This article was co-authored with Dr. Robert Ulanowicz and Dr. Sally Goerner. The full, original text can be found here.
I: The Crisis of 2008
By now, everybody knows that we have entered a major global financial crisis. Indeed, the infamous “subprime crisis,” which first hit the American banking system in August 2007, has been spreading internationally. It reached a new level of global banking systemic contagion in September 2008. The question that is being debated is the depth and extent of the crisis – whether it can become as bad as the 1930s Depression. For instance, Alan Greenspan, the former Chairman of the US Federal Reserve, has stated publicly: “Let’s recognize that this is a once-in-a- half-century, probably once-in-a-century type of event.”
The causes of this crisis will be debated for years to come. Some will blame unrestrained greed, others a “sorcerer’s apprentice” problem in which financial engineering created products too complex even for their creators, still others will condemn excessive financial deregulation, incompetence by bankers and/or regulators, or even willful manipulation. What nobody is arguing about is that the financial sector has chalked up simultaneous losses on an unprecedented scale.
So far, simultaneous losses of a record US$ 348 billion are being acknowledged. We estimate, however, that this represents less than half of the total of the subprime issue alone. Indeed, the total loss to the financial system due to the subprime crisis is at least US$ 1.2 trillion. The subprime is only the tip of the iceberg, however, as the same lax practices that were applied to mortgages were also prevailing for car loans or student loans, and particularly credit card debt in the United States.
What this means, in practice, is that we have now entered the period of unprecedented convergence of four planetary problems — climate change, financial instability, high unemployment and the financial consequences of an aging society (as predicted in Lietaer’s 1999 book, The Future of Money). It is most likely that the ensuing crisis will play out in a classic two or three steps downwards for every step upwards pattern. Every small step upward (i.e., any temporary improvement) will predictably be hailed as the “end of the crisis.” It is quite understandable why governments, banks and regulators will make such statements simply because saying otherwise would only make the situation worse.
The next logical phase in this systemic crisis is now unfolding on automatic pilot. Whatever governments do, the banks and other financial institutions will want to cut back drastically on their loans portfolios wherever possible, in order to rebuild their balance sheets after huge financial losses. This in turn will weaken the world economy to the point of a recession, which in turn, will strike the banks’ balance sheets, and so on, down a vicious spiral towards a possible depression. Thus, while cutting back on its loan portfolio is a logical reaction for each individual bank, when they all do it simultaneously, it deepens the hole that is being collectively dug for the world economy and ultimately for the financial system itself.
We are not alone anymore in this view. The London-based newspaper The Independent gathered opinions about the ongoing crisis from a series of outstanding personalities:
“This recession will be long, ugly, painful and deep. All the credit losses associated with it will be closer to $2 trillion — leading to the most severe systemic financial and baking crisis since the Great Depression. The credibility and viability of the most sophisticated financial system is at stake now, as most of this financial and banking system is on its way to substantial and formal insolvency and bankruptcy.” (Nouriel Roubini — Professor of Economics and International Business, New York University)
“The USA is a nation that is consuming too much, and the Bush Administration’s response has been to tell people to consume more.” (Joseph Stiglitz — Professor at Columbia University and 2001 Recipient of the Nobel Prize for Economics). More recently, he added: “When the American economy enters a downturn, you often hear the experts debating whether it is likely to be V-shaped (short and sharp) or U-shaped (longer but milder). Today, the American economy may be entering a downturn that is best described as L-shaped. It is in a very low place indeed, and likely to remain there for some time to come.”
“The second stage [of this economic crisis] is an attempt by the banks to cut their losses and leverage and reduce their lending so helping to drive the economy into recession. That will then feedback via bad debts and impact the capital strength of the banks so we will see an adverse vicious circle of weak banks creating a weak economy, which in turn creates more weak banks.” (Charles Goodhart — Professor Emeritus, London School of Economics)
“There is a super bubble that has been going on for 25 years or so that started in 1980 when Margaret Thatcher became Prime Minister and Ronald Reagan became President. That is when the belief that markets are best left to their own devices became the dominant belief. Based on that we had a new phase of globalisation and liberalisation of financial markets. The idea is false. Markets do not correct towards equilibrium. The whole construct, this really powerful financial structure, has been built on false grounds. For the first time this entire system has been engaged in this [economic] crisis.” (George Soros — Global Financier and Philanthropist)
In short, our financial system is in serious trouble from whatever angle one looks at it.
The Economist editorializes on October 11, 2008, in its lead story: “Confidence is everything in finance…With a flawed diagnosis of the causes of the crisis, it is hardly surprising that many policymakers have failed to understand its progression.” This paper will show that this is indeed the case, although in a deeper way than The Economist itself believes.
