108. Debt, The First 5,000 Years

Note: This post is the one hundred and eighth in a series about government and commercial ethics. Click here for the full listing of the series. The first post in the series has more detail on the book 'Systems of Survival' by Jane Jacobs which inspired this series.

Well, that was a slightly longer break than I planned, and I can't really promise a return to regular posting, but at any rate, this week's topic is the book, "Debt: The First 5,000 Years' by David Graeber. I was expecting this book to be interesting, but not too relevant to this series of posts, but I was quite wrong about that, as Graeber spends as much or more time talking about ethics as he does talking about money and debt (generally he talks about the two topics together).

In fact, Graeber argues that our current society is so dominated by the morality and logic of exchange that we don't can't even talk about morality without using the language of exchange.

One drawback of the book is that it is not particularly orderly, with Graeber wandering from topic to topic without offering much in the way of summaries or argument structure - so this post will likely suffer from the same deficiencies.

Early on (page 29), Graeber makes the point that barter is a form of economic transaction that is used between strangers and/or enemies, not amongst people who know each other well who would typically either share or use gifts instead of bargaining and negotiating to decide who gets what.  Later (page 68), Graeber notes that a commercial transaction (exchange) imply both separation and equality. On page 81, Graeber characterizes the 20th century as a situation where,

"on one side is the logic of the market, where we like to imagine we all start out as individuals who don't owe each other anything. On the other side is the logic of the state, where we all being with a debt we can never truly pay. We are constantly told that they are opposites, and that between them they contain the only real human possibilities. But it's a false dichotomy. States created markets. Markets require states. Neither could continue without the other, at least, in anything like the forms we would recognize today."

In the fifth chapter of the book, 'The Moral Grounds of Economic Relations, Graeber talks about the different moral systems we have for regulating economic activity,

"Anthropology has shown just how different and numerous are the ways in which humans have been known to organize themselves. But it also reveals some remarkable commonalities - fundamental moral principles that appear to exist everywhere, and that will always tend to be invoked, wherever people transfer objects back and forth or argue about what other people owe them.

One of the reasons that human life is so complicated, in turn, is because many of these principles contradict one another. ... The moral logic of exchange, and hence of debt, is only one; in any given situation, there are likely to be completely different principles that could be brought to bear. ...moral thought is founded on this very tension."

Graeber continues on to argue that we have 3 different ways of relating to each other, and that exchange is just one of these three ways.  The other two ways described by Graeber are Communism and Hierarchy.


Graeber describes communism as the 'default' mode of interaction, in which, for example, if two people are working on a car and one asks the other to hand him a wrench, the other person won't ask what they are getting in return. Graeber notes that even in clearly commercial contexts, such as a local store, there is a tendency towards a communistic approach in which what people are expected to pay depends on their means. He notes that this is why shopkeepers in poor neighbourhoods are almost always from a non-local ethnic group. Someone local would face too much pressure to cut prices for their poor customers who are also their neighbours.

After communism, Graeber discuss exchange, noting that , "what marks commercial exchange is that it's 'impersonal.'" Graeber notes that commercial relations are impermanent and can be broken off at any time, and whether in a bargaining session where both parties are trying to pay each other as little as possible or in a gift-exchange where both parties are trying to outdo one another in generosity, people feel a need to maintain equality. 

Next, Graeber describes hierarchy as a system where adherence to custom and tradition is the primary virtue and this appeal to custom is used to justify the use of force in maintaining a hierarchical social structure. The pattern of custom also takes precedence over any notion of reciprocity, "If you give some coins to a panhandler,  and that panhandler recognizes you later, it is unlikely that he will give you any money - but he well consider you more likely to give him money again."

"This is what I mean when I say that hierarchy operates by a principle that is the very opposite of reciprocity. Whenever the lines of superiority and inferiority are clearly drawn and accepted by all parties as the framework of a relationship, and relations are sufficiently ongoing that we are no longer simply dealing with arbitrary force, then relations will be seen as being regulated by a web of habit or customer."

After describing the three different modes, Graeber notes that these modes always co-exist, "We are all communists with our closest friends and feudal lords when dealing with small children."

----

Later, Graeber devotes a chapter to the slippery concept of 'Honour'.  Jane Jacobs classified 'Treasure Honour' as a guardian virtue in 'Systems of Survival' but Graeber sees two sides to honour, "to this day, 'honour' has two contradictory meanings. On the one hand we can speak of honour as simple integrity. Decent people honour their commitments ... to be an honourable man meant to be one who speaks the truth, obeys the law, keeps his promises, is fair and conscientious in commercial dealings ... [but] honour simultaneously meant something else, which had everything to do with ...violence"

Although Graeber sees honour as existing in both a commercial and a guardian sense, he repeatedly notes how violent (guardian-minded)  men are particularly obsessed with honour.

Graeber describes an Irish system of honour in which "one's honour was the esteem one had in the eyes of others, one's honesty integrity and character, but also one's power, in the sense of the ability to protect oneseld, and one's family and followers, from any sort of degradation or insult." This system was strictly hierarchical with greater honour assigned to people of higher rank.

In a key passage, Graeber notes the Irish system seems strange because they precisely quantified the 'price' of honour (it took 21 cows to pay for insulting the king's honour, fewer if you insulted someone of lower rank).

"What makes Medieval Irish laws seem so peculiar from our perspective is that their exponents had not the slightest discomfort with putting an exact monetary price on human dignity. For us, the notion that the sanctity of a priest or the majesty of a king could be held equivalent to a million fried eggs or a hundred thousand haircuts is simply bizarre. These are precisely the things that ought to be considered beyond all possibility of quantification. If Medieval Irish juries felt otherwise, it was because people at that time did not use money to buy eggs or haircuts. It was the fact that it was still a human economy, in which money was used for social purposes, that it was possible to create such an intricate system whereby it was possible not just to mesaure but to add and subtract specific quantities of human dignity - and in doing so, provide us with a unique window into the true nature of honour itself.


The obvious question is: What happens to such an economy when people do begin to use the same money used to measure measure dignity to buy eggs and haircuts? As the history of Mesopotamia and the Mediterranean world reveals, the result was a profound - and enduring - moral crisis."

