to drop the assumption of fully rational behaviour, which was basically the New Keynesian response. For the most part, however, those who had bought into Lucas-type models chose to cling to the maximizing model, which was economics as they knew how to do it, despite attempts by the data to tell them it was wrong. Let me be blunt: real business cycle theory was always a faintly (or more than faintly) absurd enterprise, a desperate attempt to protect intellectual capital in the teeth of reality.

But the New Keynesian alternative, while far better, wasn’t especially satisfactory either. Clever modellers pointed out that in the face of imperfect competition the aggregate costs of departures from perfectly rational price-setting could be much larger than the individual costs. As a result, small menu costs or a bit of bounded rationality could be consistent with widespread price and wage stickiness.

To be blunt again. however, in practice this insight served as an excuse rather than a basis for deep understanding. Sticky prices could be made respectable just allowing modellers to assume something like one-period-ahead price-setting, in turn letting models that were otherwise grounded in rationality and equilibrium produce something not too inconsistent with real-world observation. New Keynesian modelling thus acted as a kind of escape clause rather than a foundational building block.

But is that escape clause good enough to explain the failure of deflation to emerge despite multiple years of very high unemployment? Probably not. And yet we still lack a compelling alternative explanation, indeed any kind of big idea. At some level, wage and price behaviour in a depressed economy seems to be a subject for which our intellectual tools are badly fitted.

The good news is that if one simply assumed that prices and wages are sticky, appealing to the experience of the 1930s and Japan in the 1990s (which never experienced a true deflationary spiral), one did reasonably well on other fronts.

So my claim that basic macroeconomics worked very well after the crisis needs to be qualified by what looks like a big failure in our understanding of price dynamics but this failure didn’t do too much damage in giving rise to bad advice, and hasn’t led to big new ideas because nobody seems to have good ideas to offer.

V. The system sort of worked

In 2009 Barry Eichengreen and Kevin O’Rourke made a splash with a data comparison between the global slump to date and the early stages of the Great Depression; they showed that at the time of writing the world economy was in fact tracking quite close to the implosion that motivated Keynes’s famous essay ‘The Great Slump of 1930’ (Eichengreen and O’Rourke, 2009)

Subsequent updates, however, told a different story. Instead of continuing to plunge as it did in 1930, by the summer of 2009 the world economy first stabilized, then began to recover. Meanwhile, financial markets also began to normalize; by late 2009 many measures of financial stress were more or less back to pre-crisis levels.

So the world financial system and the world economy failed to implode. Why?

We shouldn’t give policy-makers all of the credit here. Much of what went right, or at least failed to go wrong, refiected institutional changes since the 1930s. Shadow banking and wholesale funding markets were deeply stressed, but deposit insurance still protected at good part of the banking system from runs. There never was much discretionary fiscal stimulus, but the automatic stabilizers associated with large welfare states kicked in, well, automatically: spending was sustained by government transfers, while disposable income was buffered by falling tax receipts.

That said, policy responses were clearly much better than they were in the 1930s. Central bankers and fiscal authorities officials rushed to shore up the financial system through a combination of emergency lending and outright bailouts; international cooperation assured that there were no sudden failures brought on by shortages of key currencies. As a result, disruption of credit markets was limited in both scope and duration. Measures of financial stress were back to pre-Lehman levels by June 2009.

Meanwhile, although fiscal stimulus was modest, peaking at about 2 per cent of GDP in the United States, during 2008-9 governments at least refrained from drastic tightening of fiscal policy, allowing automatic stabilizers, which, as I said, were far stronger than they had been in the 1930s to work.

Overall, then, policy did a relatively adequate job of containing the crisis during its most acute phase. As Daniel Drezner argues (2012), ‘the system worked’-well enough, anyway, to avert collapse.

So far, so good. Unfortunately, once the risk of catastrophic collapse was averted, the story of policy becomes much less happy. After practising more or less Keynesian policies in the acute phase of the crisis, governments reverted to type: in much of the advanced world, fiscal policy became Hellenized, that is, every nation was warned that it could become Greece any day now unless it turned to fiscal austerity. Given the validation of Keynesian multiplier analysis, we can confidently assert that this turn to austerity contributed to the sluggishness of the recovery in the United States and the even more disappointing, stuttering pace of recovery in Europe.

Figure 1 sums up the story by comparing real GDP per capita during two episodes: Western Europe after 1929 and the EU as a whole since 2007. In the modern episode, Europe avoided the catastrophic declines of the early 1930s, but its recovery has been so slow and uneven that at this point it is tracking below its performance in the Great Depression.

Now, even as major economies turned to fiscal austerity, they turned to unconventional monetary expansion. How much did this help? The literature is confusing enough to let one believe pretty much whatever one wants to. Clearly Mario Draghi’s “whatever it takes’ intervention (Draghi, 2012) had a dramatic effect on markets, heading off what might have been another acute crisis, but we never did get a clear test of how well outright monetary transactions would have worked in practice, and the evidence on the effectiveness of Fed policies is even less clear.

The purpose of this paper is not, however, to evaluate the decisions of policy-makers, but rather to ask what lessons macroeconomists should and did take from events. And the main lesson from 2010 onwards was that policy-makers don’t listen to us very much, except at moments of extreme stress.

This is clearest in the case of the turn to austerity, which was not at all grounded in conventional macroeconomic models. True, policy-makers were able to find some economists telling them what they wanted to hear, but the basic Hicksian approach that did pretty well over the whole period clearly said that depressed economies near the zero lower bound should not be engaging in fiscal contraction. Never mind, they did it anyway.

Even on monetary policy, where economists ended up running central banks to a degree I believe was unprecedented, the influence of macroeconomic models was limited at best. A basic Hicksian approach suggests that monetary policy is more or less irrelevant in a liquidity trap. Refinements (Krugman, 1998; Eggertsson and Woodford, 2003) suggested that central banks might be able to gain traction by raising their inflation targets, but that never happened.

The point, then, is that policy failures after 2010 tell us relatively little about the state of macroeconomics or the ways it needs to change, other than that it would be nice if people with actual power paid more attention. Macroeconomists aren’t, however, the only researchers with that problem; ask climate scientists how it’s going in their world.

Meanwhile, however, what happened in 2008-9, or more precisely, what didn’t happen, namely utter disaster, did have an important impact on macroeconomics. For by taking enough good advice from economists to avoid catastrophe, policy-makers in turn took off what might have been severe pressure on economists to change their own views.

VI. That 80s show

Why hasn’t macroeconomics been transformed by (relatively) recent events in the way it was by events in the 1930s or the 1970s? Maybe the key point to remember is that such transformations are rare in economics, or indeed in any field. ‘Science advances one funeral at a time,’ quipped Max Planck: researchers rarely change their views much in the light of experience or evidence. The 1930s and the 1970s, in which senior economists changed their minds, eg. Lionel Robbins converting to Keynesianism, were therefore exceptional.

What made them exceptional? Each case was marked by developments that were both clearly inconsistent with widely held views and sustained enough that they couldn’t be written off as aberrations. Lionel Robbins published The Great Depression, a very classical/Austrian interpretation that prescribed a return to the gold standard, in 1934. Would he have become a Keynesian if the Depression had ended by the mid-1930s? The widespread acceptance of the natural-rate hypothesis came more easily, because it played into the neoclassical mindset, but still might not have happened as thoroughly if stagflation had been restricted to a few years in the early 1970s.

From an intellectual point of view, I’d argue, the Great Recession and aftermath bear much more resemblance to the 1979-82 Volcker double-dip recession and subsequent recovery in the United States than to either the 1930s or the 1970s. And here I can speak in part from personal recollection.

By the late 1970s the great division of macroeconomics into rival saltwater and freshwater schools had already happened, so the impact of the Volcker recession depended on which school you belonged to. But in both cases it changed remarkably few minds.

For saltwater macroeconomists, the recession and recovery came mainly as validation of their pre-existing beliefs. They believed that monetary policy has real effects, even if announced and anticipated; sure enough, monetary contraction was followed by a large real downturn. They believed that prices are sticky and inflation has a great deal of inertia, so that monetary tightening would produce a ‘clockwise spiral’ in unemployment and inflation: unemployment would eventually return to the NAIRU (non-accelerating inflation rate of unemployment) at a lower rate of inflation, but only after a transition period of high unemployment. And that’s exactly what we saw.

Freshwater economists had a harder time: Lucas-type models said that monetary contraction could cause a recession only if unanticipated, and as long as economic agents couldn’t distinguish between individual shocks and an aggregate fall in demand. None of this was a tenable description of 1979-82. But recovery came soon enough and fast enough that their worldview could, in effect, ride out the storm. (I was at one conference where a freshwater economist, questioned about current events, snapped ‘I’m not interested in the latest residual.’)

What I see in the response to 2008 and after is much the same dynamic. Half the macroeconomics profession feels mainly validated by events-correctly, I’d say, although as part of that faction I would say that, wouldn’t I? The other half should be reconsidering its views but they should have done that 30 years ago, and this crisis, like that one, was sufficiently well-handled by policy-makers that there was no irresistible pressure for change. (Just to be clear, I’m not saying that it was well-handled in an objective sense: in my view we suffered huge, unnecessary losses of output and employment because of the premature turn to austerity. But the world avoided descending into a full 1930s-style depression, which in effect left doctrinaire economists free to continue believing what they wanted to believe.)

If all this sounds highly cynical, well, I guess it is. There’s a lot of very good research being done in macroeconomics now, much of it taking advantage of the wealth of new data provided by bad events. Our understanding of both fiscal policy and price dynamics are, I believe, greatly improved. And funerals will continue to feed intellectual progress: younger macroeconomists seem to me to be much more flexible and willing to listen to the data than their counterparts were, say, 20 years ago.

But the quick transformation of macroeconomics many hoped for almost surely isn’t about to happen, because events haven’t forced that kind of transformation. Many economists myself included are actually feeling pretty good about our basic understanding of macro. Many others, absent real-world catastrophe, feel free to take the blue pill and keep believing what they want to believe.

Adults in the room. My battle with Europe’s Deep Establishment – Yanis Varoufakis.

What happens when you take on the establishment? In this blistering, personal account, world-famous economist Yanis Varoufakis blows the lid on Europe’s hidden agenda and exposes what actually goes on in its corridors of power.


Varoufakis sparked one of the most spectacular and controversial battles in recent political history when, as finance minister of Greece, he attempted to re-negotiate his country’s relationship with the EU. Despite the mass support of the Greek people and the simple logic of his arguments, he succeeded only in provoking the fury of Europe’s political, financial and media elite. But the true story of what happened is almost entirely unknown not least because so much of the EU’s real business takes place behind closed doors.

In this fearless account, Varoufakis reveals all: an extraordinary tale of brinkmanship, hypocrisy, collusion and betrayal that will shake the deep establishment to its foundations.

