No Way to Run an Economy: Why the System Failed and How to Put it Right available in Hardcover
- Pub. Date:
- Pluto Press
Graham Turner is one of the few economists who predicted the world financial crisis. His new book, No Way to Run an Economy, explains why the world remains mired in economic crisis and claims the Obama administration has failed to stem the slide into deep recession.
Turner recommended aggressive measures, such as quantitative easing, in early 2008. But the action that has been taken has been too little, too late. He dissects policy errors including Obama's doomed market-led response to the crisis and the obsession of central banks with the red herring of inflation.
Ultimately, Turner argues, the mistakes are the fault of a flawed economic system.
|Product dimensions:||5.50(w) x 8.60(h) x 0.70(d)|
About the Author
Read an Excerpt
FROM BEAR STEARNS TO RECESSION
'Time is running out for the Federal Reserve' was the blunt assessment in early April 2008 as The Credit Crunch went to print. Borrowing costs, in particular mortgage rates, had to be targeted and driven lower, through a mixture of deep rate cuts and quantitative easing. Otherwise, more banks would fail and depression could follow recession. Delay would prove costly.
Governments and central banks had to act quickly to prevent debt deflation from taking root. But after a bankrupt Bear Stearns had been sold to JP Morgan in March 2008, policymakers and politicians sat back. They did little to arrest the downward spiral in house prices and the inevitable slide into deep recession. Bear Stearns was a one-off, they thought. They switched tack, fretting about inflation when the real threat was the Japanese curse of falling prices and multiple banking failures.
That was hard to square with the evidence. By the time the US had lost the first of its five major investment banks, 238 mortgage companies had already gone out of business. More banks were certain to fail if the Federal Reserve did not try to stabilise the property market. Bad debts would continue to accumulate causing shareholders to flee banks and sparking depositor runs.
Federal Reserve Chair Ben Bernanke has since claimed that the Federal Reserve 'responded aggressively to the crisis since its emergence in the summer of 2007'. The policy response was 'exceptionally rapid and proactive' in historical comparison, he has argued.
The Fed had allowed money supply to contract during 1930 and 1931, amplifying the initial fallout of the stock market crash a year earlier and turning a recession into depression. The contrast with the supposedly more proactive policy adopted from the summer of 2007 onwards showed the Fed had learnt the lessons that would prevent another economic slump.
In reality, Ben Bernanke's Fed made precisely the same mistakes that fuelled the Great Depression. Huge numbers of banks defaulted a year after the stock market crash in 1929, notably in Missouri, Indiana, Illinois, Iowa, Arkansas and North Carolina. In November 1930, 256 banks failed and a month later another 352 banks collapsed, including the Bank of United States. Very little was done to prevent their demise.
The decline in money supply was driven by the loss of these banks. As they failed, credit suddenly became scarce and the decline in asset prices accelerated. More banks collapsed and the economy spiralled deeper into recession.
In this critical respect, the latter months of 2006 and early 2007 were no different from 1930 or 1931. The implosion of so many mortgage originators from 2006 onwards similarly accelerated the decline in the availability of credit. The failure of the Federal Reserve to act when these lenders collapsed turned what might have been a soft landing into a crash.
Indeed, it is perhaps notable that Ben Bernanke claims the summer of 2007 marks the starting point of the crisis. For many financial market participants the crisis began in February 2007 following profit warnings in the US from HSBC and New Century Financial. For huge numbers of US homeowners struggling to meet debt repayments, the problems started two years before that. Indeed, sub-prime borrowers were in trouble even before interest rates started to rise during 2004.
Federal Reserve data should have alerted the US authorities to the risks of a hard landing. At the peak of the boom in Q3 2005, $631.5 billion of new mortgage-backed bonds were issued to fund the lending frenzy. Throughout 2006, the pace of issuance dropped progressively. By the third quarter of 2006, it had already fallen by nearly a fifth. As mortgage originators started to fold, issuance fell sharply in the final quarter, by just over a third from a year earlier. And it carried on sliding during the first half of 2007.
By the third quarter of 2007, the disappearance of so many lenders, combined with a reluctance of investors to buy mortgage bonds, had caused issuance to collapse to minus $232.4 billion (see Figure 1.1). Mortgage funding from these bonds – a critical driver of the housing boom – had not just slowed. It was contracting.
This was a stunning reversal and without precedent in modern times. It represented a shrinkage and collapse of money supply similar to that seen in the first year of the Great Depression. History was repeating itself.
The Inflation 'Crisis'
The Federal Reserve governors of 1930 and 1931 were also unwilling to support the banks. They tended to view bank failures as 'regrettable consequences of bad management and bad banking practices'. They were also 'beholden' to the Gold Standard because it was considered to be the ultimate bulwark against inflation.
The Fed of 2007 and 2008 overestimated the inflation risks too, with tragic consequences for millions who would lose their jobs and homes. The Fed was not alone. The Bank of England and the European Central Bank also failed to comprehend the true threat facing the world economy.
