April 09, 2008

Made your plans for the upcoming financial Armageddon yet? Betting upon a second Great Depression, or are you like me and thinking that yes, we’ve got some tough times coming, but the only people that can create disaster are the politicians? Sadly, that last isn’t quite as comforting as it could be for it was the politicians and bank regulation itself that created the first depression: as long as we don’t make the same mistakes again (or newer and even more inventive ones) the disaster, although perhaps not a recession, can be avoided.

Perhaps the most encouraging sign that we won’t make the same mistakes is who we actually have at the top of the Fed these days: Ben Bernanke made his academic bones studying the causes of the Great Depression so he’s as aware of what was done wrong as anyone else … more so in fact. Yes, there is even now a great deal of argument about this but Bernanke and those most closely involved in studying what went wrong (as opposed to those who want to claim that FDR got it right in his solutions, which is a very different political ball game) generally point to the following sequence of events. Yes, irrational exuberance in the 20s, then the Great Crash, then recession. So far, so very like our own times. But what took it from a crash to a depression, that’s the part we want to know, so that we can avoid doing that.

Two things figure high on the list of suspects: first the system of banking and banking regulation, secondly the fall in trade as a result of the Smoot Hawley tariffs. Now it’s pretty usual at this point for someone like me, a classically liberal free trader, to place the majority of the blame upon those tariffs the imposition of retaliatory tariffs by other countries and the general clogging up of the world trade system. But I’m not sure that this argument holds all that much water: international trade as a percentage of the economy wasn’t all that high to begin with, certainly nowhere near today’s levels. I don’t think tariffs were the real problem. No, I think the blame should be on three things. The first is that the Fed refused to cut interest rates. The second was a large tax rise so as to cut the budget deficit (alarming as it may seem, Keynes was right in part, deficit spending does mitigate recessions, it’s the cutting of the spending in the good times that governments have so much problem with). The third was the then extant system of bank regulation.

U.S. banking then was based on the single branch model: banks did not have widely diversified portfolios of risks, either geographically or by industry sector. Rather, all of their exposure was concentrated in the immediate hinterlands of their one deposit taking branch. This led to a certain fragility: it’s worth noting that in Canada no banks went bust, while 8,000 did in the US. Canadian banks were allowed to operate countrywide, thus providing them with that diversification. It’s that mass bankruptcy of banks which turned the shrinking of the credit markets into a rout.

Which brings us back to today: we see people arguing for some of the same things, but let’s try not to make those same mistakes again, shall we? The first and most obvious is that we should ignore those siren calls for tax hikes, whether they’re from deficit hawks or from those insistent that “€œthe rich”€ should pay more. No, in an economy with contracting credit deficit spending is a rather good idea. Bernanke and his boys are most certainly not leaving interest rates too high, so that’s one thing we don’t need to worry about. Which leaves us, domestically, with just one thing”€”bank regulation.

I’ve spotted one or two calls here and there for the reinstatement of Glass-Steagall, that rigid division between commercial and investment banking which was only relaxed in recent decades. This fails, I think, on two grounds. The first in that it’s a marvellous example of stable door bolting. Yes, we do have successive financial crises, that’s in the nature of a market system that people will try new things and some of them will be stupid (making a loss is the market’s way of telling you that you are indeed doing something stupid), but they’re not all caused by the same things. Limits upon the mortgage markets and syndication are simply unneccessary: no one is going to make that mistake again, as they’re not going to overinvest in telecoms companies with “€œinteresting”€ accounting techniques, nor internet stocks, nor emerging nations, to give just a flavor of what has caused previous problems. Lessons learned at the cost of hundreds of billions of dollars tend to stay learned.

The second revolves around that very diversification which we would rather like banks to get themselves involved in. Christian Noyer, the governor of the French Central Bank (in reality, he’s the provincial manager of the French branch of the European Central Bank) makes the point that the sub-prime crisis isn’t going to topple European banks precisely because “€œtheir model of universal banking allows them to mitigate the consequences of a crisis in one segment of their activity.”€œ UBS may have been hit with vastly larger losses than Bear Sterns, but it didn’t go bust because it has other business lines and resources to draw upon.

At this point, talking about diversification and the ability to handle losses, this is where globalisation and tariffs come in again. Some interesting research from the Cato Institute has shown that as the U.S. economy has become more open to trade over recent decades, as international trade has become a greater precentage of the economy, so there have been fewer recessions and those that have occured have been both shorter and shallower. The underlying cause is, I think, that the more the global economy is integrated then the more of that wonderful diversification there is.

Think of it this way (as Adam Smith pointed out in a slightly different context, “€œWhat is prudence in the conduct of every private family can scarce be folly in that of a great kingdom.”€) we can quite easily produce a depression in a one income household: an extra beer after the company softball game and an incautious word about (or even to) the boss’s wife can cause a catastophic drop in income. For a two income unit there is more diversification, for a city like Detroit to enter a decline you need both the local industry to collapse and a level of boneheadedness remarkable even by the already low standards of municipal governance. And as the economic unit gets larger and larger, the shock required to create a recession, let alone a depression, gets that much larger too, if not larger at a faster rate.

It’s at this point that I do start to worry about what the politicians might do to us. Yes, there are the usual Democratic primary campaign twitters about how awful trade is but then this is simply expected. There’s also the Lou Dobbs/Pat Buchanan wing of economic populism, but neither of those two strands are strong enough to overturn the recent decades of globalisation. I do think it’s a sadness that the economics profession hasn’t managed to get over the central insight (once described as the only non-obvious and non-trivial result in all of the social sciences) of the entire field of study: it’s the imports that make us rich, exports are only the drudgery we do to pay for them. But that point, while true, is not widely understood but widely enough that the opposition to trade isn’t likely to win.

Unless, that is, the green movement gets any stronger. Now there’s many strands to it, not all who want to conserve nature are aged hippies worhipping Gaia. It’s also true that there are differing views on whether global warming is happening or not and whether it’s a major and immediate problem if it is. But what is undeniable is that there’s great political agitation to do something: sadly, to the extent that people are suggesting almost anything, some of them hugely counter-productive.

The latest suggestion is that those countries which do not adopt the “€œcorrect”€ carbon-denying ordinances should have import tariffs imposed upon their products. We would thus see a reduction in trade, and an unravelling of globalisation: and if the above is correct, thus make ourselves more vulnerable to both having recessions and those that do occur being worse and of greater length. Further, given the way in which we all are so dependent upon international trade, those that we do have could deepen into depressions, as some still insist Smoot Hawley aided last time around.

One final point though about the entire idea of credit syndication, the CDOs and the rest. The aim was, at least was said to be, that by bundling mortgages together and then selling of tranches of the pool, thus risk would be spread. That it hasn’t worked out quite like the plans is true, that we aren’t quite where we might have wanted to be. But have a look at who has actually lost money out of the process. Yes, there’s Citibank, Bear Sterns of course. But UBS, a Swiss bank? IKB and WestLB, German ones? Soc Gen, a French one? Barclays, of the UK?

Well, whatever else you want to say about the whole process, it certainly did spread the risk, didn’t it?

Tim Worstall is a businessman dealing with the rare earth metals, a freelance writer, and a Fellow of the Adam Smith Institute..


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