As is now clear, the same policies that required the tragic and brutal suppression of Greece’s democratic uprising have led directly to authoritarianism, populist revolt and instability throughout the Western world.

Adults In The Room is an urgent wake-up call to renew European democracy before it is too late.

Yanis Varoufakis is the former finance minister of Greece and now the figurehead of an international grassroots movement, DiEM25, campaigning for the revival of democracy in Europe. He speaks to audiences of thousands worldwide and is the author of the international bestseller And the Weak Suffer What They Must? Born in Athens in 1961, he was for many years a professor of economics in Britain, Australia and the USA before he entered government. He is currently Professor of Economics at the University of Athens.

*

A Note on Quoted Speech

In a book of this nature, in which so much depends on who said what to whom, I have made every effort to ensure the accuracy of quoted speech. To this end, l have been able to draw on audio recordings that I made on my phone, as well as on notes I made at the time, of many of the official meetings and conversations that appear in this book. Where my own recordings or notes are unavailable, I have relied on memory and, where possible, the corroboration of other witnesses.

The reader should note that many of the discussions reported in this book took place in Greek. This includes all conversations that occurred with my staff at the finance ministry, in parliament, on the streets of Athens, with the prime minister, in cabinet, and between my partner Danae and me. Necessarily, l have translated those conversations into English.

The only discussions I report that took place in neither Greek nor English were those I had with Michel Sapin, the French finance minister. Indeed, Mr Sapin was the only member of the Eurogroup not to address the meetings in English. Either we communicated through translators or, quite often, he would address me in French and I would reply in English, our grasp of the other’s language being good enough to carry on those conversations.

In every instance I have confined my account strictly to exchanges that are in the public interest and have therefore included only those that shed important light on events that affected the lives of millions.

Preface

My previous book, And the Weak Suffer What They Must?: Europe, Austerity and the Threat to Global Stability, offered an historical explanation of why Europe is now in the process, decades in the making, of losing its integrity and forfeiting its soul. Just as l was finishing it in January 2015 I became finance minister of Greece and found myself thrust into the belly of the beast I had been writing about. By accepting the position of finance minister of a chronically indebted European country in the midst of a tumultuous clash with its creditors, Europe’s most powerful governments and institutions, I witnessed first hand the particular circumstances and immediate causes of our continent’s descent into a morass from which it may not escape for a long, long while.

This new book tells that story. It could be described as the story of an academic who became a government minister for a while before turning whistle-blower. Or as a kissand-tell memoir featuring powerful personages such as Angela Merkel, Mario Draghi, Wolfgang Schauble, Christine Lagarde, Emmanuel Macron, George Osborne and Barack Obama. Or as the tale of a small bankrupt country taking on the Goliaths of Europe in order to escape from debtors’ prison before suffering a crushing if fairly honourable defeat. But none of these descriptions convey my real motivation for writing this book.

Shortly after the ruthless suppression of Greece’s rebellion in 2015, also known as the Greek Spring or the Athens Spring, the leftwing party Podemos lost its momentum in Spain; no doubt many potential voters feared a fate similar to ours at the hands of a ferocious EU. Having observed the EU’s callous disregard for democracy in Greece, many supporters of the Labour Party in Britain then went on to vote for Brexit. Brexit boosted Donald Trump. Donald Trump’s triumph blew fresh wind into the sails of xenophobic nationalists throughout Europe and the world.

Vladimir Putin must be rubbing his eyes in disbelief at the way the West has been undermining itself so fabulously.

The story in this book is not only symbolic of what Europe, Britain and the United States are becoming; it also provides real insights into how and why our polities and social economies have fractured. As the so-called liberal establishment protests at the fake news of the insurgent alt-right, it is salutary to be reminded that in 2015 this same establishment launched a ferociously effective campaign of truth-reversal and character assassination against the pro-European, democratically elected government of a small country in Europe.

But as useful as I hope insights such as this may be, my motivation for writing this book goes deeper. Beneath the specific events that I experienced, I recognised a universal story, the story of what happens when human beings find themselves at the mercy of cruel circumstances that have been generated by an inhuman, mostly unseen network of power relations.

This is why there are no ‘goodies’ or ‘baddies’ in this book. Instead, it is populated by people doing their best, as they understand it, under conditions not of their choosing. Each of the persons I encountered and write about in these pages believed they were acting appropriately, but, taken together, their acts produced misfortune on a continental scale. Is this not the stuff of authentic tragedy? Is this not what makes the tragedies of Sophocles and Shakespeare resonate with us today, hundreds of years after the events they relate became old news?

At one point Christine Lagarde, managing director of the International Monetary Fund, remarked in a state of exasperation that to resolve the drama we needed ‘adults in the room’. She was right. There was a dearth of adults in many of the rooms where this drama unfolded.

As characters, though, they fell into two categories: the banal and the fascinating. The banal went about their business ticking boxes on sheets of instructions handed down to them by their masters. In many cases though, their masters, politicians such as Wolfgang Schauble and functionaries like Christine Lagarde and Mario Draghi were different. They had the ability to reflect on themselves and their role in the drama, and this ability to enter into dialogues with themselves made them fascinatingly susceptible to the trap of self-fulfilling prophecy.

Indeed, watching Greece’s creditors at work was like watching a version of Macbeth unfold in the land of Oedipus. Just as the father of Oedipus, King Laius of Thebes, unwittingly brought about his own murder because he believed the prophecy that he would be killed by his son, so too did the smartest and most powerful players in this drama bring about their own doom because they feared the prophecy that foretold it. Keenly aware of how easily power could slip through their fingers, Greece’s creditors were frequently overpowered by insecurity. Fearing that Greece’s undeclared bankruptcy might cause them to lose political control over Europe, they imposed policies on that country that gradually undermined their political control, not just over Greece but over Europe.

At some point, like Macbeth, sensing their power mutate into insufferable powerlessness, they felt compelled to do their worst. There were moments I could almost hear them say

I am in blood

Stepped in so far that, should I wade no more, Returning were as tedious as go o’er. Strange things I have in head, that will to hand; Which must be acted ere they may be scann’d.

Macbeth, iii. iv.

An account by any one of the protagonists in a cut-throat drama such as this cannot escape bias nor the desire for vindication. So, in order to be as fair and impartial as possible, I have tried to see their actions and my own through the lens of an authentic ancient Greek or Shakespearean tragedy in which characters, neither good nor bad, are overtaken by the unintended consequences of their conception of what they ought to do. I suspect that l have come closer to succeeding in this task in the case of those people whom I found fascinating and rather less so in the case of those whose banality numbed my senses. For this I find it hard to apologize, not least because to present them otherwise would be to diminish the historical accuracy of this account.

PART ONE

Winters of our discontent

Introduction

The only colour piercing the dimness of the hotel bar was the amber liquid flickering in the glass before him. As I approached, he raised his eyes to greet me with a nod before staring back down into his tumbler of whiskey. I sank onto the plush sofa, exhausted.

On cue, his familiar voice sounded imposingly morose. ‘Yanis,’ he said, ‘you made a big mistake.’

In the deep of a spring night a gentleness descends on Washington, DC that is unimaginable during the day. As the politicos, the lobbyists and the hangers-on melt away, the air empties of tension and the bars are abandoned to the few with no reason to be up at dawn and to the even fewer whose burdens trump sleep. That night, as on the previous eighty-one nights, or indeed the eighty-one nights that were to follow, I was one of the latter.

It had taken me fifteen minutes to walk, shrouded in darkness, from 700 19th Street NW, the International Monetary Fund’s building, to the hotel bar where l was to meet him. I had never imagined that a short solitary stroll in nondescript DC could be so restorative. The prospect of meeting the great man added to my sense of relief: after fifteen hours across the table from powerful people too banal or too frightened to speak their minds, l was about to meet a figure of great influence in Washington and beyond, a man no one can accuse of either banality or timidity.

All that changed with his acerbic opening statement, made more chilling by the dim light and shifting shadows.

Faking steeliness, I replied, ‘And what mistake was that, Larry?’

‘You won the election!’ came his answer.

It was 16 April 2015, the very middle of my brief tenure as finance minister of Greece. Less than six months earlier I had been living the life of an academic, teaching at the Lyndon B. Johnson School of Public Affairs at the University of Texas at Austin while on leave from the University of Athens. But in January my life had changed utterly when l was elected a member of the Greek parliament. I had made only one campaign promise: that I would do everything I could to rescue my country from the debt bondage and crushing austerity being imposed on it by its European neighbours and the IMF. It was that promise that had brought me to this city and with the assistance of my close team member Elena Paraniti, who had brokered the meeting and accompanied me that night to this bar.

Smiling at his dry humour and to hide my trepidation, my immediate thought was, Is this how he intends to stiffen my resolve against an empire of foes? I took solace from the recollection that the seventy-first secretary of the United States Treasury and twenty-seventh president of Harvard is not known for his soothing style.

Determined to delay the serious business ahead of us a few moments more, I signalled to the bartender for a whiskey of my own and said, ‘Before you tell me about my “mistake”, let me say, Larry, how important your messages of support and advice have been in the past weeks. I am truly grateful. Especially as for years I have been referring to you as the Prince of Darkness.’

Unperturbed, Larry Summers replied, ‘At least you called me a prince. l have been called worse.’

For the next couple of hours the conversation turned serious. We talked about technical issues: debt swaps, fiscal policy, market reforms, ‘bad’ banks. On the political front he warned me that I was losing the propaganda war and that the ‘Europeans’, as he called Europe’s powers that be, were out to get me. He suggested, and I agreed, that any new deal for my long-suffering country should be one that Germany’s chancellor could present to her voters as her idea, her personal legacy.

Things were proceeding better than I had hoped, with broad agreement on everything that mattered. It was no mean feat to secure the support of the formidable Larry Summers in the struggle against the powerful institutions, governments and media conglomerates demanding my government’s surrender and my head on a silver platter. Finally, after agreeing our next steps, and before the combined effects of fatigue and alcohol forced us to call it a night, Summers looked at me intensely and asked a question so well rehearsed that I suspected he had used it to test others before me.

‘There are two kinds of politicians,’ he said: ‘insiders and outsiders. The outsiders prioritize their freedom to speak their version of the truth. The price of their freedom is that they are ignored by the insiders, who make the important decisions. The insiders, for their part, follow a sacrosanct rule: never turn against other insiders and never talk to outsiders about what insiders say or do. Their reward? Access to inside information and a chance, though no guarantee, of influencing powerful people and outcomes.’ With that Summers arrived at his question. ‘So, Yanis,’ he said, ‘which of the two are you?’

Instinct urged me to respond with a single word; instead I used quite a few.