Further on (page 260), Graeber notes the historical success of China resulting from maintaining a clear line of separation between the hierarchical and commercial spheres,

"In Confucian terms, merchants were like soldiers. Those drawn to a career in the military were assumed to be largely driven by a love of violence. As individuals, they were not good people; but they were also necessary to defend the frontiers. Similarly, merchants were driven by greed and basically immoral; yet if kept under careful administrative supervision, they could be made to serve the public good. Whatever one might think of the principles, the results are hard to deny. For most of its history, China maintained the highest standard of living in the world - even England only really overtook it in perhaps the 1820's"

For the thesis of Jane Jacob's 'Systems of Survival', the most challenging aspect of "Debt: The First 5,000 Years" is that Graeber sees medieval/enlightenment Europe as a place where there was a lot of mixing of Commercial and Guardian roles (on page 346 he refers to the 'familiar but particularly European entanglement of war and commerce"), which according to Jane Jacobs, should lead only to corruption and suffering, but instead, as Graeber notes, the countries of medieval Europe eventually attained the world's highest standards of living. Graeber dwells on the negatives caused by this mixture, the slave trade and all the ills of colonialism, but the fact remains that it was Europe that developed the means to impose their will on the rest of the world through the development of new technology and social forms of organization.

Leaving this challenge aside for now, the main thrust of Graeber's work seems to be the harm caused by the notion of debt when it crosses the boundaries of moral systems. If a commercial debt is just a commercial debt, then if a business venture fails, you declare bankruptcy and move on. If a debt is non-commercial in nature, then it is governed by human relations that take into account the relative status and ability to pay of the people involved. When commercial debts become treated as debts of honour, then people are forced to do anything to pay, no matter how horrific or unpleasant. For example, Graeber describes the depredations of Spanish soldiers in Central America as driven by their own need to pay debts back home.


This distinction between commercial debts and non-commercial ones is perhaps most noticeable in the sheer number of times that Graeber refers to some historical debt forgiveness scheme that was implemented for all debts except commercial debts.To take just a few examples:
Page 256, "where earlier codes had established a 15-percemt annual rate of interest, with exceptions for commercial loans..."

Page 290, "the revival of Roman law ... put new weapons in the hands of those who wished to argue that, at least in the case of commercial loans, usury laws should be relaxed"

Page 390, "It seems to me that we are long overdue for some kind of Biblical-style Jubilee: one that would affect both international debt and consumer debt"

Digging around on the internet, it seems I'm not the only person who noticed this. Here's a quote from a post by Daniel Davies at Crooked Timber:

"The argument I found myself having again and again related to this particular point – on more than one occasion during the history of debt, it was noted almost parenthetically that a particular debt reform was carried out on the basis “except commercial debts”, and I found myself saying “No! Hang on! Tell me more about these exceptions!”.

And I think this because commercial debts between merchants are a really important part of the story here.

..

In general in the commercial world, the ability to put yourself in debt is a privilege, not an obligation – one of the most important aspects of corporate legal personhood, as an introductory legal textbook will tell you, is not the right to sue other people, but the right to be sued. If you can be sued, then you can enter into agreements with other people that they have confidence that the courts will enforce.

...

Although the parallel track of debt as obligation, religion and morality has certainly been there, and is described expertly in the book, from day one it has been recognised among merchants and men of commerce that the point of the debt relation is to serve the organisation and arrangement of commercial need."

 -

Debt as per Graeber’s book is an example of this – the debt contract is basically a tool of industrial organisation that escaped from the laboratory and ran wild.

...

Having said that, there are some situations where Graeber’s analysis seems completely accurate. Countries don’t have bankruptcy codes governing them, and so in the sphere of international debt negotiations, one can see all the pernicious aspects of the “folk-economics” version of the debt contract that Graeber describes. Looking at the relationship between the European Union and Greece, or even Ireland, one can see that the debt relation is being specifically shaped into a tool for exercising power in a way which would not have been possible through democratic means.

...

...it’s a very salutary reminder of what happens when people forget that debt is really only (or really only ought to be) the legal system’s best guess at what kind of arrangements would best serve the general purposes of commerce. It is, as Graeber intimates, when the debt relation takes on an independent life of its own that the problems all start."

---
As Davies notes, aside from providing a supporting voice to the notion of economic relations being governed by Guardian or Commercial (or Communistic) values, and aside from enumerating the many ways in which societies throughout history have separated commerce from governance and violence, Graeber ultimately makes the argument that debt in particular is a human relation that needs to be carefully regulated so that we do not mistake commercial debts for moral debts.

More Krugman on Debt

Paul Krugman has posted one of his more in-depth explanations of his thoughts on debt and getting out of economic depressions.

For the most part, it is reminiscent of my final thoughts on the topic, expressed back here.

The main difference is that Krugman seems to think government borrowing can somehow trigger an eventual reduction in overall debt levels, paving the way for a more balanced economy and future growth. In my view, government borrowing only prolongs the debt party a little, but it will take either money printing or default on a significant scale to bring debt levels back down and right the economy.

More discussion of this topic over at Worthwhile Canadian Initiative

A License to Print Money 3

A little while back I expressed disappointment that Paul Krugman seemed to hold back from an obvious conclusion that printing money was the sensible course of action given the current economic predicament (weak overall demand, high private debt levels).

So it is good to see that he stuck his nose out a little further on this topic while I was away.

Says Krugman,

"In the end, I’d argue, what must happen is an effective default on a significant part of debt, one way or another. The default could be implicit, via a period of moderate inflation that reduces the real burden of debt; that’s how World War II cured the depression. Or, if not, we could see a gradual, painful process of individual defaults and bankruptcies, which ends up reducing overall debt."

It's also reassuring to see that, since I wrote this post summarizing my thoughts on the economic situation in mid-2009, the views of notable economists I respect (such as Paul Krugman) seem to be coming around much more to the view I articulated at that time - in particular that we either need to inflate or default in order to reset our debt to a much lower level. Or maybe they knew this all along and are just now becoming willing to spell it out clearly - either way, it seems like progress to me.

Non Sequitur

The Globe and Mail has one of its business section articles where it tacks a bunch of different stories onto one another...