Superficially, it did appear as if the policymakers had a point. By March 2008, inflation had risen to 4.0 per cent in the US, 2.4 per cent in the UK and 3.5 per cent in Euroland. Oil and food prices were soaring. Over the summer, inflation would climb to a high of 5.6 per cent in the US. It would more than double in the UK, rising to 5.2 per cent by September. And in Euroland, it would accelerate to more than twice the European Central Bank's target, jumping to 4.1 per cent by July.
The debate over runaway commodity prices was polarised. Some saw this as a manifestation of loose monetary policies in the West and particularly emerging market economies. Central banks in the West would have to hike interest rates further, it was claimed, to compensate for the unwillingness of policymakers to tame a surge in inflation across emerging market economies. Across Eastern Europe, Asia, Latin America, the Middle East and Africa, inflation was accelerating, climbing well into double digits in many countries.
Some economists highlighted the specific supply problems that had contributed to big cost increases. Peak Oil, the growth of biofuels and climate change were held responsible for the surge in energy and food costs. However, metals and other non-food and energy commodity prices were also rising sharply in response to strong emerging market demand.
But the longer-term or secular threat to inflation was far from clear-cut. Much of the rapid growth in emerging market demand reflected domestic credit bubbles that in many cases were more extreme than in the West. When they burst, demand for commodities would collapse taking prices down swiftly.
And so it proved. Having more than doubled in three years, base metal prices finally peaked on 5 March 2008. Oil prices reached their zenith on 11 July. As the world economy lurched towards recession, the reversal was swift and brutal. By the end of 2008, base metals had tumbled 60 per cent and oil had fallen 75 per cent. Overall, commodity prices had slumped by 61 per cent from their 2008 high (see Figure 1.2). Even with food and energy excluded, they had still dropped 39 per cent. Furthermore, non-energy commodity prices had peaked in March before Bear Stearns failed.
Inflation proved not to be the danger portrayed by many. It did rise in the first half of 2008. But this never marked a shift to the inflationary spiral that bedevilled the 1970s or 1980s.
Central banks – and many politicians for that matter – massively overstated the inflation threat. Employers were unwilling to raise wage rates in line with the acceleration in consumer prices. Many companies still had the upper hand, and the choice was simple: higher wages would mean more jobs would be lost to overseas. Today's globalised economy had irrevocably altered the inflation dynamics.
As a result, incomes fell sharply in real terms. There were no 'second-round effects' typical of the 1970s and 1980s. High levels of borrowing also limited the ability of workers to absorb cost shocks, such as surging oil prices and utility bills. Debt was the new slavery.
Through the summer of 2008, central bankers inveighed against the threat of higher wages, arguing that their priority was to bring inflation back under control. Only that would underpin financial stability, they claimed. After being lambasted for allowing credit growth to spin out of control during the boom, central banks belatedly relished the opportunity to act tough, resisting pleas to do more to arrest the housing slumps. They were following their mandate, and in the long run, the public would thank them for not deviating from their goal. Soon after the Bear Stearns collapse, interest rate hikes were back on the agenda.
But as the months rolled by, wage settlements and pay rates barely shifted. Policymakers had switched their focus to fight a phoney war, with catastrophic consequences for the housing market, financial stability and the real economy.
The dogmatism of central banks was aided and abetted by a political class that saw fighting inflation as the key to the economic boom. They could not – or preferred not to – see that it was unrestrained credit growth, housing bubbles and out of control banks that had driven the long upswing. They were wedded to a broken and out-of-date ideology. Cost cutting, deregulation and the growth of free trade had been the cornerstones of economic policy throughout the West. And yet, these very policies had led ineluctably to rapid credit growth, which in turn, nullified the threat of inflation becoming embedded.
The risks were clearly asymmetric. Oil prices might have been soaring, but eventually they would stop rising. Even if the world was running short of supplies, oil prices would eventually reach an equilibrium. Once they had levelled out, the lack of response from wages implied inflation would then fall quickly.
By overreacting to the rise in commodity prices, central banks accelerated the collapse into deep recession. Through their misjudgement or ideological dogmatism, they amplified the slide into deflation. The slump in commodity prices, when it arrived, would prove precipitous because demand was crushed by an inappropriate monetary policy. Even if the Peak Oil theory was right, the fall in demand would be so great that tight supplies at some point would prove irrelevant. And that moment would arrive even sooner than many expected.
Many warnings were ignored. Core inflation, which excludes food and energy, moved higher in the US and UK, but the rise was limited. It peaked in 2008 at 2.5 per cent in the US and just 2.2 per cent in the UK. In the early 1980s, core inflation and RPIX hit highs of 13.6 per cent and 20.8 per cent respectively. In the early 1990s, it peaked at 5.6 per cent and 9.5 per cent respectively.
There was even less excuse for the policy blunders committed by the European Central Bank. Core inflation peaked at just 2.0 per cent in March 2008. The rise in inflation above the 2.0 per cent target was exclusively due to oil and food prices.
Furthermore, there were some elements of core inflation that were palpably affected by higher oil prices. They would stop rising as soon as oil prices levelled out. Airfares were a case in point. This had significant impact on core inflation, but airfares soon went into reverse as oil prices tumbled.