‘By character I am a natural outsider,’ I began, ‘but,’ I hastened to add, ‘I am prepared to strangle my character if it would help strike a new deal for Greece that gets our people out of debt prison. Have no doubt about this, Larry: I shall behave like a natural insider for as long as it takes to get a viable agreement on the table for Greece, indeed for Europe. But if the insiders I am dealing with prove unwilling to release Greece from its eternal debt bondage, I will not hesitate to turn whistleblower on them to return to the outside, which is my natural habitat anyway.’

‘Fair enough,’ he said after a thoughtful pause.

We stood up to leave. The heavens had opened while we were talking. As I saw him to a taxi, the downpour soaked my spring clothes in seconds. With his taxi speeding away, I had the opportunity to realize a wild dream of mine, one that had kept me going during the interminable meetings of the previous days and weeks: to walk alone, unnoticed, in the rain.

Powering through the watery curtain in pristine solitude, I took stock of the encounter. Summers was an ally, albeit a reluctant one. He had no time for my government’s left-wing politics, but he understood that our defeat was not in America’s interest. He knew that the eurozone’s economic policies were not just atrocious for Greece but terrible for Europe and, by extension, for the United States too. And he knew that Greece was merely the laboratory where these failed policies were being tested and developed before their implementation everywhere across Europe.

This is why Summers offered a helping hand. We spoke the same economic language, despite different political ideologies, and had no difficulty reaching a quick agreement on what our aims and tactics ought to be. Nevertheless, my answer had clearly bothered him, even if he did not show it. He would have got into his taxi a much happier man, I felt, had I demonstrated some interest in becoming an insider. As this book’s publication confirms, that was never likely to happen.

Back at my hotel, getting dry and with two hours to go before the alarm clock would summon me back to the front line, I pondered a great anxiety: how would my comrades back home, the inner circle of our government, answer Summers’s question in their hearts? On that night l was determined to believe that they would answer it as I had done.

Less than two weeks later I began to have my first real doubts.

Super black boxes

Yiorgos Chatzis went missing on 29 August 2012. He was last sighted at the social security office in the small northern Greek town of Siatista, where he was told that his monthly disability allowance of €280 had been suspended. Eyewitnesses reported that he did not utter a word of complaint. ‘He seemed stunned and remained speechless,’ a newspaper said. Soon after, he used his mobile phone for the last time to call his wife. No one was at home, so he left a message: ‘I feel useless. I have nothing to offer you any more. Look after the children.’ A few days later his body was found in a remote wooded area, suspended by the neck over a cliff, his mobile phone lying on the ground nearby.

The wave of suicides triggered by the great Greek depression had caught the attention of the international press a few months earlier after Dimitris Christoulas, a seventy-seven-year-old retired pharmacist, shot himself dead by a tree in the middle of Athens’s Syntagma Square, leaving behind a heart-wrenching political manifesto against austerity. Once upon a time the silent, dignified grief of Christoulas’s and Chatzis’s loved ones would have shamed into silence even the most hardened bailiff, except that in Bailoutistan, my satirical term for post-2010 Greece, our bailiffs keep their distance from their victims, barricading themselves in five-star hotels, whizzing around in motorcades and steadying their occasionally flagging nerves with baseless statistical projections of economic recovery.

During that same year, 2012, three long years before Larry Summers was to lecture me on insiders and outsiders, my partner Danae Stratou presented an art installation at a downtown Athens gallery. She called it, It is time to open the black boxes! The work comprised one hundred black metal boxes laid out geometrically on the floor. Each contained a word selected by Danae from the thousands that Athenians had contributed through social media in response to her question, ‘In a single word, what are you most afraid of, or what is the one thing you want to preserve?’

Danae’s idea was that unlike, say, the black box of a downed aircraft, these boxes would be opened before it was too late. The word that Athenians had chosen more than any other was not jobs, pensions or savings. What they feared losing most was dignity. The island of Crete, whose inhabitants are renowned for their pride, experienced the highest number of suicides once the crisis hit. When a depression deepens and the grapes of wrath grow ‘heavy for the vintage’, it is the loss of dignity that brings on the greatest despair.

In the catalogue entry I wrote for the exhibition I drew a comparison with another kind of black box. In engineering terms, I wrote, a black box is a device or system whose inner workings are opaque to us but whose capacity to turn inputs into outputs we understand and use fluently. A mobile phone, for instance, reliably converts finger movements into a telephone call or the arrival of a taxi, but to most of us, though not to electrical engineers, what goes on within a smartphone is a mystery. As philosophers have noted, other people’s minds are the quintessential black boxes: ultimately we can have no idea of precisely what goes on inside another’s head. (During the 162 days that this book chronicles I often caught myself wishing that the people around me, my comrades-in-arms in particular, were less like black boxes in this regard.)

But then there are what I called ‘super black boxes’, whose size and import is so great that even those who created and control them cannot fully understand their inner workings: for example, financial derivatives whose effects are not truly understood even by the financial engineers who designed them, global banks and multinational corporations whose activities are seldom grasped by their CEOs, and of course governments and supranational institutions like the International Monetary Fund, led by politicians and influential bureaucrats who may be in office but are rarely in power. They too convert inputs money, debt, taxes, votes into outputs profit, more complicated forms of debt, reductions in welfare payments, health and education policies. The difference between these super black boxes and the humble smartphone or even other humans is that while most of us have barely any control over their inputs, their outputs shape all our lives.

This difference is encapsulated in a single word: power. Not the type of power associated with electricity or the crushing force of the ocean’s waves, but another, subtler, more sinister power: the power held by the ‘insiders’ that Larry Summers referred to but which he feared I would not have the disposition to embrace, the power of hidden information.

During and after my ministry days people constantly asked me, ‘What did the IMF want from Greece? Did those who resisted debt relief do so because of some illicit hidden agenda? Were they working on behalf of corporations interested in plundering Greece’s infrastructure its airports, seaside resorts, telephone companies and so on?’ If only matters were that straightforward.

When a large-scale crisis hits, it is tempting to attribute it to a conspiracy between the powerful. Images spring to mind of smoke-filled rooms with cunning men (and the occasional woman) plotting how to profit at the expense of the common good and the weak. These images are, however, delusions. If our sharply diminished circumstances can be blamed on a conspiracy, then it is one whose members do not even know that they are part of it. That which feels to many like a conspiracy of the powerful is simply the emergent property of any network of super black boxes.

The keys to such power networks are exclusion and opacity. Recall the ‘Greed is great’ ethos of Wall Street and the City of London in the years before the 2008 implosion. Many decent bank employees were worried sick by what they were observing and doing. But when they got their hands on evidence or information foreshadowing terrible developments, they faced Summers’s dilemma: leak it to outsiders and become irrelevant; keep it to themselves and become complicit; or embrace their power by exchanging it for other information held by someone else in the know, resulting in an impromptu two-person alliance that turbocharges both individuals’ power within the broader network of insiders. As further sensitive information is exchanged, this two-person alliance forges links with other such alliances. The result is a network of power within other pre-existing networks, involving participants who conspire de facto without being conscious conspirators.

Whenever a politician in the know gives a journalist an exclusive in exchange for a particular spin that is in the politician’s interest, the journalist is appended, however unconsciously, to a network of insiders. Whenever a journalist refuses to slant their story in the politician’s favour, they risk losing a valuable source and being excluded from that network. This is how networks of power control the flow of information: through co-opting outsiders and excluding those who refuse to play ball. They evolve organically and are guided by a supraintentional drive that no individual can control, not even the president of the United States, the CEO of Barclays or those manning the pivotal nodes in the IMF or national governments.

Once caught in this web of power it takes an heroic disposition to turn whistle-blower, especially when one cannot hear oneself think amid the cacophony of so much money-making. And those few who do break ranks end up like shooting stars, quickly forgotten by a distracted world.

Fascinatingly, many insiders, especially those only loosely attached to the network, are oblivious to the web that they reinforce, courtesy of having relatively few contacts with it. Similarly, those embedded in the very heart of the network are usually too far inside to notice that there is an outside at all. Rare are those astute enough to notice the black box when they live and work inside one. Larry Summers is one such rare insider. His question to me was in fact an invocation to reject the lure of the outside. Underpinning his belief system was the conviction that the world can only be made better from within the black box.

But this was where, I thought, he was very wrong.

Theseus before the labyrinth

Before 2008, while the super black boxes functioned stably, we lived in a world that seemed balanced and self-healing. Those were the times when the British chancellor Gordon Brown was celebrating the end of ‘boom and bust’ and the soon-to-be-chairman of the Federal Reserve Ben Bernanke was heralding the Great Moderation. Of course it was all an illusion generated by the super black boxes whose function no one understood, especially not the insiders running them. And then, in 2008, they broke down spectacularly, generating our generation’s 1929, not to mention little Greece’s fall.

It is my view that the 2008 financial crisis, which is still with us almost a decade later, is due to the terminal breakdown of the world’s super black boxes of the networks of power, the conspiracies without conspirators, that fashion our lives. Summers’s blind faith that the remedies to this crisis will spring from those same broken down networks, through the normal operations of insiders, struck me even at the time as touchingly naive. Perhaps that is not surprising. After all, three years earlier I had written in Danae’s catalogue that ‘opening these super black boxes has now become a prerequisite to the survival of decency, of whole strata of our fellow humans, of our planet even. Put simply, we have run out of excuses. It is, therefore, time to open the black boxes!’ But in real terms, what would this entail?

First, we need to acquire a readiness to recognize that we may very well, each one of us, already be a node in the network; an ignorant de facto conspirator. Secondly, and this is the genius of Wikileaks, if we can get inside the network, like Theseus entering the labyrinth, and disrupt the information flow; if we can put the fear of uncontrollable information leaking in the mind of as many of its members as possible, then the unaccountable, malfunctioning networks of power will collapse under their own weight and irrelevance. Thirdly, by resisting any tendency to substitute old closed networks with new ones.

By the time I entered that Washington bar three years later I had tempered my stance. My priority was not to leak information to outsiders but to do whatever it took to get Greece out of debtors’ prison. If that meant pretending to be an insider, so be it. But the instant the price of admission to the insiders’ circle became acceptance of Greece’s permanent incarceration, I would leave. Laying down an Ariadne’s thread inside the insiders’ labyrinth and being ready to follow it to the exit is, I believe, a prerequisite for the dignity on which the Greek people’s happiness relies.

The day after my meeting with Larry Summers I met Jack Lew, the incumbent US Treasury secretary. After our meeting at the Treasury, an official seeing me out startled me with a friendly aside: ‘Minister, I feel the urge to warn you that within a week you will face a character assassination campaign emanating from Brussels.’ Larry’s pep talk about the importance of staying inside the proverbial tent, along with his warning that we were losing the media war, suddenly came into sharp focus.