The first story is about the housing market and starts,

"National Bank of Canada worries that the impact of rising interest rates on the residential housing sector “could be dire” in Canada. 'Though the Bank of Canada has done well to set its rate normalization process in motion, the fact remains that the stakes at play are high, with home prices and household debt at record levels relative to income,'"

The second story is about what's the mind of our finance minister and starts,

"Finance Minister Jim Flaherty says a solution to Europe's debt problem will be the top issue for the G20 summit in Toronto this month."

I hope Mr. Flaherty remembers that we have debt problems of our own...

Good News / Bad News

Paul Kedrosky links to a McKinsey report that contains some information I've been looking for for a while now.

In particular, this chart, showing total debt as a percentage of GDP for Canada (click to enlarge).



The good news is that of all the countries shown, the total debt/gdp ratio in Canada is the lowest. The bad news is that the line on the chart for Canada is going almost straight up and that when the folks at McKinsey started factoring in more qualitative factors to assess risk levels, they came up with the following chart...



... which echoes concerns recently expressed by the Bank of Canada about household debt in Canada.

Anyway, it's nice to finally have at least an estimate of the path of total debt/gsp in Canada.

33. Prosperity Gospel vs. Austerity Gospel

A bit of a digression for this holiday season post...

Mike Konczal (of the blog Rortybomb), links toa pair of articles in The Atlantic on two different religious movements that involve questions of ethics, economics and debt:

The first is an article by Megan McArdle on Dave Ramsay, who preaches his gospel of living debt-free in evangelical churches and to the secular world as well:

"On a fine summer day at the end of August, I paid $220 for front-row seats on the floor of a minor-league hockey rink in Detroit, just to hear Ramsey talk for five hours. The ostensible topic: getting your financial life in order. Afterward, my fiancé, who grew up in the Bible Belt, called me to ask what I'd thought.

'I think I just attended my first prayer meeting,' I told him.

There was, of course, a great deal of talk about money, and what to do with it. But the format was more tent revival than accounting seminar, with the first 90 minutes or so mostly devoted to Ramsey’s personal story of ruin and redemption. We heard how, during the second half of the 1980s, a young Ramsey built up a multimillion-dollar real-estate empire—then lost it all as the bank got nervous and called his loans, ultimately forcing him and his wife into bankruptcy. How, searching for help in his hour of need, he turned to the Bible and discovered Proverbs 22:7: 'The rich rule over the poor, and the borrower is slave of the lender.' At that moment, he told an audience so hushed that we could hear the ice squeak, Ramsey decided to never borrow another dollar again."

The second is an article by Hanna Rosin on 'The Prosperity Gospel'

"That Sunday, Garay was preaching a variation on his usual theme, about how prosperity and abundance unerringly find true believers. 'It doesn’t matter what country you’re from, what degree you have, or what money you have in the bank,' Garay said. 'You don’t have to say, 'God, bless my business. Bless my bank account.' The blessings will come! The blessings are looking for you! God will take care of you. God will not let you be without a house!'

Pastor Garay, 48, is short and stocky, with thick black hair combed back. In his off hours, he looks like a contented tourist, in his printed Hawaiian shirts or bright guayaberas. But he preaches with a ferocity that taps into his youth as a cocaine dealer with a knife in his back pocket. 'Fight the attack of the devil on my finances! Fight him! We declare financial blessings! Financial miracles this week, NOW NOW NOW!' he preached that Sunday. 'More work! Better work! The best finances!' Gonzales shook and paced as the pastor spoke, eventually leaving his wife and three kids in the family section to join the single men toward the front, many of whom were jumping, raising their Bibles, and weeping. On the altar sat some anointing oils, alongside the keys to the Mercedes Benz."

Reading the two articles, I was struck by how the two different approaches picked up different elements from the commercial set of ethics that Jacobs described in Systems of Survival: Ramsay emphasizes thrift, and investing for productive purposes while the prosperity gospel emphasizes optimism and the promotion of comfort and convenience. Neither one really seems quite right on its own. Ramsay's approach would cutoff prudent borrowing to fund a business venture while the prosperity gospel seems to just encourage imprudent borrowing in the belief that God will provide one way or the other.

Anyway, it's some interesting reading.

Media Illiteracy

From the Globe and Mail:

"Seven of the members of the Group of 20 nations are on a trajectory that will leave them with debts bigger than 75 per cent of their economies by 2014" ... "Even in Canada, a relative paragon of fiscal prudence, the combined gross debt of the federal and provincial governments is on pace to reach 79 per cent of gross domestic product next year"

So here's 3 statements in those 2 paragraphs:
1) 7 out of the G20 nations will have a public debt/GDP ratio above 75% by 2014.
2) Canada's ratio will be at 79% next year.
3) Canada is a relative paragon of fiscal prudence.

OK then.

Since I'm posting, I have to say I find it somewhat mystifying how much more attention high levels of public debt get vs. high levels of private debt. I understand there being some more focus on the public debt, but the ratio seems way out of proportion - especially given events of the last few years.

20/20 Hindsight

Every now and then I run across some economic forecast from 2006/2007. They are almost always amusing, and a good reminder not to take any of the current prognostications about the economy (in either direction) too seriously.

Here's the TD 'Consumer Pulse' from January 7, 2007 which offers the following insight:

"It is evident that around the world there has been a general trend towards consumers carrying more debt. This is partly a reflection of a sustained low inflation and interest rate environment. However, the accumulation of debt has largely been a rational decision, which is why repeated fears of a consumer-led financial crisis have proven unfounded."

Oops. Maybe not so rational after all.

People often seem to confuse the fact that something hasn't happened yet, with an argument that it won't or can't happen.

Debt, Redux

"Your servant here, he has been told
to say it clear, to say it cold:
It's over, it ain't going
any further"

I keep writing this same post about the role of debt in the economy and the economic cycle, but I think the reason why I keep coming back to it from slightly different angles is that I am wary of being in disagreement with the majority of experts on a complicated topic about which I am not an expert. It seems as though adherents of the notion that our troubles stem from too much debt and will be cured by eliminating the debt come from the fringes on either the left or right, with few mainstream or 'establishment' figures supporting this notion.