The last time we dealt with a crisis of this scale, the 1930s, it ended up creating widespread totalitarianism and ultimately World War II. The trillion dollar questions are:
– How can we do better this time?
– What are the strategies that will avoid getting us caught into an economic tailspin?
– What are all the options available to deal with large scale systemic banking crises?
II. Why Save the Banks?
Since governments’ initial response has been to bail out banks and other financial institutions, the first question must be: Why should governments and taxpayers get involved in saving banks in the first place? After all, when a private business fails, it is considered part of the “creative destructiveness” that characterizes the capitalist system. But when large banks fail, somehow that doesn’t seem to apply, as shown again in the present-day scenario.
The short answer to why banks are being saved is fear that the 1930 Depression nightmare would again become a reality. Since banks enjoy the monopoly on creating money through providing loans, bankrupt banks means reduced credit which in turn results in a lack of money for the rest of the economy. Without access to capital, business and the means of production contract, which causes mass unemployment and a host of collateral social problems. Thus, when banks are in trouble, they can trigger what is know as a “Second Wave” crisis, through a ferocious circle making a victim of the real economy: bad banking balance sheets => credit restrictions => recession => worse bank balance sheets => further credit restrictions and so the spiral downward goes…
It is to avoid such a tailspin that governments feel the need to prop up the banks’ balance sheets. This exercise is under way. For instance, several major banks were able to refinance themselves earlier in 2008, mainly by tapping sovereign funds. But, as the depth of the rot has become more obvious, this has become harder to do. Central banks will help by providing an interest yield curve that makes it easy for financial institutions to earn a lot of money at no risk.
The next logical step is also formulaic. Whenever a bank that is “too big to fail” is in real trouble, the recipe has been the same since the 1930s: the taxpayers end up footing the bill to bail out the banks, so that they can start all over again. Of the 96 major banking crises around the world that the World Bank has counted over a recent 25 year period, 9 taxpayer bailouts have been the answer in every instance. For example, the United States government that had funded Reconstruction Finance Corporation during 1932-53 period, repeated the exercise with the Resolution Trust Corporation for the Savings and Loan crisis in the 1989-95 period, and now again with the Troubled Assets Relief Program (TARP) of 2008. Other recent examples include the Swedish Bank Support Authority (1992-96) and the Japanese Resolution and Collection Corporation, which started in 1996 and is still ongoing. In the current international crisis, among the first institutions that were “saved” in this way we can mention Bear Stearns in the US, and the nationalization of Northern Rock in the UK. In mid-October 2008, European governments pledged an unprecedented 1.873 trillion Euros, combining credit guarantees and capital injections into banks, based on the strategy pioneered by the United Kingdom.
These bailouts end up being expensive for the taxpayers and the economy at large. For instance, the scale of the commitments made by European countries for the bailout of the banking system is without precedent, representing potentially a multiple of their annual GDP. To give an idea of what we are dealing with, here is the ratio of the assets of the three largest banks in each country that have now been guaranteed by their respective governments. This ratio represent 130% of annual GDP for Germany; 142% of annual GDP for Italy; 147% of GDP for Portugal; 218% for Spain; 257% for France; 253% for Ireland; 317% for the UK; 409% for the Netherlands (2 largest banks); 528% for Belgium-Luxemburg; 773% for Switzerland (2 largest banks); and 1,079% of the GDP for Iceland (the first country that went formally bankrupt).
If we add in the Citibank bailout announced in November 2008, the total cost to the American taxpayer of the bailout now exceeds $4.6165 trillion dollars! The only event in American history that comes even close to matching the cost of the banking crisis so far is World War II: Original Cost: $288 billion, Inflation Adjusted Cost: $3.6 trillion. It is hard to believe, but true, that the US bailout has cost more than the inflation adjusted cost of the Louisiana Purchase, the New Deal and the Marshall Plan, the Korean and Vietnam War, the S&L debacle, NASA and the Race to the Moon combined! The $4.6165 trillion dollars committed by November 25, 2008 is about a trillion dollars ($979 billion dollars) greater than the entire cost of World War II borne by the United States: $3.6 trillion, adjusted for inflation (original cost was $288 billion).
Governments, the world over, have just bled themselves dry to a totally unprecedented extent, just to save the banking system — to the point that the Financial Times even wonders whether the worldwide panic in the stock markets in October 2008 “is not about faith in the banks, but faith in the governments to save them.”
This begs the question: What happens when the costs for rescuing the bank system become unbearable? Governments learned in the 1930s that they can’t afford to let the banking system go under, as this brings down the entire economic system. What they may learn in our times is that they can’t afford to save the banking system.