Of course, it was no great surprise. Insiders, I had written in 2012, would react aggressively to anyone who dared open up their super black box to the outsiders’ gaze: ‘None of this will be easy. The networks will respond violently, as they are already doing. They will turn more authoritarian, more closed, more fragmented. They will become increasingly preoccupied with their own “security” and monopoly of information, less trusting of common people.

The following chapters relate the networks’ violent reaction to my stubborn refusal to trade Greece’s emancipation for a privileged spot inside one of their black boxes.

Sign here!

It all boiled down to one small doodle on a piece of paper whether I was prepared to sign on the dotted line of a fresh bailout loan agreement that would push Greece further into its labyrinthine jail of debt.

The reason why my signature mattered so much was that, curiously, it is not presidents or prime ministers of fallen countries that sign bailout loan agreements with the IMF or with the European Union. That poisoned privilege falls to the hapless finance minister. It is why it was crucial to Greece’s creditors that I be bent to their will, that I should be co-opted or, failing that, crushed and replaced by a more pliant successor. Had I signed, another outsider would have turned insider and praise would have been heaped upon me. The torrent of foul adjectives directed at me by the international press, arriving right on cue only a little more than a week after that Washington visit, just as the US official had warned me it would, would never have descended onto my head. I would have been ‘responsible’, a ‘trustworthy partner’, a ‘reformed maverick’ who had put his nation’s interests above his ‘narcissism’.

Judging by his expression as we walked out of the hotel and into the pouring rain, Larry Summers seemed to understand. He understood that the ‘Europeans’ were not interested in an honourable deal with me or with the Greek government. He understood that, in the end, I would be pressurised inordinately to sign a surrender document as the price of becoming a bona fide insider. He understood that l was not willing to do this. And he believed that this would be a pity, for me at least.

For my part I understood that he wanted to help me secure a viable deal. I understood too that he would do what he could to help us, provided it did not violate his golden rule: insiders never turn against other insiders and never talk to outsiders about what insiders do or say. What I was not sure about was whether he would ever understand why there was no chance in heaven or hell for that matter that I would sign a non-viable new bailout loan agreement. It would have taken too long to explain my reasons, but even if there had been time I feared that our backgrounds were too different for my explanation to make any sense to him.

My explanation, had I offered it, would have come in the form of a story or two.

The first would have probably begun inside an Athenian police station in the autumn of 1946, when Greece was on the brink of a communist insurgency and the second phase of its catastrophic civil war. A twenty-year-old chemistry student at Athens University named Yiorgos had been arrested by the secret police, roughed up and left in a cold cell for a few hours until a higher-ranking officer took him to his office ostensibly to apologize. I am sorry for the rough treatment, he said. You are a good boy and did not deserve this. But you know these are treacherous times and my men are on edge.

Forgive them. Just sign this and off you go. With my apologies.

The police officer seemed sincere and Yiorgos was relieved that his earlier ordeal at the hands of the thugs was at an end. But then, as he read the typewritten statement the officer was asking him to sign, a cold chill ran down his spine. The page read, I hereby denounce, truly and in all sincerity, communism, those who promote it, and their various fellow travellers.

Trembling with fear, he put the pen down, summoned all the gentleness that his mother Anna had instilled in him over the years, and said, Sir, I am no Buddhist but I would never sign a state document denouncing Buddhism. I am not a Muslim but I do not think the state has the right to ask me to denounce Islam. Similarly, I am not a communist but I see no reason why I should be asked to denounce communism.

Yiorgos’s civil liberty argument stood no chance. Sign or look forward to systematic torture and indefinite detention the choice is yours! shouted the enraged officer. The officer’s ire was based on perfectly reasonable expectations. Yiorgos had all the makings of a good boy, a natural insider. He had been born in Cairo to a middle-class family within the large Greek community, itself embedded in a cosmopolitan European enclave of French, Italian and British expats, and raised alongside sophisticated Armenians, Jews and Arabs. French was spoken at home, courtesy of his mother, Greek at school, English at work, Arabic on the street and Italian at the opera.

At the age of twenty, determined to connect with his roots, Yiorgos had given up a cushy job in a Cairo bank and moved to Greece to study chemistry. He had arrived in Athens in January 1945 on the ship Corinthia only a month after the conclusion of the first phase of Greece’s civil war, the first episode of the Cold War. A fragile détente was in the air, and so it had seemed reasonable to Yiorgos when student activists of both the Left and the Right had approached him as a compromise candidate for president of his school’s students’ association.

Shortly after his election, however, the university authorities had increased tuition fees at a time when students wallowed in absolute poverty. Yiorgos had paid the dean a visit, arguing as best as he could against the fee hike. As he left, secret policemen had manhandled him down the school’s marble steps and into a waiting van. and he had ended up with a choice that makes Summers’s dilemma seem like a walk in the park.

Given the young man’s bourgeois background, the police had every expectation that Yiorgos would either sign gladly or break quickly once torture began. However, with every beating Yiorgos felt less able to sign, end the pain and go home. As a result, he ended up in a variety of cells and prison camps that he could have escaped at any point simply by putting his signature on a single sheet of paper. Four years later, a shadow of his former self, Yiorgos emerged from prison into a grim society that neither knew of his peculiar choice nor really cared.

Meanwhile, during the period of Yiorgos’s incarceration, a young woman four years his junior had become the first female student to gain admittance to the University of Athens Chemistry School, despite their best efforts to keep her out. Eleni, for that was her name, began university as a rebellious proto-feminist but nevertheless felt a powerful dislike for the Left: during the years of the Nazi occupation she had been abducted as a very young girl by left-wing partisans who mistook her for a relative of a Nazi collaborator. Upon enrolling at the University of Athens, a fascist organization called X recruited her on the strength of her anticommunist feelings. Her first and, as it would turn out, her last mission for them was to follow a fellow chemistry student who had just been released from the prison camps.

This, in a nutshell, is the story of how I came about. For Yiorgos is my father, and Eleni, who ended up a leading member of the 1970s feminist movement, was my mother. Blessed with this history, signing on the dotted line in return for the mercy shown to insiders was never on the cards for me. Would Larry Summers have understood? I don’t think so.

Not for me

The other story is as follows. I met Lambros in the Athens apartment I share with Danae a week or so before the January 2015 election that brought me to office. It was a mild winter’s day, the campaign was in full swing, and I had agreed to give an interview to lrene, a Spanish journalist. She came to the apartment accompanied by a photographer and by Lambros, an Athens-based Greek-Spanish translator. On that occasion Lambros’s services were unnecessary as lrene and I talked in English. But he stayed, watching and listening intensely. After the interview, as Irene and the photographer were packing up their gear and heading for the door, Lambros approached me. He shook my hand, refusing to let go while addressing me with the concentration of a man whose life depends on getting his message across: ‘I hope you did not notice it from my appearance. I do my best to cover it up, but in fact I am a homeless person.’ He then told me his story as briefly as he could.

Lambros used to have a flat, a job teaching foreign languages and a family. In 2010, when the Greek economy tanked, he lost his job, and when they were evicted from their flat he lost his family. For the past year he had lived on the street. His only income came from providing translation services to visiting foreign journalists drawn to Athens by yet another demonstration in Syntagma Square which turned ugly and thus newsworthy. His greatest concern was finding a few euros to recharge his cheap mobile phone so that the foreign news crews could contact him.

Feeling he needed to wrap up his soliloquy, he rushed to the one thing he wanted from me:

I want to implore you to promise me something. l know you will win the election. I talk to people on the street and there is no doubt that you will. Please, when you win, when you are in office, remember those people. Do something for them. Not for me! I am finished. Those of us whom the crisis felled, we cannot come back. It is too late for us. But, please, please do something for those who are still on the verge. Who are clinging by their fingernails. Who have not fallen yet. Do it for them. Don’t let them fall. Don’t turn your back to them. Don’t sign what they give you like the previous ones did. Swear that you won’t. Do you swear?

‘I swear,’ was my two-word answer to him.

A week later I was taking my oath of office as the country’s finance minister. During the months that followed, every time my resolve weakened I had only to think back to that moment. Lambros will never know of his influence during the bleakest hours of those 162 days.

Bailoutistan

By early 2010, some five years before I took office, the Greek state was bankrupt. A few months later the European Union, the International Monetary Fund and the Greek government organized the world’s greatest bankruptcy cover-up. How do you cover up a bankruptcy? By throwing good money after bad. And who financed this cover-up? Common people, ‘outsiders’ from all over the globe.

The rescue deal, as the cover-up was euphemistically known, was signed and sealed in early May 2010. The European Union and the IMF extended to the broke Greek government around €110 billion, the largest loan in history. Simultaneously a group of enforcers known as the troika so called because they represent three institutions: the European Commission (EC), which is the EU’s executive body, the European Central Bank (ECB) and the International Monetary Fund (IMF) was dispatched to Athens to impose measures guaranteed to reduce Greece’s national income and place most of the burden of the debt upon the weakest Greeks. A bright eight-year-old would have known that this couldn’t end well. Forcing new loans upon the bankrupt on condition that they shrink their income is nothing short of cruel and unusual punishment.

Greece was never bailed out. With their ‘rescue’ loan and their troika of bailiffs enthusiastically slashing incomes, the EU and lMF effectively condemned Greece to a modern version of the Dickensian debtors’ prison and then threw away the key.

Debtors’ prisons were ultimately abandoned because, despite their cruelty, they neither deterred the accumulation of new bad debts nor helped creditors get their money back. For capitalism to advance in the nineteenth century, the absurd notion that all debts are sacred had to be ditched and replaced with the notion of limited liability. After all, if all debts are guaranteed, why should lenders lend responsibly? And why should some debts carry a higher interest rate than other debts, reflecting the higher risk of going bad?

Bankruptcy and debt write-downs became for capitalism what hell had always been for Christian dogma unpleasant yet essential but curiously bankruptcy denial was revived in the twenty-first century to deal with the Greek state’s insolvency. Why? Did the EU and the IMF not realize what they were doing?

They knew exactly what they were doing. Despite their meticulous propaganda, in which they insisted that they were trying to save Greece, to grant the Greek people a second chance, to help reform Greece’s chronically crooked state and so on, the world’s most powerful institutions and governments were under no illusions. They appreciated that you could squeeze blood out of a stone more easily than make a bankrupt entity repay its loans by lending it more money, especially if you shrink its income as part of the deal. They could see that the troika, even if it managed to confiscate the fallen state’s silverware, would fail to recoup the money used to refinance Greece’s public debt. They knew that the celebrated ‘rescue’ or ‘bailout’ package was nothing more than a one-way ticket to debtors’ prison.

How do I know that they knew? Because they told me.

Prisoners of their own device

As finance minister five years later, I heard it straight from the horse’s mouth. From top IMF officials, from Germany’s finance minister, from leading figures in the ECB and the European Commission they all admitted, each in their own way, that it was true: they had dealt Greece an impossible hand. But having done so, they could see no way back.