At any rate, here goes.


Consider the game of Reversi, aka Othello. The fun in the game derives from the placement of pieces on the board – deciding which spot to occupy and when to occupy it is what the game is about. At the start of the game, the board is wide open and filled with possibilities. The game ends when the board is full, when there is nowhere left to place stones. At that point the only way to continue to enjoy playing Reversi is to clear the stones off the board and start over.

Now, consider the economy. Economic growth occurs as people invest money into producing goods and services. Generally, investment to support production involves taking on debt. Either people simply don't have enough money available to use as equity to start/expand production, or they figure that if the venture works out, higher leverage (more debt) will increase the return on their equity and if the venture doesn't work out (goes bust) then at least some of the money lost will be someone else's as opposed to their own.

Not everyone has the inclination or ability to go into debt to produce goods and services. In any society there is a mix of people who will and people who wont. For this post, let's call the people who will, entrepreneurs, and the people who won't, bankers (since the people who have savings place them in the bank, and the bank then lends those savings out – effectively anyone with savings is a banker).

To start with, imagine an economy with no debt* – it is like the Reversi board at the start of the game, filled with possibilities. All of the society's entrepreneurial types have no leverage (no debt) and the greatest ability to borrow (for a given level of equity) that they will ever have.

Then you set the economy in motion. As the entrepreneurs borrow and invest, the economy expands. This is equivalent to the placing of the stones on the Reversi board.

The problem is that, although individual entrepreneurs can and will succeed, as a whole they seem doomed to eventually fail. Over time, as the economy expands, both the entrepreneurs and the bankers grow more confident and the level of the entrepreneur's debt relative to their equity increases. i.e. Debt expands faster than the rate of economic growth. True, some entrepreneurs will go bankrupt, eliminating their debts, but there is a strong correlation between the individual entrepreneurs success or failure, so during the up part of the cycle when times are good, bankruptcies will be relatively rare.

Every now and then there is a breakthrough of some sort that allows higher than normal growth rates in a particular area. The invention of the steam engine and the railroad for example, or the development of the internet. These cases lead to an understandable gold rush where a mass of entrepreneurs piles in with their investments until they eventually blow a big bubble which collapses at some point once people realize that the investments have swamped the productive capacity of the new phenomenon (e.g. Once AOL's stock is so high that it can 'buy' Time Warner in a stock swap).

Sooner or later, whether due to a speculative mania or just a steady accumulation of good times and increasing risk tolerance, society reaches a point where the class of entrepreneurs has so much debt that they simply can't or won't take on any more. i.e. The Reversi board becomes full.

When the board is full, you have to clear the stones and start over, much like Solon did in Greece, back in the day. In economic terms, the debts must be eliminated or at least reduced.

Note that although it's certainly not very stable, and people do get hurt, especially in the cleaning stones off the board phase, there's nothing unsustainable about this cycle and the net result is positive (wiping out the debts doesn't wipe out the productive investments that the entrepreneurs have made). In every game the entrepreneurs take the risks and do the investing that builds up our wealth but eventually they lose and they can't play any more stones (take on any more debt) and they have to declare bankruptcy. For example, the Reichmans went bankrupt building Canary Wharf, but Canary Wharf is still there and the Reichmans were able to rebuild their fortune in the next cycle.

The role of the bankers is twofold:

While the stones are being played, they must try to direct the money they lend to the entrepreneurs with the best chance of making good investments with the money. This allows the entrepreneurs to do as much productive work as possible before they eventually lose out. In a sense, the role of the bankers is to try and expand the debt as much as possible while at the same time promoting as much growth as possible in order to sustain more and more debt.

The second role of the bankers in the cycle is to win gracefully. That is, when the game is over they must allow the stones to be cleared off the board so that the game can be replayed. Of course, clearing the stones off the board means wiping out all the accumulated money that the bankers are owed so this can be difficult. Deposit insurance was a progressive innovation designed to prevent small scale bankers (savers) from being wiped out in the process of stone removal so that the costs would fall heaviest upon the large scale bankers who would no doubt feel aggrieved but would still be handily able to clothe, feed and shelter themselves after having their stones removed.

In a sense, both sides are propelled forward by a certain perverse competitive behaviour. The entrepreneurs know that as a class they will eventually get in over their heads and fail, but each one believes that they will be one of the ones that succeeds. The bankers know that they can't accumulate claims against the entrepreneurs forever and that eventually most of the claims will have to be eliminated, but each one believes that they will lend to the entrepreneurs that succeed and that their claims will be preserved.

Besides, in the long run we are all dead, and both entrepreneurs and banks might as well enjoy the upside of the cycle while it lasts.


The question of the moment is what happens when the bankers refuse to win gracefully. What happens when, instead of allowing the stones to be removed from the board, they try to get blood from them instead?

Bankers can use the power of the government** to try and extend the game (or at least prevent it from being restarted) in a number of ways.

1) By lowering interest rates, they can reduce the burden of a given level of debt (sort of like shrinking the stones on the Reversi board so you can have more squares on the same board). The limiting case here is when government set interest rates reach 0.

2) You can substitute household borrowing for business borrowing. So when entrepreneurs can't or won't borrow any more, you encourage their customers to borrow instead (do not pay until 2017!). The resulting increased demand for their products will allow the entrepreneur to expand some more.

Eventually, however, the customers will in turn reach their limit with respect to capacity / willingness to borrow, and again, this can be extended by reducing rates, with a limiting case of 0 rates. (Note that this approach will direct investment towards the priorities of impatient consumers instead of towards whatever entrepreneurs see at the greatest unmet needs of people in general (in proportion to how much money they have, of course) – this may not be for the best).

3) By inflating asset prices, the perception (on both sides) of people's capacity to borrow can be increased, because the collateral is perceived to be worth more. Of course once asset prices get too high, they are vulnerable to a sudden loss of confidence followed by a crash. Where the limits are here is not known precisely and is a matter of psychology, but that they exist is certain.