There was considerable anecdotal evidence to suggest higher commodity prices were not inflationary too. Discount retailers were experiencing a boom. In the UK, cost-cutting supermarkets Aldi and Lidl were notable beneficiaries of an underlying price squeeze. Suffering deep wage cuts, many workers were trading down, substituting and switching to cheaper alternatives. High-value stores, such as Marks & Spencer, suffered a disproportionate decline in sales. Other retailers reported a sudden rise in price-conscious shoppers, buying cheaper and, of course, less healthy brands. And the trend accelerated in the early months of 2008. Business was booming at 'run-down stores' and street markets were enjoying a resurgence. With unemployment rising, hard-pressed consumers were turning their backs on mainstream stores.
The severe pressure on retailers was self-evident from the official data. The Office for National Statistics in the UK publishes an alternative measure of inflation – the retail sales deflator. The retail sales deflator is a measure of price changes based on a changing basket of goods. By contrast, the Consumer Price Index (CPI) assumes shopping habits remain static every year. As a result, the deflators are more subtle. They had, for example, provided an early indication that inflation risks were beginning to subside in the West during the mid-1990s.
As headline inflation accelerated in the UK from the spring onwards, the retail sales deflator flashed a warning. It remained stubbornly in negative territory until May 2008, and then rose to a high of just 2.1 per cent y/y three months later, before turning down again (see Figure 1.5). It was difficult to see how this could be construed as an inflation threat. In the early 1980s, the deflator had peaked at 16.5 per cent y/y. In the early 1990s it reached a high of 6.5 per cent y/y.
Hard-pressed, cash-strapped shoppers weighed down by record debt levels and squeezed by falling real wages, were unable to afford the price increases reflected in the official CPI. Decomposing the retail sales deflator provided an insight into the impact of the credit squeeze on retailers and consumers. The CPI suggested that food prices were rising at an annual rate of 14.5 per cent by August 2008. By contrast, the retail sales deflator for food showed that once this switching to cheaper alternatives had been taken into account, the annual increase was much lower – just 6.7 per cent (see Figure 1.6). The same was true for non-food stores, where consumer resistance caused prices to fall by an average of 3.1 per cent y/y between January and August 2008 (see Figure 1.7). That compared with a drop of 1.4 per cent y/y on the comparable CPI measure.
Bank of England Misjudges
None of this registered with the Bank of England. Its August 2008 inflation bulletin was littered with warnings. In the 52-page report released just weeks before the financial system went into meltdown, import inflation was cited 22 times, food prices 32 times, oil 32 times, while energy prices were referenced on 40 separate occasions. The retail sales deflator was not mentioned once. The implicit squeeze on shoppers in response to falling real wages was discussed only briefly. Instead, the possibility that an increase in inflation expectations would feed through to higher wages was the predominant risk.
Indeed, the Bank argued that real wages had to shrink otherwise there would be a more pronounced rise in unemployment. Falling real wages were the price workers had to pay to hold on to their jobs. That unemployment would soar anyway because interest rates had been left too high for too long, was beyond the Bank's comprehension.
Along with so many others, Bank of England officials were oblivious to the realities of life for hard-pressed workers, and missed the true impact of globalisation on inflation. The one exception was Professor David Blanchflower, an expert in the labour market. He had been consistently warning of a sharp rise in unemployment, urging fellow members of the Monetary Policy Committee to cut interest rates. For much of 2008, his pleas went unanswered. For nine consecutive meetings between January and September, Mr Blanchflower dissented, urging rate cuts or voting for bigger reductions.
By contrast, one Monetary Policy Committee member voted twice for rate hikes over the summer of 2008. Timothy Besley invoked the US detective programme Starsky and Hutch and the film Saturday Night Fever, as he hyped the perils of a return to the 1970s. Writing in the down-market Sun newspaper on 19 August 2008 – days before the credit crunch erupted for the fourth time – the London School of Economics professor claimed the pain from keeping interest rates high would be worthwhile. It would provide 'the best basis for the economy to grow, create jobs and allow living standards to rise' and he warned workers not to 'chase inflationary wage increases'.
Andrew Sentance had been head of economic policy at the Confederation of British Industry before joining the Bank of England's Monetary Policy Committee. It was not difficult to imagine where his sympathies lay. He had been reluctant to cut rates earlier in the year, siding with Timothy Besley following the collapse of Bear Stearns, arguing for rates to be left on hold, when the rest of the Monetary Policy Committee could see the need for action. Even after the collapse of Lehman Brothers, he was urging fellow Monetary Policy Committee members to 'stick to basics' and focus on the inflation target, while fretting over a 'wage-price spiral'.
Excerpted from "No Way to Run an Economy"
Copyright © 2009 Graham Turner.
Excerpted by permission of Pluto Press.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.
Table of Contents
List of Tables and Figures, vi,
GFC Economics, xiii,
1 From Bear Stearns to Recession, 12,
2 Learning from the Great Depression, 43,
3 Policy Mistakes in the 2008/09 Bear Market, 63,
4 Globalisation and the Race to the Bottom, 97,
5 Structural Causes of the Recession, 112,
6 A Flawed Economic System?, 140,
7 Obama's Crisis?, 148,
8 Breaking with the Past, 163,