Less than a month after my election, on 11 February 2015, in one of those spirit-numbing, windowless, neon-lit meeting rooms that litter the EU’s Brussels buildings, I found myself sitting opposite Christine Lagarde, the lMF’s managing director, France’s ex-finance minister and a former Washington-based high-flying lawyer. She had waltzed into the building earlier that day in a glamorous leather jacket, making me look drab and conventionally attired. This being our first encounter, we chatted amicably in the corridor before moving into the meeting room for the serious discussion.

Behind closed doors, with a couple of aides on each side, the conversation turned serious but remained just as friendly. She afforded me the opportunity to present my basic analysis of the causes and nature of the Greek situation as well as my proposals for dealing with it, and nodded in agreement for much of the time. We seemed to share a common language and were both keen to establish a good rapport. At the meeting’s end, walking towards the door, we got a chance for a short, relaxed but telling téte-a-téte. Taking her cue from the points I had made, Christine seconded my appeals for debt relief and lower tax rates as prerequisites for a Greek recovery. Then she addressed me with calm and gentle honesty: You are of course right, Yanis. These targets that they insist on can’t work. But, you must understand that we have put too much into this programme. We cannot go back on it. Your credibility depends on accepting and working within this programme.

So, there I had it. The head of the IMF was telling the finance minister of a bankrupt government that the policies imposed upon his country couldn’t work. Not that it would be hard to make them work. Not that the probability of them working was low. No, she was acknowledging that, come hell or high water, they couldn’t work.

With every meeting, especially with the troika’s smarter and less insecure officials, the impression grew on me that this was not a simple tale of us versus them, good versus bad. Rather, an authentic drama was afoot reminiscent of a play by Aeschylus or Shakespeare in which powerful schemers end up caught in a trap of their own making. In the real-life drama I was witnessing, Summers’s sacred rule of insiders kicked in the moment they recognized their powerlessness. The hatches were battened down, official denial prevailed, and the consequences of the tragic impasse they’d created were left to unfold on autopilot, imprisoning them yet further in a situation they detested for weakening their hold over events.

Because they, the heads of the IMF, of the EU, of the German and French governments, had invested inordinate political capital in a programme that deepened Greece’s bankruptcy, spread untold misery and led our young to emigrate in droves, there was no alternative: the people of Greece would simply have to continue to suffer.

As for me, the political upstart, my credibility depended on accepting these policies, which insiders knew would fail, and helping to sell them to the outsiders who had elected me on the precise basis that I would break with those same failed policies.

It’s hard to explain, but not once did I feel animosity towards Christine Lagarde. I found her intelligent, cordial, respectful. My view of humanity would not be thrown into turmoil were it to be shown that she actually had a strong preference for a humane Greek deal. But that is not relevant. As a leading insider, her top priority was the preservation of the insiders’ political capital and the minimization of any challenge to their collective authority.

Yet credibility, like spending, comes with tradeoffs. Every purchase means an alternative opportunity lost. Boosting my standing with Christine and the other figures of power meant sacrificing my credibility with Lambros, the homeless interpreter who had sworn me to the cause of those people who, unlike him, had not yet been drowned in the torrent of bankruptcy ravaging our land. This trade-off never came close to becoming a personal dilemma. And the powers that be realized this early on, making my removal from the scene essential.

A little more than a year later, in the run-up to the UK referendum on 23 June 2016, I was travelling across Britain giving speeches in support of a radical remain platform, the argument that the UK ought to stay within the EU to oppose this EU, to save it from collapse and to reform it. It was a tough sell. Convincing Britain’s outsiders to vote remain was proving an uphill struggle, especially in England’s north, because even my own supporters in Britain, women and men closer in spirit and position to Lambros than to Christine, were telling me they felt compelled to deliver a drubbing to the global establishment. One evening I heard on the BBC that Christine Lagarde had joined the heads of the world’s other top financial institutions (the World Bank, the OECD, the ECB, the Bank of England and so on) to warn Britain’s outsiders against the lure of Brexit. I immediately texted Danae from Leeds, where l was speaking that night, ‘With such allies, who needs Brexiteers?’

Brexit won because the insiders went beyond the pale. After decades of treating people like me as credible in proportion to our readiness to betray the outsiders who had voted for us, they still confused outsiders with people who gave a damn about their counsel. Up and down America, in Britain, in France and in Germany everywhere the insiders are feeling their authority slip away. Prisoners of their own device, slaves to the Summers dilemma, they are condemned, like Macbeth, to add error upon error until they realize that their crown no longer symbolizes the power they have but the power that has slipped away. In the few months I spent dealing with them, I caught glimpses of that tragic realization.

It was the (French and German) banks, stupid!

Friends and journalists often ask me to describe the worst aspect of my negotiations with Greece’s creditors. Not being able to shout from the rooftops what the high and mighty were telling me in private was certainly frustrating, but worse was dealing with creditors who did not really want their money back. Negotiating with them, trying to reason with them, was like negotiating a peace treaty with generals hell-bent on continuing a war safe in the knowledge that they, their sons and their daughters are out of harm’s way.

What was the nature of that war? Why did Greece’s creditors behave as if they did not want their money back? What led them to devise the trap in which they now found themselves? The riddle can be answered in seconds if one takes a look at the state of France’s and Germany’s banks after 2008.

Greece’s endemic underdevelopment, mismanagement and corruption explain its permanent economic weakness. But its recent insolvency is due to the fundamental design faults of the EU and its monetary union, the euro.

The EU began as a cartel of big business limiting competition between central European heavy industries and securing export markets for them in peripheral countries such as Italy and, later, Greece. The deficits of countries like Greece were the reflection of the surpluses of countries like Germany. While the drachma devalued, these deficits were kept in check. But when it was replaced by the euro, loans from German and French banks propelled Greek deficits into the stratosphere.

The Credit Crunch of 2008 that followed Wall Street’s collapse bankrupted Europe’s bankers who ceased all lending by 2009. Unable to roll over its debts, Greece fell into its insolvency hole later that year.

Suddenly three French banks faced losses from peripheral debt at least twice the size of the French economy. Numbers provided by the Bank of International Settlements reveal a truly scary picture: for every thirty euros they were exposed to, they had access to only one. This meant that if only 3 per cent of that exposure went bad that is, if €106 billion of the loans they had given to the periphery’s governments, households and firms could not be repaid then France’s top three banks would need a French government bailout.

The same three French banks’ loans to the Italian, Spanish and Portuguese governments alone came to 34 per cent of France’s total economy, €627 billion to be exact. For good measure, these banks had in previous years also lent up to €102 billion to the Greek state. If the Greek government could not meet its repayments, money men around the globe would get spooked and stop lending to the Portuguese, possibly to the Italian and Spanish states as well, fearing that they would be the next to go into arrears.

Unable to refinance their combined debt of nearly €1.76 trillion at affordable interest rates, the Italian, Spanish and Portuguese governments would be hard pressed to service their loans to France’s top three banks, leaving a black hole in their books. Overnight, France’s main banks would be facing a loss of 19 per cent of their ‘assets’ when a mere 3 per cent loss would make them insolvent.

To plug that gap the French government would need a cool €562 billion overnight. But unlike the United States federal government, which can shift such losses to its central bank (the Fed), France had dismantled its central bank in 2000 when it joined the common currency and had to rely instead on the kindness of Europe’s shared central bank, the European Central Bank. Alas, the ECB was created with an express prohibition: no shifting of Graeco-Latin bad debts, private or public, onto the ECB’s books. Full stop. That had been Germany’s condition for sharing its cherished Deutschmark with Europe’s riff-raff, renaming it the euro.

It’s not hard to imagine the panic enveloping President Sarkozy of France and his finance minister, Christine Lagarde, as they realized that they might have to conjure up €562 billion from thin air. And it’s not difficult to picture the angst of one of Lagarde’s predecessors in France’s finance ministry, the notorious Dominic Strauss-Kahn, who was then managing director of the IMF and intent on using that position to launch his campaign for France’s presidency in two years’ time.

France’s top officials knew that Greece’s bankruptcy would force the French state to borrow six times its total annual tax revenues just to hand it over to three idiotic banks.

It was simply impossible. Had the markets caught a whiff that this was on the cards, interest rates on France’s own public debt would have been propelled into the stratosphere, and in seconds €1.29 trillion of French government debt would have gone bad. In a country which had given up its capacity to print banknotes the only remaining means of generating money from nothing that would mean destitution, which in turn would bring down the whole of the European Union, its common currency, everything.

In Germany, meanwhile, the chancellor’s predicament was no less taxing. In 2008, as banks in Wall Street and the City of London crumbled, Angela Merkel was still fostering her image as the tight-fisted, financially prudent Iron Chancellor. Pointing a moralizing finger at the Anglosphere’s profligate bankers, she made headlines in a speech she gave in Stuttgart when she suggested that America’s bankers should have consulted a Swabian housewife, who would have taught them a thing or two about managing their finances. Imagine her horror when, shortly afterwards, she received a barrage of anxious phone calls from her finance ministry, her central bank, her own economic advisers, all of them conveying an unfathomable message:

“Chancellor, our banks are bust too! To keep the ATMs going, we need an injection of €406 billion of those Swabian housewives’ money by yesterday!”

It was the definition of political poison. How could she appear in front of those same members of parliament whom she had for years lectured on the virtues of penny-pinching when it came to hospitals, schools, infrastructure, social security, the environment, to implore them to write such a colossal cheque to bankers who until seconds before had been swimming in rivers of cash? Necessity being the mother of enforced humbleness, Chancellor Merkel took a deep breath, entered the splendid Norman Foster designed federal parliament in Berlin known as the Bundestag, conveyed to her dumbfounded parliamentarians the bad news and left with the requested cheque. At least it’s done, she must have thought. Except that it wasn’t. A few months later another barrage of phone calls demanded a similar number of billions for the same banks.

Why did Deutsche Bank, Finanzbank and the other Frankfurt-based towers of financial incompetence need more? Because the €406 billion cheque they had received from Mrs Merkel in 2009 was barely enough to cover their trades in USbased toxic derivatives. It was certainly not enough to cover what they had lent to the governments of Italy, Ireland, Portugal, Spain and Greece a total of €477 billion, of which a hefty €102 billion had been lent to Athens. lf Greece lost its capacity to meet its repayments? German banks faced another loss that would require of Mrs Merkel another cheque for anything between €340 billion and €406 billion, but consummate politician that she is, the chancellor knew she would be committing political suicide were she to return to the Bundestag to request such an amount.

Between them, the leaders of France and Germany had a stake of around €1 trillion in not allowing the Greek government to tell the truth; that is, to confess to its bankruptcy.