4) Finally, when all else fails, the government itself can step into the shoes of the entrepreneurs and consumers and borrow for itself – up until the government also reaches its limit. This borrowing can either be done directly via government deficits or indirectly by either bribing or forcing entrepreneurs and consumers to borrow more. For example, if consumers have reached the limits of their willingness to take on mortgage debt, the government can guarantee their mortgage in order to tempt them with lower interest rates, and if the sweet, sweet offer of low interest rates is not enough to make them jump, then government can outright offer people an $8,000 bribe to buy a house. And if that doesn't work, try $15,000. Of course encouraging people to take on mortgage debt is a 2 for 1 deal in terms of expanding debt, since it expands household debt directly and also supports asset prices.


You can see that we have plowed our way through phases 1,2 and 3 and have reached the 4th and final option. Unwilling to allow any stones to be removed from the board (this would hurt the bankerseconomy!) the government (acting on behalf of the bankers) intends to put at least one stone of its own down for every stone that the private sector tries to remove. But sooner or later, the stones have to come off the board if we want to play again.

As I described above, we reach this final stage when entrepreneurs and their surrogates (consumers) have reached a point where they can't or won't borrow any more. The flip side of this, of course, is that it means bankers and their suppliers (people who save/lend money) have accumulated a massive amount of claims on the economy.

This relationship clarifies why we see such a strong historical relationship between inequality and debt crises. Also note that, if the government were to intervene on behalf of the entrepreneurs instead of on behalf of the bankers (e.g. by taking money from creditors and giving it to debtors), this would help to solve rather than aggravate the problem. Again, this clarifies why the period from the end of WW2 to the 70’s which had strongly progressive taxation was marked by unprecedented economic stability and the subsequent removal of this progressive taxation has brought us back to crisis. To put it simply, when the problem is that the bankers have all the money/claims on the economy, the only solution is to change this distribution.

As a society, we need to say to the bankers, ‘look, you win, let’s play again’. Either we wipe out the debts via bankruptcy or we inflate them away via bankruptcy or we redistribute income from bankers to entrepreneurs or we find some other way to reset the board. Naturally, this is not fair (Personally, I am a banker, not an entrepreneur – remember that we are including anyone who has net savings in the bank as a banker!), but fairness is beside the point – what must happen, will, and putting it off doesn't help. Of course, the bankers/savers will do almost anything to prevent this outcome, and they will try to convince us that we can grow our way out of the debts that we grew ourselves into (which we could if they were willing to accept interest rates below the rate of economic growth, but I'm not optimistic on this point, and even then it would take a long, long time).

The banker's incentive is to say that if entrepreneurs won't put any more stones on the board, then consumers will. If consumers won't do it then government will continue the game for them. Government will bribe people with low interests and cash payments for borrowing. If that doesn't work, the upper class bankers will direct the government to take the savings of the lower/middle class bankers via taxes and use that to support more government borrowing. But in the end, even holding all the political power, and controlling all the media, all the banker's kings will prove unable to keep Humpty Dumpty from falling off his wall.

The current game of 'run-up the debt' has been underway for decades. Maybe it can continue to be played, or at least held in stasis, for another year, or another decade, or even a couple of decades, I don't know. But someday, and the day is not too far off I fear/hope, we’ll hit that final, global, Minsky Moment when it’s over / it ain’t going any further.








* i.e. All money has zero maturity or pays no interest, like a $20 bill – holding it doesn’t require you to pay interest to anyone.

** I'm taking a break from the ethics series with this post, but note that the interference of bankers in government is exactly the sort of 'syndrome mixing' that Jane Jacobs identified as systemic corruption in 'Systems of Survival'.

No Hobgoblins Here

A week after affirming the bank's policy of paying people to borrow and taking money from those who (try to) save, Bank of Canada chief Mark Carney worries about household's high and rising debt levels.

I like how he says he's not worried about a U.S. style banking crisis here because in Canada the risky mortgages are *already* all guaranteed by the government, whereas in the U.S. they're only getting around to that now.

So we might see the same price drops and foreclosures as the U.S., and greater costs to the taxpayer than in the U.S., but the situation will be better because we won't see the same losses incurred by banks as in the U.S. Gives you some sense of how warped our priorities have become.

Thoughts on the economic crisis

I thought I’d post some updated thoughts on my views on the current global economic crisis. To be honest not much has changed since I wrote this post a couple of months ago, other than my confidence in my conclusions has increased.

Note that if you haven't already read Stoneleigh's must-read summary of the financial crisis (written almost a year and a half ago, now) you should read that rather than reading this post. (abridged version here)

Some other posts you'd be better off reading before reading my thoughts are as follows:

Steve Keen's Roving Cavaliers of Credit

Martin Wolf, Why Dealing with the Huge Debt Overhang is so Hard

Naked Capitalism, Irving Fisher's Debt Deflation Theory (and read the comments, too)

Mish, Wealth Does not pass three generations

Update: Another good post, 'Recession? No, it's a D-process, and it will be long', from an interview with Ray Dalio in Barron's (via Automatic Earth)
Before I begin it's worth noting the ideologically (from a left vs. right point of view) scattered nature of the people linked above, a group united more in its outsider status vs. the establishment status quo than in any left vs. right political views.
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Here are 5 culprits in the crisis, moving from ultimate towards proximate causes:

Human Nature
Bad Regulation (fractional reserve banking, monetary policy to lower interest rates, etc.)
Inequality
Financial System Leverage
Debt

Basically what we have seen is a debt/credit bubble. There are two forces that drive the creation and then destruction of the credit bubble:

1) Increasing financial system leverage along with an increasing ratio of credit money to fiat/currency/non-debt bearing money
2) Increasing inequality as debtors enrich creditors via exponentially rising interest payments.