III. Re-Regulation of the Financial Sector
The first strategy, re-regulating the financial sector, will predictably be on everybody’s political agenda, particularly for a new administration in the US. The debate about how and what to regulate will be intense. History shows, however, that we have engaged in the same cat and mouse game between regulators and banks for several centuries, since the beginning of handing the money issuance function to the private banking system. To be precise, while such re- regulation may avoid the repetition of the identical traps and abuses next time, over time, new loopholes will be discovered or created, resulting in a new variation of the same type of banking crisis.
Some re-regulation is, at this point, politically unavoidable, and we concur with the general consensus that it is also necessary. It will be clearly shown below, however, why this solution will, at best, only reduce the frequency of such crashes, not avoid their repetition. Furthermore, stricter regulation may also lengthen the period necessary for banks to improve their balance sheets, which will simply deepen and prolong the “Second Wave” problem.
IV. Conventional Solutions: Nationalizations
There are two conventional ways for governments to prop up the banks balance sheets, both involving a form of nationalization. The first is nationalizing what Ben Bernanke called in his presentation to the US Congress the banking system’s “toxic assets.” The second is nationalizing the banks themselves. Let’s briefly explore the advantages and disadvantages of both.
A. Nationalizing the Toxic Assets
This solution is invariably preferred by the banks themselves. It consists of either the government (in the initial Paulson bailout plan, for example, it is the U.S. Treasury Department) or a specially created institution funded by the government buying assets from the banks that they now want to jettison. Of course, determining the price at which these assets are purchased is a very tricky issue, particularly when a liquid market for such assets has dried up completely, as is the case now. If the government buys the assets at too high a price, it will be seen as a straightforward subsidy for previous bad behavior, and accentuate the “moral hazard” problem (defined below), something that is politically unpalatable. On the other hand, if the government buys the assets at too low a price, it doesn’t really replenish the banks’ balance sheet.
Buying the toxic assets clearly doesn’t convince everybody as an appropriate remedy. It is also by far the most expensive solution, because it doesn’t take advantage of the leveraging factor available in the banking system. Consequently, the injection of money by the government as capital directly to the banks is a lot more effective financially.
B. Nationalizing the Banks
The second way to buttress the banks is by governments providing capital directly to banks themselves, either by buying stocks, or by acquiring a newly issued preferred stock. For example, this is what Warren Buffet did for Goldman Sachs in September 2008 in the US: He injected $5 billion in the form of preferred stock that would give him not only 7% of the capital, but also a guaranteed 10% dividend forever.
In Europe, governments have typically taken the bank-nationalization road, although with less demanding terms than what Warren Buffet obtained. Nationalizing the banks was the option taken for instance in Sweden in 1992, and in 2008, first for Northern Rock in the UK, and then for a wide range of banks in all countries by mid-October 2008.
There are two advantages in this approach compared to the previous one of nationalizing the toxic assets. First, thanks to the fractional banking system by which all money is created, when banks make loans to customers, they can create new money at a multiplier of the amount of capital they actually have. Consequently, if a bank’s “leveraging factor” is 10, then injecting $1 billion in the bank’s capital makes it possible for it to create at least $10 billion in new money, or carry $10 billion in problem assets. In fact, the multiplier is typically much higher. For instance, Lehman’s and Goldman Sachs’ ratio of assets to capital were respectively 30 and 26, before they both disappeared. Some European banks had even a higher leverage: BNP Parisbas at 32; Dexia and Barclays’ leverage ratios are both estimated at about 40; UBS’ at 47; and Deutsche Bank’s a whopping 83.17. Therefore, very conservatively put, it is 10 times more financially effective for governments to bolster the balance sheets of the banks directly than to buy toxic assets.
The second advantage to buying bank shares instead of toxic assets is that there is generally a market which indicates some relative value between different banks. In contrast, when the market for toxic assets has dried up, there is no such indication, and the decisions can be quite arbitrary.
The banks themselves, of course, prefer to avoid the dilution of bank equity and control that this approach implies. Politically, nationalizing the banks also sounds like the “socialization” of the economy, since the former communist states nationalized their banks. This ideological taint may explain why this approach was not initially considered in Washington.
Yet, we must also not underestimate some of the unmentioned additional risks of the crisis. The cost of bailing out the world’s financial system will unquestionably significantly increase most governmental debt, which somehow will have to be financed from somewhere. For instance, today, the US’ biggest financiers — China, Russia and the Gulf states — are rivals to the US, not allies. At this point all are condemned to cooperate to some extent, in order to reduce the effects on their own economies, but such “forced” cooperation is a highly unstable one. The question is: What will happen to already shaky national currencies during such wrangling, including several developing countries’ and Eastern European ones, not to mention the dollar itself?