Yet they still had to find a way to bail out their bankers a second time without telling their parliaments that this was what they were doing. As Jean-Claude Juncker, then prime minister of Luxembourg and later president of the European Commission, once said, ‘When it becomes serious, you have to lie.’

After a few weeks they figured out their fib: they would portray the second bailout of their banks as an act of solidarity with the profligate and lazy Greeks, who while unworthy and intolerable were still members of the European family and would therefore have to be rescued. Conveniently, this necessitated providing them with a further gargantuan loan with which to pay off their French and German creditors, the failing banks.

There was, however, a technical hitch that would have to be overcome first: the clause in the eurozone’s founding treaty that banned the financing of government debt by the EU. How could they get round it? The conundrum was solved by a typical Brussels fudge, that unappetizing dish that the Europeans, especially the British, have learned to loathe.

First, the new loans would not be European but international, courtesy of cutting the IMF into the deal. To do this would require the IMF to bend its most sacred rule: never lend to a bankrupt government before its debt has had a ‘haircut’, been restructured. But the lMF’s then managing director, Dominic Strauss-Kahn, desperate to save the banks of the nation he planned to lead two years down the track, was on hand to persuade the IMF’s internal bureaucracy to turn a blind eye. With the IMF on board, Europeans could be told that it was the international community, not just the EU, lending to the Greeks for the higher purpose of underpinning the global financial system. Perish the thought that this was an EU bailout for an EU member state, let alone for German and French banks!

Second, the largest portion of the loans, to be sourced in Europe, would not come from the EU per se; they would be packaged as a series of bilateral loans that is to say, from Germany to Greece, from Ireland to Greece, from Slovenia to Greece, and so on with each bilateral loan of a size reflecting the lender’s relative economic strength, a curious application of Karl Marx’s maxim ‘from each according to his capacity to each according to his need’.

So, of every €1000 handed over to Athens to be passed on to the French and German banks, Germany would guarantee €270, France €200, with the remaining €530 guaranteed by the smaller and poorer countries.

This was the beauty of the Greek bailout, at least for France and Germany: it dumped most of the burden of bailing out the French and German banks onto taxpayers from nations even poorer than Greece, such as Portugal and Slovakia. They, together with unsuspecting taxpayers from the lMF’s co-funders such as Brazil and Indonesia, would be forced to wire money to the Paris and Frankfurt banks.

Unaware of the fact that they were actually paying for the mistakes of French and German bankers, the Slovaks and the Finns, like the Germans and the French, believed they were having to shoulder another country’s debts. Thus, in the name of solidarity with the insufferable Greeks, the Franco-German axis planted the seeds of loathing between proud peoples.

From Operation Offload to bankruptocracy

As soon as the bailout loans gushed into the Greek finance ministry, ‘Operation Offload’ began: the process of immediately siphoning the money off back to the French and German banks. By October 2011, the German banks’ exposure to Greek public debt had been reduced by a whopping €27.8 billion to €91.4 billion. Five months later, by March 2012, it was down to less than €795 million. Meanwhile the French banks were offloading even faster: by September 2011 they had unburdened themselves of €63.6 billion of Greek government bonds, before totally eliminating them from their books in December 2012. The operation was thus completed within less than two years. This was what the Greek bailout had been all about.

Were Christine Lagarde, Nicolas Sarkozy and Angela Merkel naive enough to expect the bankrupt Greek state to return this money with interest? Of course not. They saw it precisely as it was: a cynical transfer of losses from the books of the FrancoGerman banks to the shoulders of Europe’s weakest taxpayers. And therein lies the rub:

The EU creditors I negotiated with did not prioritize getting their money back because, in reality, it wasn’t their money. Socialists, Margaret Thatcher liked to say, are bound to make a mess of finance because at some point they run out of other people’s money. How would the iron Lady have felt if she’d known that her dictum would prove so fitting a description of her own self-proclaimed disciples, the neoliberal apparatchiks managing Greece’s bankruptcy? Did their Greek bailout amount to anything other than the socialization of the French and German banks’ losses, paid for with other people’s money?

In my book The Global Minotaur, which I was writing in 2010 while Greece was imploding, I argued that free-market capitalist ideology expired in 2008, seventeen years after communism kicked the bucket.

Before 2008 free-market enthusiasts portrayed capitalism as a Darwinian jungle that selects for success among heroic entrepreneurs. But in the aftermath of the 2008 financial collapse, the Darwinian natural selection process was stood on its head: the more insolvent a banker was, especially in Europe, the greater his chances of appropriating large chunks of income from everyone else: from the hard-working, the innovative, the poor and of course the politically powerless.

Bankruptocracy is the name I gave to this novel regime.

Most Europeans like to think that American bankruptocracy is worse than its European cousin, thanks to the power of Wall Street and the infamous revolving door between the US banks and the US government. They are very, very wrong. Europe’s banks were managed so atrociously in the years preceding 2008 that the inane bankers of Wall Street almost look good by comparison. When the crisis hit, the banks of France, Germany, the Netherlands and the UK had exposure in excess of $30 trillion, more than twice the United States national income, eight times the national income of Germany, and almost three times the national incomes of Britain, Germany, France and Holland put together.

A Greek bankruptcy in 2010 would have immediately necessitated a bank bailout by the German, French, Dutch and British governments amounting to approximately $10,000 per child, woman and man living in those four countries. By comparison, a similar market turn against Wall Street would have required a relatively tiny bailout of no more than $258 per US citizen.

If Wall Street deserved the wrath of the American public, Europe’s banks deserved 38.8 times that wrath.

But that’s not all. Washington could park Wall Street’s bad assets on the Federal Reserve’s books and leave them there until either they started performing again or were eventually forgotten, to be discovered by the archaeologists of the future. Put simply, Americans did not need to pay even that relatively measly $258 per head out of their taxes. But in Europe, where countries like France and Greece had given up their central banks in 2000 and the ECB was banned from absorbing bad debts, the cash needed to bail out the banks had to be taken from the citizenry.

If you have ever wondered why Europe’s establishment is so much keener on austerity than America’s or Japan’s, this is why. It is because the ECB is not allowed to bury the banks’ sins in its own books, meaning European governments have no choice but to fund bank bailouts through benefits cuts and tax hikes.

Was Greek’s unholy treatment a conspiracy? If so, it was one without conscious conspirators, at least at the outset. Christine Lagarde and her ilk never set out to found Europe’s bankruptocracy. When the French banks faced certain death, what choice did she have as France’s finance minister, alongside her European counterparts and the IMF, but to do whatever it took to save them even if this entailed lying to nineteen European parliaments at once about the purpose of the Greek loans? But having lied once and on such a grand scale, they were soon forced to compound the deceit in an attempt to hide it beneath fresh layers of subterfuge. Coming clean would have been professional suicide. Before they knew it, bankruptocracy had enveloped them too, just as surely as it had enveloped Europe’s outsiders.

This is what Christine was signalling to me when she confided that ‘they’ had invested too much in the failed Greek programme to go back on it. She might as well have used Lady Macbeth’s more graceful words: ‘What’s done cannot be undone.’

‘National traitor’ the origins of a quaint charge

My career as ‘national traitor’ has its roots in December 2006. In a public debate organized by a former prime minister’s think tank I was asked to comment on the 2007 Greek national budget. Looking at the figures, something compelled me to dismiss them as the pathetic window-dressing exercise that they were:

“Today we are threatened by the bubble in American real estate and in the derivatives market If this bubble bursts, and it is certain it will, no reduction in interest rates is going to energize investment in this country to take up the slack, and so none of this budget’s figures will have a leg to stand on. The question is not whether this will happen but how quickly it will result in our next Great Depression.”

My fellow panellists, who included two former finance ministers, looked at me the way one looks at an inconvenient fool.

Over the next two years I would encounter that look time and again. Even after Lehman Brothers went belly up, Wall Street crumpled, the credit crunch hit and a great recession engulfed the West, Greece’s elites were living in a bubble of self-deluded bliss. At dinner parties, in academic seminars, at art galleries they would harp on about Greece’s invulnerability to the ‘Anglo disease’, secure in the conviction that our banks were sufficiently conservative and the Greek economy fully insulated from the storm.

In pointing out that nothing could have been further from the truth I sounded a jarring dissonance, but it would only get worse.

In reality, states never repay their debt. They roll it over, meaning they defer repayment endlessly, paying only the interest on the loans. As long as they can keep doing this, they remain solvent.

It helps to think of public debt as a hole in the ground next to a mountain representing the nation’s total income. Day by day the hole gets steadily deeper as interest accrues on the debt, even if the state does not borrow more. But during the good times, as the economy grows, the income mountain is steadily getting taller. As long as the mountain rises faster than the debt hole deepens, the extra income added to the mountain’s summit can be shovelled into the adjacent hole, keeping its depth stable and the state solvent. Insolvency beckons when the economy stops growing or starts to contract: recession then eats into a country’s income mountain, doing nothing to slow the pace at which the debt hole continues to grow. At this point alarmed money men will demand higher interest rates on their loans as the price for continuing to refinance the state, but increased rates operate like overzealous excavators, digging yet faster and making the debt hole even deeper.

*

from

Adults in the room. My battle with Europe’s Deep Establishment

by Yanis Varoufakis

get it at Amazon.com

Marx’s analysis of the laws of capital and the share market crisis – Nick Beams.

Down through the years one of the most persistent attacks on Karl Marx by the high priests of bourgeois economics, the ideological guardians of the profit system, has been his contention that, in the final analysis, capitalism depends on the impoverishment of the working class. History, they maintain, has proven otherwise and refuted Marx. While there have been periods of crisis, and rapid and even prolonged falls in the living standards of the masses, in the long run the profit system has served to uplift them and will continue to do so into the indefinite future, whatever fluctuations it may undergo.

Moreover, there is no possible alternative because the market system is not a historically developed mode of production, which came into being at one point and is therefore destined to pass away like earlier modes of production before it, slavery and feudalism. Rather, it is rooted in the laws of nature itself and is necessary and therefore eternal. In other words, despite some imperfections, which may give rise to problems at certain points, all is really for the best in the best of all possible worlds.

In feudal times, the high priests of the Church, who played the key role in sustaining and sanctifying the ruling classes of their day, maintained that when crises arose this was not a product of the social system but an “act of God,” a punishment for the sins of man deriving from his fall.

While there have been enormous advances in social and political thought since then—a product of the Enlightenment and the vast advances in the scientific understanding—the modus operandi of the present day “high priests” of capitalist economy, the bourgeois economists and pundits, is not altogether different from their predecessors.

When confronted with economic crises and their persistence, they maintain that these are not a product of the inexorable workings of the capitalist system itself, but arise from “market imperfections” or some external, unforeseen or accidental event. That is, they proceed, as Marx put it, on the basis that so long as capitalism acts according to the textbooks—the modern day scriptures used to justify the present socio-economic order—crises are not endemic to the system.

