Economists must bear blame for recession

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This was published 14 years ago

Economists must bear blame for recession

By Robert Skidelsky

ALL epoch-defining events are the result of conjunctures — the correlation of normally unconnected events that jolt humanity out of a rut. Such conjunctures create what the author Nassim Nicholas Taleb calls "Black Swans" — unpredictable events with a vast impact.

A small number of Black Swans, Taleb believes, "explain almost everything in our world".

The prosperity of the first age of globalisation before 1914, for example, resulted from a constellation of developments: falling transport and communication costs, technological breakthroughs of the second industrial revolution, pacific international relations, and Great Britain's management of the gold standard.

By contrast, in the interwar years poisonous international politics combined with global economic imbalances to create the Great Depression and set the scene for World War II.

Now consider recent financial innovations. On the back of the new computer and telecommunications technology, a giant market for derivative instruments was built. Collateralised debt obligations (CDOs, mainly tied to mortgages) made aspiring home owners supposedly creditworthy by enabling banks to sell "subprime" debt to other investors.

Before securitisation, banks typically held mortgages; now they could get them off their books, but such credit usually ended up on another bank's books. What resulted was a system for diversifying individual bank risk, but only by magnifying the default risk of all banks that held what came to be called "toxic" debt. Because all the derivatives were based on the same assets, if anything happened to those assets, all the banks holding the debt would find themselves in the soup.

What made the spread of derivatives possible was the ease with which the volume of debt for a given set of real assets could be expanded. This scalability was magnified by the use of credit default swaps (CDSs), which offered phoney insurance against default. Since an unlimited number of CDSs could be sold against each borrower, the supply of swaps could grow much faster than the supply of bonds.

CDSs magnified the size of the bubble. The CDO market grew from $US275 billion to $US4.7 trillion from 2000 to 2006, whereas the CDS market grew four times faster, from $US920 billion in 2001 to $US62 trillion by the end of 2007.

Derivatives soon found their way into portfolios of banks all over the world. But the dependence of the whole structure on continually rising house prices was rarely made explicit. If the housing market started to fail, these paper assurances would become, in Warren Buffett's words, "financial weapons of mass destruction".

Financial intermediation would never have brought disaster (or indeed gone so far) save for the global imbalances arising from America's twin trade and budget deficits, financed to a large extent by Chinese savings. Floating exchange rates were supposed to prevent countries from manipulating their currencies. But by accumulating large quantities of US Treasury bills, East Asian countries, especially China, kept their exchange rates artificially low. This East Asian "savings glut" enabled a debt-fuelled consumption glut in much of the Western world.

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The marriage between Chinese savings and American consumption had a fatal flaw: it created non-repayable debts. Chinese investments in US Treasury bills did not create new resources for repayment. The counterpart of the US debt build-up was the relocation of much of its manufacturing to China. Chinese savings flowed into financial speculation and consumer binges.

"Surplus" Chinese savings made possible America's credit expansion between 2003 and 2005. Ultra-cheap money produced a surge in subprime mortgage lending and that market collapsed when interest rates increased steadily after 2005. The financial crisis of 2008 was the start of a painful, but inevitable, process of de-leveraging.

This interpretation of the present slump is disputed by the "money glut" school. In their view, there was only one cause of the crisis: excessive credit creation that took place when Alan Greenspan was US Federal Reserve chairman.

This view draws on the "Austrian" theory of booms and slumps, and also Milton Friedman's explanation of the Great Depression. It was wrong then, and it is wrong now.

This reasoning assumes that markets are perfectly efficient. If they go wrong, it must be because of policy mistakes. This view is also self-contradictory, for if market participants are perfectly rational and perfectly informed, they would not have been fooled by a policy of making money cheaper than it really was.

This suggests a more fundamental reason for the economic crisis: the dominance of the Chicago school of economics, with its belief in the self-regulating properties of unfettered markets. This belief justified the deregulation of financial markets in the name of the "efficient-market hypothesis". It led to the spread of financial risk-management models, which grossly underestimated the amount of risk in the system.

John Maynard Keynes wrote that "practical men who believe themselves to be quite immune from intellectual influences are usually the slaves of some defunct economist". Most of today's economists are not defunct, but work in the ideological vicinity of Chicago. Their assumptions should be ruthlessly exposed, for they have come close to destroying our world.

Robert Skidelsky, a member of the British House of Lords, is professor emeritus of political economy at Warwick University. Copyright: Project Syndicate, 2009.

www.project-syndicate.org

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