In more detail:

1) We start with a healthy economy.
2) This healthy economy is growing due to improved productivity, population growth, etc., or maybe because interest rates have fallen.
3) Optimistic and impatient people take on debt believing either that they can earn a great enough return on the borrowed money to repay with interest or that consuming now instead of later is worth the interest payments.
4) Borrowing expands the supply of credit money in the system and this expansion is self-reinforcing in that the optimistic expansion of borrowing creates the money needed to pay back the original loans
5) The self reinforcing dynamic keeps the default rate on loans low.
6) Some of the newly created money starts to go into speculation on asset prices
7) This is again self-reinforcing as rising asset prices collateralize greater lending (think ‘taking equity out of your house’ and prevent losses on defaults (rather than default on your house, sell your house and pocket the profits due to appreciation)
8) The good times allow people to repay their loans which leads to greater inequality, since the rich lend to the poor, if loans are repaid with interest the rich get richer vs. the poor (except in cases where the return on borrowed money above the interest rate exceeds the rate of interest, but this is the exception rather than the rule)
9) The rising asset prices also increase inequality since the wealthy own more assets than the poor.
10) The proportion of the economy devoted to the financial sector grows as the volume of credit expands relative to the size of the economy.

There are four things which can limit this self-reinforcing credit bubble dynamic:
1) People choose to stop borrowing money out of a moral aversion to taking on more debt
2) Regulation prevents further lending (via reserve requirements, capital requirements, leverage constraints, or other restrictions)
3) Lenders choose not to lend any more money due to the increased risk
4) People’s debt to income ratios rise so high (due to the expansion of debt and the rising inequality) that they simply can’t afford to borrow any more money but they do it anyway and begin to default.

If 1,2 and 3 fail, as they have failed us in this latest crisis, then sooner or later 4 will take hold.

There is one way to forestall point 4) and that is to have the government lower interest rates. Since the early 1980’s when interest rates hit 20%, interest rates have fallen. Lower interest rates support higher asset prices (you can buy more house if the mortgage rate is lower) and they lower the burden of accumulated debt levels by reducing the interest payments. In 2001 when it looked like the expansion of the credit/debt bubble was at risk, central banks dramatically lowered interest rates and succeeded in triggering another 5-6 years of credit/debt bubble expansion along the lines described above.

What happens if point 4) happens and interest rates are already pretty much at 0% you ask? You reach our present situation.

What we see now is that (almost) everything that happened on the way up goes into reverse.

A) Without new credit expansion to support rising asset prices, asset prices begin to fall
B) Once people default on loans that are no longer fully collateralized due to falling asset prices, banks start to take losses.
C) Once speculators realize the game is up, they start trying to pull their money out of their speculative investments, aggravating the decline.
D) The bank losses quickly wipe out the capital of over-leveraged financial institutions making it impossible for them to lend money, further accelerating the destruction of the credit/debt bubble
E) Even if you give the banks money to lend, they won’t do it, because without the promise of the ever expanding credit/debt bubble, nobody is credit-worthy since they either have too much debt or they just defaulted on their debt.
F) Even if the banks want to lend, few people want to borrow because they are afraid of deflation making their debts harder to pay because…
G) Deflation means that real interest rates are high even though nominal interest rates are 0 because…
H) The one thing that isn’t shrinking is the size of the debts owing since your mortgage doesn’t shrink just because you got a 10% pay cut. So the deflation makes it impossible even for those people who originally borrowed at reasonable levels to repay their now massive and growing debts. This further aggravates the downward spiral.
I) As people default on their debts, the balance between rich and poor is restored as rich creditors lose money to poor debtors. Falling asset prices have the same effect.
J) Only when enough of the debt has been defaulted upon so that the ratio of debt/credit money in the economy to actual debt-free currency is restored to a low enough value and the debtors are no longer being crushed under the weight of their debts can people once again start lending and rebuilding the economy.

So 2 questions arise:

1)How do we get out of the current mess?
2)How do we avoid getting into this mess in the future?


1)How do we get out of the current mess?

We can’t get out by repaying the loans since repayment of the loans will just make poor debtors even poorer. Also, deflation will make repayment extremely difficult.

One way out is through inflation. However, it is unclear that central banks have the will to print the truly massive amounts of money that would be needed to cause inflation in the midst of deflation of a credit/debt bubble. History suggests they don’t as far as I know (although I’m open to corrections, aside from the Weimar Republic which I know about).

Also, using inflation is a bit like stopping a free fall by using rocket thrusters. It will work but you have to be extremely careful not to apply so much force that you fly off into space (hyperinflation).

The best way out, to my mind, is to wipe out the debts in as orderly a fashion as possible. I don’t say this lightly since I have no debts and I would find it galling to see all the people who irresponsibly piled up debts and enjoyed themselves with this spending spree now getting bailed out because collectively all the debtors were too big to fail but I’ll settle for getting screwed over to having a depression which won’t be any barrel of laughs either. Society’s preferred method for discharging debt is via bankruptcy and I believe the government should be trying to encourage a widespread outbreak of bankruptcy to reduce the overall debt levels.

In a nutshell we need to rebalance the amount of currency (money not created as debt) with the amount of debt/credit. We can attack this from two sides, both by printing more currency and by encouraging/allowing defaults on the debt. Once this balance is restored things can start growing again, but we are so far, far from being in balance that it is inevitably going to be painful getting from here to there.

Measures to try and preserve the existing ratio (e.g. forcing banks to lend at gunpoint, negative real interest rates that punish savers and reward borrowers) will either cause another run-up in the bubble leading to even greater pain next time the bubble pops (as happened from 2001-2007, but I suspect we are too far gone to have happen again), or freeze things in place allowing us to limp along Japan style for year after year without ever really getting out of stagnation.

Having government take on debts as private sector debt collapses will help, but only in the sense that raising the flaps helps you land a plane that has run out of gas. It acts as a brake on the collapse in credit money but can only slow it down since moving risk from one holder to another doesn't really change the underlying dynamics.

2)How do we avoid getting into this mess in the future?

If the great depression only scared us straight for a couple of generations (see the post by Mish linked above), it seems unlikely that we can make any permanent fixes here either. Still, I have a few suggestions:

1) 100% reserve requirements for financial institutions – Preventing lenders and central bankers from working together to supply an infinite amount of credit at zero cost will mean that in future, if people want to borrow, they have to find someone willing to lend their actual money, not just give them made up money. In this scenario, although the central bank may want to lower interest rates, doing so will be constrained by the limited supply of people willing to lend out their money at these low interest rates. 100% reserve requirements won’t prevent credit bubbles, because they won’t change human nature (the enduring belief that it’s different this time, it’s different here, the fundamentals don’t matter, etc.), but it will remove one enabling element that supports the growth of credit bubbles, and that’s a start.