The events of the past two weeks, with the largest fall in markets since the crisis of 2008, raising the spectre of an even bigger disaster than that of a decade ago, have provided a damning exposure of this entire ideological framework.

Before going into a deeper analysis of the underlying driving forces and the inherent and irresolvable contradictions of which these events are an expression, let us begin with one undeniable economic fact.

In the decade since the eruption of the global financial crisis of 2008, none of the underlying contradictions that exploded to the surface has been resolved. At the same time, the immediate and ongoing consequences of the breakdown have been the reduction of the living standards of billions of people, while creating unprecedented wealth for a capitalist oligarchy occupying the heights of society. Or as Marx put it, the accumulation of wealth at one pole, amid poverty, misery and degradation at the other.

Whatever the immediate outcome, the financial turmoil of the past days has established, as an undeniable reality, the continuing threat of a meltdown of the capitalist economy. It hangs like a sword of Damocles over the working masses of the world, destined to fall, if not in this crisis, then in others to come.

Moreover, one of the most striking features of the latest crisis, is that it was not sparked by the immediate threat of recession but by news that economic growth was enjoying an uptick—the best period of synchronised global growth since 2009, according to the International Monetary Fund. Most significantly, it was triggered by data showing that wages in the US experienced their largest annual rise since 2009.

Most of what passed for analysis in the bourgeois media did little better than the tweet forthcoming from the very limited intelligence of US President Donald Trump. He noted: “In the ‘old days,’ when good news was reported the Stock Market would go up. Today, when good news is reported, the Stock Market goes down. Big mistake and we have so much good (great) news about the economy!”

Trump’s “analysis” omitted a central feature of the market rise over the past nine years. It has not taken place on the basis of “good news” but in a period of the lowest growth in any “recovery” in the post-World War II period. It has been sustained only by the continued inflow of ultra-cheap money from the US Federal Reserve and other major central banks.

Lawrence Summers, former treasury secretary in the Clinton administration and now Harvard professor of economics, was slightly more insightful. “This is not yet a major earthquake,” he wrote. “Whether it’s an early tremor or a random fluctuation remains to be seen. I’m nervous and will stay nervous. [It is] far from clear that good growth and stable finance are compatible.”

Summers is at least vaguely aware that in the present situation there is something deeply troubling for the capitalist class for which he speaks. The very measures undertaken in response to the last crisis, supposedly aimed at restoring economic health and growth, may in fact have created the conditions for another financial disaster as growth begins to rise.

The tendency of the rate of profit to fall

To analyse the present situation, it is necessary to leave the sphere of bourgeois economics—based on the premise that there are no inherent and objective contradictions in the profit system—and probe its historical development on the basis of the laws of motion of the capitalist economy uncovered by Marx.

The ongoing turmoil in financial markets, beginning with the Wall Street crash of October 1987, must be analysed on the basis of one of the most important contradictions of the capitalist economy explained by Marx. That is the long-term tendency of the rate of profit to fall.

This tendency was noted by the foremost representatives of English classical political economy—Adam Smith and David Ricardo—who preceded Marx in the period when the bourgeoisie was a rising and progressive class.

While Smith and Ricardo found the tendency of the rate of profit to fall deeply disturbing, especially the latter because of its implications for the long-term future of the capitalist economy, they were unable to give any scientific explanation for it. That was provided by Marx, beginning with his uncovering of the secret of surplus value.

While Smith and Ricardo had the notion that the origin of surplus value was the labour of the developing working class, its actual source always remained a mystery to Marx’s predecessors. How was it possible, they cudgelled their brains, on the basis of the laws of commodity exchange in the market, where equivalents exchange for equivalents, for a surplus to arise and for this surplus to be appropriated by capital?

Marx’s solution consisted in his probing of the most important commodity exchange in capitalist economy, that between capital and labour. He showed that the commodity which the worker sold to the capitalist was not, as had been previously maintained, his or her labour, but labour power, the capacity to work.

Like every other commodity in the market, labour power’s value was determined by the value of the commodities needed to reproduce it—in this case, the value of the commodities needed to sustain the individual worker and his or her family to ensure the continued supply of wage workers.

Surplus value arose from the difference between the value created by the worker in the course of the working day through the production process, and the value of the commodity, labour power, that the worker sold to capital through the wage contract.

The raw materials and machinery used up in the production process did not add new value, but passed on to the final product the value they already embodied.

Yet the analysis was not yet complete. The rate of profit had to be explained. This rate was not determined at the level of the individual capitalist firm, but at the level of the capitalist economy as a whole. It was given by the ratio of the total surplus value extracted from the working class to the total capital outlaid—the expenditure on labour power plus the expenditure on the means of production, raw materials and machinery.

The tendency of the rate of profit to fall arose not from some external factor, Marx showed, but from a contradiction at the very heart of this process.

The development of capitalist production led to the expansion of the productive forces and the use of ever-larger amounts of raw materials and machinery in the production process. As a result, expenditure on materials and machinery tended to comprise an increasing proportion of the total capital laid out. But this increased expenditure on what Marx called constant capital, as opposed to the expenditure on labour power, or variable capital, did not give rise to additional or surplus value.

Because the rate of profit was determined by the ratio of total surplus value to the total mass of capital—constant and variable—employed, there was an inherent tendency for it to decline.

Now, as Marx clearly identified, there were countervailing factors. These included: the increased exploitation of the working class in order to widen the difference between the value of labour power and the value created by the worker in the course of the working day; the lowering of wages to below the value of labour power, enforced through the creation of unemployment and a surplus working population; the cheapening of the costs of raw materials and machinery, so reducing the total value of capital on which the rate of profit was calculated; and the expansion of foreign trade.

But while these countervailing factors lessened the tendency of the rate of profit to fall, and at times could operate very powerfully—even lifting the profit rate—the basic tendency continually reasserted itself.

Marx characterised the law of the tendency of the rate of profit to fall as the most important law of political economy, above all from an historical point of view. This was because, on the one hand, it drove capital to develop the productive forces in an attempt to overcome its effects, while, on the other, it was the source of the continually recurring crises that beset the capitalist mode of production.

Marx’s critics and the end of the post-war boom

With the development of the post-war capitalist boom, extending from the late 1940s to the early 1970s, Marx’s law, it was claimed, had been refuted by historical events. As had been seen in the case of the German revisionist Eduard Bernstein at the end of the 19th century, the attack on Marx’s analysis came from those who claimed to be his followers, but insisted it needed to be revised and updated.

The assault on Marx’s law of the tendency of the rate of profit to fall was at the centre of one of the most influential books of the late 1960s, Monopoly Capital, written by the “independent” Marxist economist Paul Sweezy in co-authorship with Paul Baran in the midst of the post-war boom.

Sweezy, the founder of the journal Monthly Review, had already cast considerable doubt on the validity of Marx’s law in his first book, The Theory of Capitalist Development, published in 1941. He now maintained that Marx had developed the law under conditions of competition in the 19th century and that in 20th century monopoly capitalism it no longer applied, if it ever had.

Sweezy maintained that the key question confronting capital was not the insufficient extraction of surplus value relative to the ever-growing mass of capital—the issue to which Marx’s law had pointed—but the reverse. Monopoly capital created an increased mass of surplus value that had to be continually “absorbed.”

A key aspect of Sweezy’s theory, flowing directly from his economic analysis, was that in the advanced capitalist countries, dominated by monopolies, the working class was no longer a revolutionary force. The vehicle for socialist revolution, he claimed, was now the masses in the so-called Third World countries, striving for national liberation.

Monopoly Capital is no longer widely read but it continues to exert an influence. David Harvey, for example, adheres to much of Sweezy’s economic analysis, as well as his insistence on the non-revolutionary role of the working class.

However, as so often happens, Sweezy’s “refutation” of Marx came right at the point when developments in the capitalist economy were confirming Marx’s scientific insights. Earlier, Bernstein had maintained that the Marxist analysis of the inevitable breakdown of capitalism was rendered a fiction by the boom beginning in the late 1890s. The collapse of Bernstein’s prognosis came just 14 years after its elaboration, with the outbreak of World War I in 1914.

In Sweezy’s case, his refutation was almost instantaneous. The publication of Monopoly Capital in 1966 came at a point when profit rates in the advanced capitalist economies were starting to turn down. This led to mounting economic problems and the rise of class tensions that were soon to produce potentially revolutionary struggles by the working class from 1968 to 1975.

Starting with the May–June 1968 general strike in France, the largest and most extended in history, and including the 1969 hot autumn in Italy, the 1974 miners’ strike that brought down the Tory government in Britain, the revolutionary situation in Chile (1970–73) and the upheavals in the US, to name just some of the events, world capitalism was shaken to its foundations.

With the direct collaboration of the Stalinist, social democratic and trade union apparatuses, which betrayed these struggles, the capitalist classes were able to bring the situation under control and maintain their rule.

However, the underlying economic problems of the US and other major capitalist economies, rooted in declining profit rates, remained. Having kept themselves in the saddle, the ruling classes undertook a massive offensive against the working class, coupled with a restructuring the world economy.

The global counter-offensive was initiated in the US under Federal Reserve chairman Paul Volcker, who put in place a high-interest rate regime. Its purpose was two-fold: to wipe out unprofitable sections of industry and force a major industrial restructure, and eliminate the large industrial complexes that were the centres of militant working class struggles in an earlier period. The Volcker purge had vast global ramifications, leading in 1982–83 to the most serious global recession since the Great Depression.

The decade of the 1980s was characterised by major class battles, of which the mass sacking of US air traffic controllers in 1981 by Reagan and the state violence unleashed by the Thatcher Tory government against the British miners’ strike in 1984–85 were two of the most prominent. The decade also saw a fundamental transformation in the role of the trade unions. From organisations that had fought for limited gains by the working class, they betrayed all of its struggles as they became the chief enforcers of the program of pro-market, capitalist restructuring.

The attack on the social position of the working class—aimed at increasing the extraction of surplus value to counter the fall in the rate of profit—was accompanied by a reorganisation of production, through downsizing and globalisation to take advantage of cheaper sources of labour.

The growth of financial speculation

Crucial to this restructuring was the freeing of financial capital from the restrictions and regulations that were set in place following the disastrous experiences of the 1930s. The growing operations of finance, through the issuing of so-called junk bonds and other measures, were central to hostile takeovers, downsizing and mergers and acquisitions that transformed the organisation of capitalist production.

At the same time, the pressure on profit rates, as Marx predicted, resulted in a turn by capital to operations in the financial markets and speculative ventures as a means of profit accumulation.

This process led to financial storms by the end of the 1980s, with the eruption of the savings and loans debacle and the October 1987 share market crash, in which the Dow plunged by more than 22 percent in a single day.