C. Unresolved Problems
The first objection to nationalizing banks or their toxic assets is the well known “moral hazard” problem. If banks know that they will be saved when in trouble, they may be tempted to take higher risks than otherwise would be prudent. When these risks pay off, the profits are held privately and translated into generous dividends for the banks’ shareholders and extraordinary bonuses to management. But when they fail, the losses end up being absorbed by the taxpayers. The current salvage programs confirm that this problem hasn’t gone away and is unavoidably further strengthened by new bailouts. Christine Lagarde, Minister of the Economy, Industry and Employment in the current Sarkozy government in France, stated “Moral hazard has to be dealt with later… Maintaining the functioning of our markets is the top priority.” This is exactly the argument that pops up at every systemic crisis…
Secondly, even if both strategies — bailing out the banks and re-regulation of the financial sector — are implemented reasonably well, neither resolves the “Second Wave” problem: The banking system will get caught in a vicious circle of credit contraction that invariably accompanies the massive de-leveraging that will be needed. Depending on how the re-regulation is implemented, it may actually inhibit banks from providing the finances needed for a reasonably fast recovery of the real economy. In any case, given the size of the losses to be recovered, it will take many years, in the order of a decade, certainly more than enough time to bring the real economy into real trouble.
In practice, this means we are only at the beginning of a long, drawn-out economic unraveling. The social and political implications for such a scenario are hard to fathom. The last time we faced a problem of this size and scope was in the 1930’s, and that event resulted in social and economic problems that ended up manifesting violently in a wave of fascism and ultimately World War II. Still, there are important differences vis-à-vis the situation of the 1930s. So far, the situation is less extreme economically, in unemployment and business bankruptcies, than what happened in the 1930s. On the other hand, governments are now a lot more indebted than was the case at the beginning of the Great Depression, and today’s crisis is a lot more global than was the case then.
More important still, a financial/banking issue isn’t the only one we have to deal with. It happens to coincide with several major global challenges, by now generally accepted: climate change and mass species extinction, the increase of structural unemployment, and the financial consequences of unprecedented aging in our societies. In some respects, therefore, today’s crisis is less dramatic, and in others far worse than what our previous generation had to face.
D. Nationalizing the Money Creation Process
Nationalizing the money creation process itself is an old proposal, if much less conventional approach, that reappears periodically in the “monetary reform” literature, particularly during periods of major banking crises, such as the one we are facing now. For historical reasons, the right to create money was transferred to the banking system as a privilege, originally to finance wars during the 17th century. So, contrary to what some people believe, our money isn’t created by the governments or the central banks, it is created as bank debt. When banks are private, as they are in most of the world, the creation of money is therefore a private business. If the banking system abuses this prerogative, this privilege could or should be withdrawn. The logic is not new: money is a public good, and the right of issuing legal tender belongs at least theoretically to governments.
So, while bailing out the banking system through nationalizing banks or nationalizing the problem assets is the classical policy choice, it can also be expected that proposals for nationalizing the money creation process itself will reemerge, as they have in previous predicaments, including the 1930s. Under a government run monetary system, the governments would simply spend money into existence without incurring interest at its creation; banks would become only brokers of money they have on deposit, not creators of money, as is the case now.
This would definitely make systemic banking crises a problem of the past. It would also make it possible to re-launch the economy through a large-scale Keynesian stimulus at a much lower cost to the taxpayers, given that the money thus created wouldn’t require interest payments to be reimbursed in the future.
One objection to a government managing the monetary system is that governments may abuse this power, issue more money than is appropriate, and thereby create inflation. That argument is valid. However, given that the current method of creating money through bank-debt has made the 20th century one of the highest inflationary centuries on the historical record, inflation is obviously not a problem specific to the process of money issuance by governments. Furthermore, there is no reason that Milton Friedman’s proposal for the issuance of money by the central banks couldn’t be applied to governments as well: put in place a rule that obliges the issuing body to increase spending by no more than a fixed 2% per year, reflecting the improvements of productivity in the economy.
The most important reason that this solution is unlikely to be implemented is that it will be doggedly resisted by the banking system itself. The financial system has always been and remains today a powerful lobby, and losing the right to create money would hit them at the core of their current business model.
Our own objection to this solution is that, even if governments were to issue the money, while that might protect us from banking crises, it would nevertheless not solve the core systemic problem of the instability of our money system. In short, it might protect us from banking crises, but not from monetary crises.
Image by alles-schlumpf, courtesy of Creative Commons license.