2) Fixed and conservative margin requirements for asset purchases (say, a minimum 25% down payment for a residential mortgage, 50% for stocks and maybe a few other asset classes, and 100% for everything else, including cars and sofas). This will help prevent the self-reinforcing cycle of rising asset prices and expanded credit from getting out of hand.

This list from Karl Denninger wouldn’t be a bad way to start either:

I picked out a few of his suggestions that I liked the best, but they almost all make sense in the American context (the Canadian banking picture is a little different than the U.S. one, in particular we have the appropriate history and culture to manage a more concentrated banking sector than the Americans do).

3. Repeal the "Bankruptcy Reform" law. Consumers must have the same right to go bankrupt and discharge debts that corporations have. Banks and others who grant loans must have this Sword of Damocles over their head - you make a bad loan and the borrower can file Chapter 7 and stick you with it, without exception. This will immediately collapse the outrageously overpriced bubbles that remain and are credit-driven, including post-secondary education.

[Ed: We didn't have this 'reform' in Canada, but in general loosening our bankruptcy laws to match the more debtor friendly American laws would help]

4. Remove the obscure little change made in the EESA/TARP legislation that allows Bernanke to set the reserve ratio to ZERO for banks, and set it statutorily to 8%. Enhance the law by declaring that ALL funds taken in by a bank irrespective of their source are subject to the 8% reserve requirement (thereby removing the "sweeps" exemption that started this mess.) This will force leverage in the regulated banking system to no more than approximately 12:1.

[Canada has no official reserve rates. Leverage is constrained instead by regulatory capital requirements but the principle remains the same, constrain financial industry leverage to a set ratio - and *enforce* this limit.

5. Set the lawful leverage limit to 12:1 for all investment banks and other entities including hedge funds. Any firm that wishes to be domiciled or operate in the United States must comply. Period. I know what the counter-argument is - "they'll go somewhere else." Fine! Go blow up some other nation's economy. We've had enough of it.

6. Said 12:1 leverage limits must apply to all assets. Yes, even US Treasuries. If you hold it at most (for the safest assets) you can gear it at 12:1. Period.

7. Ban all off-balance-sheet vehicles; no exceptions of any sort. If you have control of it or are responsible for it in any form or fashion you must consolidate it on your balance sheet. "Shell corporations" set up to evade this requirement that have no capital or assets of their own are deemed a fraudulent shell company. Close the SIV loopholes.

9. Bar the trading of derivatives contracts by commercial banks except where those contracts are backed by or insure a hard asset (e.g. a CDS on an actual bond or mortgage) and they are exchange-traded with a central clearing counterparty and thus guaranteed "good". If some Hedge Fund wishes to write or hold naked CDS and immolate themselves that's fine, but they cannot blow regulated financial firms (including insurance companies) to pieces nor can they distort share and debt-pricing mechanisms in the public, regulated markets.

11. All derivatives traded by regulated financial entities must be cleared and traded through a public exchange with a central counterparty, nightly margin supervision and published bid/ask/open interest.

12. Extend bank fraud statutes to explicitly cover actions taken by The Fed or any banking or financial institution in violation of statutory limits and name the members of the board of any such institution as personally responsible for violations. This stops the game-playing where institutions feel free to be "fast and loose" because all they will get is a slap on the wrist by FINRA or the SEC. With these offenses being federal criminal offenses the calculus changes immediately on what someone will and will not attempt.

14. Stop trying to prop up asset (especially house!) prices. Instead, preach the truth - affordable housing means no more than 28% of your income goes toward all housing expenses, you should put 20% down, and you should not take anything more aggressive than a 30 year fixed-rate loan. For many areas this means median home prices must still contract. A house is shelter, not a speculative vehicle.

Elephant in the Room

The head of the Bank of Canada, Mark Carney, gave a speech on the economy today in the House of Commons. The word 'debt' did not appear in his speech, although he did note that current Bank policy is to pay people to borrow money and take money from those who save.

Debts No Honest Economy Can Pay

"Well, I got a job and tried to put my money away
But I got debts that no honest man can pay
So I drew what I had from the central trust
And I bought us two tickets on that coast city bus
Well now, everything dies, baby, thats a fact
But maybe everything that dies someday comes back"

From Atlantic City, by Bruce Springsteen
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Over the last few years, I've thrown out the odd comment here and there about how many economic charts seemed to put us right about where we were prior to the Great Depression (or worse). Some of those charts measure income inequality, but mostly they are debt related.

The last few decades, much like the 1920's, have seen a massive run-up in debt levels across society. Now, as anyone who has borrowed money knows, the amount of money you can borrow and still make ends meet depends on interest rates: the lower the interest rate, the more debt you can handle.

So, since the early 80's we've been able to carry this increasing debt load thanks to ever lower interest rates (which have now reached 0 in the U.S.) After 9/11 when a recession looked likely, central banks lowered interest rates down to 1 or 2% for a couple of years, which was enough to prevent a serious recession from occurring, and also started us on our latest run of piling up even higher and higher debt levels.

So we now have (or had a year or two ago) a massive mountain of debt which could only be supported with very low interest rates and with an ever expanding credit bubble providing higher asset prices to prevent losses. At some point, the economy simply couldn't take on any more debt and things began to unravel. The U.S. housing market was one of the first shoes to drop and it's a pretty big shoe. But once the bubble bursts, it's hard to prevent it from collapsing entirely.

As I said, central banks managed last time by reducing rates almost to zero, prompting further inflation of the debt bubble via (in part) the creation of a global housing bubble. But this time, I'm not sure anything will prevent the debts from being wiped out in a self-reinforcing collapse.

So, from my standpoint, the problem the economy faces is a crippling debt load and the solution is anything that will reduce this debt load back to manageable levels in an orderly fashion.

With that in mind, I have to admit I find headlines like the following puzzling:

Carney Urges Banks to Lend More

I appreciate that we don't want the economy to implode as the debt bubble unwinds, but shouldn't we be trying to just manage the debt reduction process, not actively trying to create more debt? Maybe I'm missing something. It almost seems as if central banks think they can restart the economy based on further expansion of our debt levels, but surely they must have realized by now that, even if that was possible (which seems unlikely), it would only lead to an even bigger mess the next time the economy collapses under the weight of too much debt?