The response of the incoming Federal Reserve chairman, Alan Greenspan, represented a major turning point. He committed the central bank to the provision of liquidity to the financial markets in what became known as the “Greenspan put.” In effect, the Fed became the guarantor to the financial markets, reversing previous policy.

While the October 1987 crash was the most severe one-day fall in history—a position it retains to this day—it did not lead to a broader crisis in the economy as a whole.

This was because the onslaught against the working class in the US and the first wave of globalisation, marked by the transfer of large areas of industrial production to the cheaper-labour countries of East Asia, the “Asian Tigers,” was beginning to lift the rate of profit.

This was reinforced after 1991 with the liquidation of the Soviet Union and the consequent abandonment by countries such as India of their nationally-regulated development programs and the increasing turn to the free market.

Most significant was the restoration of capitalism in China and its opening up to global corporations. China, which became a source of cheap labour production in the 1980s through the establishment of special economic zones, opened up still further. The Tiananmen Square massacre of June 1989 was the signal by the Chinese Communist Party regime that it stood ready, by whatever means necessary, to ensure the exploitation of the Chinese working class by global capital.

In the first period of the Clinton presidency, beginning in 1993, the US economy enjoyed rising profit rates as a result of the boost provided by the exploitation of cheaper labour, paid as little as one thirtieth of US wages.

However, the basic tendency identified by Marx began to reassert itself from around 1997, when the average US profit rate began to turn down. As a result, the accumulation of profits by financial means, which had grown by leaps and bounds in the 1990s, became increasingly vulnerable.

By 1996, Greenspan pointed to what he called “irrational exuberance,” expressed in the tendency of stock prices to become ever-more divorced from the real economy. This warning, however, came to nothing. Greenspan, responding to the dictates and demands of finance capital, turned more openly to the provision of cheap money for speculation.

The Asian financial crisis of 1997–98 was a significant turning point. It produced a depression in South-East Asia equivalent in scope to that of the 1930s in the advanced capitalist countries, but Clinton dismissed it as a mere “glitch” on the road to globalisation.

That was followed by the 1998 collapse of the US investment fund Long Term Capital Management, which had to be wound up in an operation conducted by the New York Federal Reserve, lest its demise brought down the whole financial system.

The dot.com bubble was then getting under way as the Fed provided ever-cheaper money. And at the behest of the financial markets, the last remnants of the regulatory mechanisms controlling their predatory operations, put in place as a result of the 1930s depression, were scrapped with the Clinton administration’s 1999 repeal of the Glass-Steagall Act.

The 2001 collapse of Enron revealed the dubious practices and outright criminality that increasingly marked the speculative financial bubble. Enron had pioneered new accounting practices in which profit was decided in advance to meet market expectations and then the accounts were manipulated to show the desired result.

Following the collapse of the tech and dot.com bubble, finance capital turned to the development of new methods for speculative profit accumulation, again facilitated with cheap money from the Fed. It developed highly complex and arcane financial derivatives, centred on the sub-prime mortgage market, but extending well beyond it. Goldman Sachs, among others, was a key player. It issued new products that it knew would eventually fail, but made money in the meantime by financing both sides of the deals.

The 2008 global financial crisis

In April 2007, the then chairman of the Fed, Ben Bernanke, dismissed the possibility that the growing signs of problems with sub-prime mortgages could impact the broader market because these products only amounted to a $50 billion operation.

However, when the crisis erupted, it engulfed the entire financial system, threatening to bring down the insurance giant AIG following the collapse of Lehman Brothers. This was because the methods employed in the sub-prime market were not “rogue” activities but typical of the financial markets as a whole.

The response of the Fed and other central banks to the 2008 crisis marked another decisive turning point. No longer was it a question of stepping in to rescue a failed individual firm. Massive intervention was required to prop up the US and global financial system as a whole.

The lowering of interest rates to historic lows—in some cases to negative levels—and the injection of trillions of dollars into the financial system did not overcome the contradictions manifested in speculation—the expression of the laws of the capitalist mode of production laid bare by Marx—but exacerbated them.

The rise and rise of financial wealth accumulation in the decade following the 2008 crisis is not the outcome of growth in the real economy. In fact, the “recovery” since 2009 has been the weakest in the post-war period, and marked by the fall of investment in the real economy to historic lows and a decline in productivity.

After the Lehman crisis, finance capital responded to the blowing up of its previous mechanisms for profit accumulation via speculation by creating new ones. One of these, exchange traded notes based on “shorting” the volatility index, or Vix—that is, betting on continued market calm, has now resulted in the most significant turbulence since the 2008 crash.

However, these new forms of speculation are only a trigger. The broader significance of the recent volatility and whatever else eventuates—no one is sure that the storm has passed—is that it was provoked by the prospect of faster growth and a push by the working class for higher wages following decades of the suppression of the class struggle.

Economic events have once again confirmed the essential conclusion of Marx’s analysis of the laws of motion of the capitalist economy. Whatever its ups and downs and even periods of long upturn, the accumulation of profit—the essential driving force of capitalism—is, in the final analysis, based on the ongoing suppression of the working class and its impoverishment.

The lie, which forms the basis of all bourgeois economics, that somehow the growth of capitalist economy can, at least in the long run, provide the road to advancement for the mass of humanity, the working class, the producers of all wealth, has been exposed. It has been laid bare by the fact that signs of economic growth and a growing movement of workers against the decline in living standards have raised the prospect of a new financial disaster, even more serious than that of a decade ago.

Marx’s analysis of the laws of motion of capital—laws which express themselves, as he put it, in the same way that the law of gravity asserts itself when a house collapses around our ears—far from being refuted or rendered outdated, have been confirmed by living events.

This analysis, and Marx’s central conclusion that the working class has to take conscious control of the very wealth it has produced, must become its guiding perspective in the struggles now unfolding.

This historic task does not arise out of an abstract theoretical construct. In opposition to all the nostrums of bourgeois economy, which are self-serving justifications of the capitalist system, Marx’s analysis is a scientific elaboration of the objective tendencies and inherent logic of capitalist development.

This logic, which assumes ever-more explosive forms, now poses directly before the international working class the necessity, if humanity is to avert a catastrophe and advance, to fight in every struggle for a perspective based on the overthrow of the reactionary and historically-outmoded profit system. That is the essential meaning of the latest round of turmoil on the financial markets.

World Socialist Website

Icelandic Banking Thieves Convicted. Justice for The People.

Iceland Just Did The Exact Opposite of What the U.S. Does — It Found 9 Bad Bankers Guilty in Historic Case. 

Reykjavik, Iceland – On Thursday, Iceland’s Supreme Court found nine bankers guilty of market manipulation, affirming the conviction of the seven defendants found in a June 2015 decision by the Reykjavik District Court, and handing down a guilty verdict to two defendants previously acquitted in district court.

The Supreme Court decision found that fully financing share purchases with no other surety than the shares themselves, the bankers were accused of giving a false and misleading impression of demand for Kaupthing shares by means of deception and pretense,”

The Free Thought Project

A cautionary tale for New Zealand. We are ripe for our own ‘NZ Financial Crisis’.

The cause of the Global Economic Crisis: The collapse of the housing bubble in the U.S.

Dean Baker, from his book: The End of Loser Liberalism 2011

The picture of banks collapsing and a chain reaction of defaults and bankruptcies made for exciting news stories and provided the basis for several bestselling books, but this panic was secondary to the collapse of the housing bubble.

The housing bubble drove demand in the years since the 2001 recession, and when the trillions of dollars of bubble-generated housing equity disappeared, there was nothing to take its place.

The bubble in housing led to near-record rates of residential construction over the years from 2002 to 2006. Builders rushed to build new homes to take advantage of record-high home prices. The boom also generated an enormous amount of employment in the financial industry, which issued mortgages not just for new homes but also to refinance homes people already owned, as tens of millions of homeowners sought to take advantage of the run-up in prices and low interest rates to take equity out of their homes. This “housing wealth effect” is well-known and is a standard part of economic theory and modeling. Economists expect households to consume based on their wealth. At its peak, the housing bubble generated more than $8 trillion in home equity on top of what would have been generated had home prices continued to rise at their historic pace. Recent estimates of the size of the wealth effect put it at 6 percent, meaning that homeowners will increase their annual consumption by 6 cents for every additional dollar of home equity.

A bubble in nonresidential real estate led to a building boom in that sector that followed on the heels of the boom in housing; as construction of housing began to trail off at the end of 2005 and into 2006, construction of nonresidential projects like office buildings, retail malls, and hotels exploded. This boom led to enormous overbuilding in the nonresidential sector, and so when the recession kicked in, and especially after the financial crisis in the fall of 2008, nonresidential construction plummeted.

The impact of the collapse of these two bubbles on the demand for goods and services in the economy was enormous.

Consumers are spending in line with their wealth. Now that their wealth has been hugely reduced by the collapse of the bubble, they have adjusted their spending accordingly. The overbuilding and collapse of the bubble in nonresidential real estate led to a further loss in annual demand of roughly $250 billion. Adding together the $600 billion in lost residential construction demand, the $500 billion in lost consumption demand, and the $250 billion in lost demand in nonresidential construction gives a total drop in annual demand of $1.35 trillion.

The collapse of the real estate bubbles as the cause of our continued economic weakness stands in contrast to the financial crisis stories we keep reading and hearing about in the news. These stories hinge on the idea that the problem in the economy is the improper working of the financial system following the financial crisis of the fall of 2008. This story has an obvious problem: the reason we have a financial system is to allocate capital, and it doesn’t seem that anyone is having difficulty getting capital.

GFE, a Global Fund for Education – Jeffrey D. Sachs

Many parts of the world are headed for massive instability, joblessness, and poverty. The twenty-first century will belong to countries that properly educate their young people to participate productively in the global economy.

What US politicians and policymakers in their right minds could believe that US national security is properly pursued through a 900-to-1 ratio of military spending to global education spending? Of course, the US is not alone. Saudi Arabia, Iran, and Israel are all squandering vast sums in an accelerating Middle East arms race, in which the US is the major financier and arms supplier. China and Russia are also sharply boosting military spending, despite their pressing domestic priorities. We are, it seems, courting a new arms race among major powers, at a time when what is really needed is a peaceful race to education and sustainable development. Jeffrey D Sachs, Project Syndicate

Elizabeth Warren DESTROYS Wells Fargo CEO

YouTube

It’s touching to see economists talking about the problems of men without jobs. 

Most economists believed that we would see a quick bounce back from the crash, even without any exceptional amounts of government stimulus. This was the excuse for the austerity that was imposed across the world in 2011. As a result, we have seen an incredibly slow recovery in the United States, and an even slower one in Europe. TruthOut

The Anniversary of Lehman and Men Who Don’t Work. 

“No more Lehmans”

former Treasury Secretary Timothy Geithner.  TruthOut