Too much credit caused today’s credit crunch… but here comes more!
Modern central bank management, like Caesar’s Gaul, can be divided into three parts: One part practical politics, one part financial hocus-pocus, and one part incomprehensible. To an economist with a sense of humor, this past week was particularly entertaining – we got to see them all.
“Liquidate labour, liquidate stocks, liquidate the farmers, and liquidate real estate.” That was the advice of Andrew Mellon, U.S. treasury secretary in 1929. Mr. Mellon wasn’t being mean; he was merely trying to make things better. “It will purge the rottenness out of the system,” he explained.
He meant that there were too many people who had put too much money into too many losing propositions. The Roaring ’20s were very lucky years for Americans. Automobiles rolled off assembly lines. Electrical appliances sold like computer games. And the financial sector was more dynamic and innovative than ever before. Huge new inflows of capital created a boom on Wall Street; while new industries coast-to-coast – including the film industry in California – were making ordinary Americans rich. Almost everything they tried – from installment credit to jitterbugging – seemed to work.
From strength to strength… to catastrophe. The credit crunch came. The credit markets seized up. Risk was re-priced, upwards. Assets were re-priced, downward. The U.S. economy contracted 30%.
Sixty years later, a similarly dizzy boom hit Japan like a typhoon. In the ’80s, the island nation was the envy of the world. Western consumers first learned to say Japanese words such as Toyota and Honda. Then, business executives in New York and London worked on words such as “kaitzen” and “zaitech.” Then, the Nikkei Dow cracked in January of 1990… and we went back to speaking English. Even now, 17 years later, the Japanese economy has still not recovered its “bonsai!” Vigor.
Financial authorities in both the United States and the United Kingdom know the stories well. They’re determined not to relive them. At least, that is the popular interpretation of this week’s major events. Economists have made another 80 years of progress, they say; now they can avoid a credit crunch. So, when it began to feel like Wall Street in ‘29… or Tokyo in ‘90, central bankers knew just what to do.
The credit cycle is still more or less the same as it was in Mellon’s day. When people are flush they worry about the return on their money. When the credit turns down, they worry about the return of their money. But the art of central banking has evolved. Practical politics comes into play much faster; hardly any government outside of Buenos Aires can afford to let schoolteachers and retired plumbers lose their savings and their houses. Not with the TV cameras rolling. Hocus-pocus plays a larger role too; problems disappear like magic. “Do you see any rottenness,” Ben Bernanke might have asked British Chancellor Alistair Darling. “I don’t see any.” In the 21st century, central banking authorities would rather poke their eyes out than see any rottenness.
Seeing nothing to purge, they got down to work. In the U.K., where debt per capita is nearly three times the U.S., Chancellor Darling took just four days to make up his mind. Then, he stepped before the cameras to put the government squarely behind troubled mortgage lender Northern Rock. The conservatives accused him of being “a bit slow” and said they would have given depositors a 100% guarantee as soon as the problems came to light.
But what sort of financial quackery is this? Who else should take the loss than those who asked for it? Safe, British fixed-rate income bonds yield about 5.3%. Northern Rock offers a fixed rate of 6.2%. Take the risk out of the calculation and you make fools of the fellows who bought the prudent income bonds, and chumps out of the rest of us.
Meanwhile, in America, the central bank opened its discount window weeks ago – and practically forced Bank of America and Citigroup to take some money. And then, on Tuesday, the Fed abandoned four years of inflation-fighting and took its troops over to the other side. Now, by cutting the Fed funds rate by a half a point, its fondest desire is that consumer prices are higher tomorrow than they were today. It will get its wish, we predict.
This latest bit of price fixing made the front pages all over the world. Investors celebrated. “Euphoria after half-point cut,” said a Financial TIMES headline. But bad investments do not disappear just because the central banks lend more money to the people who made them. Nor do problems caused by too much credit disappear when you make more credit available. Householders have mortgages they can’t afford; 15% of America’s subprime mortgage payments are still late. (Measured by housing prices, Britain’s housing bubble is twice as large as the U.S. bubble.) Billions of asset-backed securities are still worth probably considerably less than they paid for them. Nor is there any noticeable decline in business, consumer or government debt (at least, when measured in the currency in which it was lent).
What is different is that instead of permitting reckless speculators to get what they’ve got coming in this credit crunch, losses will be socialized – redistributed to consumers, investors and savers all over the world. And instead of allowing the market to liquidate weak companies and remove the rot, the rottenness is jolly well encouraged to spread. Instead of the needed liquidation, in other words… we will get more liquidity… the damp, after-shower conditions that caused markets to slip-up in the first place.
Progress in science and technology may be incremental. But in love and central banking, it is largely an illusion.
Markets and Money