There's basically three ways to get rid of debt:
1) The most orderly way is for people to pay it back.
2) People can default on their debt. Bad for creditors (people who are owed money), good for debtors (the people who owe the money
3) The value of the debt owing can be reduced. This could be done by renegotiating terms, by government order, or, more usually, by inflation. Inflation reduces the value of money, allowing borrowers to repay their loan using dollars that aren't as valuable. Imagine you owe $200,000 on your mortgage, if we have 10% inflation and you get a 10% raise every year, it gets a lot easier to repay that mortgage as the years go by.

Faced with deflation (which has the opposite effect of inflation and will make our crippling debt levels extra crippling) it seems as though central banks are trying to print enough money to cause inflation instead. While dangerous (inflation can turn into hyperinflation which can wreck an economy) it seems the most likely escape from our debt prison at this point, so it's a reasonable approach. But what I can't figure out is that they seem to be trying to cause inflation by giving banks money and having the banks lend that money to people. But given that that is how we got into this mess in the first place, it seems an unlikely method to get us out.

Anyways, I don't know much about macroeconomics and this is all over my head, but it seems to me like the government should be focusing on reducing debt, not expanding it.

It brings to mind the stories we read back in school about Solon, the legendary ancient Greek leader who helped bring about the flourishing of ancient Greek society.

Here's a fairly standard account of the successful reforms Solon made:

"First coming to prominence (c. 600 B.C.) for his patriotic exhortations when Athens was fighting a war against Megara for possession of Salamis [see Map section Dab], Solon was elected eponymous archon (the magistrate whose name the year is known by) in 594/3 B.C. and perhaps, again, about 20 years later. Solon faced the daunting task of improving the condition of:

* debt-ridden farmers
* laborers forced into bondage over debt, and
* the middle classes who were excluded from government,

while not alienating the increasingly wealthy landowners and aristocracy. Because of his reforming compromises and other legislation, posterity refers to him as Solon the lawgiver.

In the 8th century B.C., rich farmers began exporting their goods: olive oil and wine. Such cash crops required an expensive initial investment. The poorer farmer was more limited in choice of crop, but he still could have continued to eke out a living, if only he had either rotated his crops or let his fields lie fallow.

When land was mortgaged, hektemoroi (stone markers) were placed on the land to show the amount of debt. During the 7th century, these markers proliferated. The poorer, wheat farmers lost their land. Laborers were free men who paid out one sixth of all they produced. In the years of poor harvests, this wasn't enough to survive. To feed themselves and their families, laborers put up their bodies as collateral to borrow from their employers. Exorbitant interest plus living on less than five sixths of what was produced made it impossible to repay loans. Free men were being sold into slavery. At the point at which a tyrant or revolt seemed likely, the Athenians appointed Solon to mediate.

Solon, a lyric poet and the first Athenian literary figure whose name we know, came from an aristocratic family which traced its ancestry back 10 generations to Hercules, according to Plutarch. Aristocratic beginnings did not prevent him from fearing that someone of his class would try to become tyrant. In his reform measures, he pleased neither the revolutionaries who wanted the land redistributed nor the landowners who wanted to keep all their property intact. Instead, he instituted the seisachtheia by which he canceled all pledges where a man's freedom had been given as guarantee, freed all debtors from bondage, made it illegal to enslave debtors, and put a limit on the amount of land an individual could own.

Plutarch records Solon's own words about his actions:
"The mortgage-stones that covered her, by me Removed, -- the land that was a slave is free;
that some who had been seized for their debts he had brought back from other countries, where
-- so far their lot to roam, They had forgot the language of their home;
and some he had set at liberty, --
Who here in shameful servitude were held."

What's the Difference?

Imagine for a moment that you are down on your luck financially. You have bills to pay and people depending on you and you just don't have the financial resources to do the things you wish you could. You've been to the banks but they've seen people like you before and they want nothing to do with you. So a friend tells you about a guy they know who deals in special cases. Lends when nobody else will. The catch is that borrowing from this guy isn't like borrowing from a bank. For one thing, if you can't make your payments you can't just declare bankruptcy to make him go away. And for another, if you're having trouble paying this guy back he's likely to come and make some friendly 'suggestions' for how you could do things differently and maybe sell off some of the stuff you own to make your payments. And these suggestions will be backed up by the unspoken threat of the harm which may come to the people who depend on you if you don't follow them.

So here's my question, is the scenario I'm talking about just some guy with a family who doesn't have a job and ends up going to the local loan shark and getting himself in even deeper, or is the scenario really about a poor 'developing' nation that gets lured into borrowing billions of dollars from the World Bank and gets forced into structural adjustments, financial crises or interest payments which exceed their health and education budgets when the loans don't generate the necessary return to repay them.

Which brings me to my second question - is there a difference?

Random Thought for the Day

I ran across this article on Yahoo about the (very commendable) reductions in Iraq's debt load, which have been spearheaded by the U.S.

And I couldn't help wondering about the human benefits which could be achieved if the U.S. were to devote the same political will towards forgiveness of the debts of all the destitute countries around the world.

I imagine the citizens of the poorest countries, where the money which goes to debt repayment dwarfs spending on health care, fighting aids, etc, must be wondering, as I am, why it's possible to achieve such massive reductions in Iraq's debt, but progress is so painfully slow (or nonexistent) everywhere else.

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Edited to add that if you want to get some background on this issue, the Jubilee USA network is a good source, the news links down the right side of their homepage provide a pretty good background of recent developments on this issue.

Hypothetical Scenario for the Day

Suppose for a moment that you have lived a long life and that you know you are nearing its end. You struggled financially some years ago and piled up some debts, but you got things in order and you've managed to pay about a third of them off. Now you have to decide how to spend your last few years. Do you:

a) Do what you can to pay off more of your debts before you pass on
b) Buy a new car, and leave your remaining debts for your children to deal with.

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Just something to think about every time you hear someone recommend that we stop paying down the principal on our (roughly) $500 billion national mortgage so that we can devote more money to tax cuts or spending increases this year.