The central banks of the European Monetary Union and China both tweaked their monetary policies this week in order to inject a touch more stimulus into their troubled economies.
At the same time as they were doing this, two of the international heavyweights of macroeconomic policy, Lawrence Summers and Lord Adair Turner independently published their views as to why central banks were now administering misconceived treatment.
Summers was the chairman of President Obama’s Council of Economic Advisers while Lord Turner was the former chairman of the UK Financial Policy Committee.
Both largely launched their criticism of current central banking orthodoxy on the basis of a recent publication analysing the root causes of the global financial crisis entitled: “House of Debt: How They (and You) Caused the Great Recession, and
How We Can Prevent It from Happening Again”.
The authors of this study are two academics Atif Mian and Amir Sufi, professors of economics at Princeton and the University of Chicago.
Summers actually reviewed the book from the perspective of an active participant in the crisis that rattled the global financial system when Lehman Brothers collapsed in 2008.
While having considerable reservations about the policy recommendations of the authors, Summers is strongly supportive of their analysis of the causes of the GFC and why the subsequent actions to address the systemic threat have focused on the wrong issues.
According to Summers, the book, despite some tough competition, looks likely to be the most important economics book of 2014. It could, he says, “be the most important book to come out of the 2008 financial crisis and the subsequent Great Recession.”
House of Debt, Summers writes, is important because it persuasively demonstrates that the conventional meta-narrative of the crisis and its aftermath, which emphasises the breakdown of financial intermediaries, is inadequate.
It’s certainly true that threat and implications of systemic institutional collapse dominated the policy formulation process. We can gather as much from the memoirs of some of the leading actors who have rushed into print to ensure that their side of the story will be heard.
Hank Paulson, Treasury secretary, Sheila Bair, chair of the Federal Deposit Insurance Corporation and Timothy Geithner, Paulson’s successor at Treasury, have published their role in the bail-out decisions reached in respect of Bear Stearns, Lehman, Fannie Mae and Freddie Mac, Wachovia, Washington Mutual, Bank of America and Citi.
Given the global reaction to the collapse of Lehman and the domino effect that this had across the inter-connected financial universe, it was not surprising that the immediate and overriding concern was to prevent contagion and panic, to quickly return to business as usual for the clients of banking systems around the globe.
As President George Bush summed it up, he wanted to “free up banks to resume the flow of credit to American families and businesses.”
And as Lord Turner noted last week in a syndicated article that has been distributed around the world, the growth of credit had collapsed in 2008 with Lehman’s completely unexpected bankruptcy.
The issue that should have been prioritised after the financial system had been stabilised was whether the contraction in credit reflected low demand or constrained supply.
Initially it was the latter. As Lord Turner points out: “a ‘credit crunch’ – particularly in trade finance – was certainly a key reason why the financial crisis generated a real economy recession.
“Taxpayer–funded bank rescues, higher bank capital requirements and ultra-easy monetary policy were all vital to overcome credit supply constraints.”
But, Lord Turner continues, “There is strong evidence that once the immediate crisis was over, lack of demand for credit played a far larger role than restricted supply in impeding economic growth.”
Mian and Sufi do not go along with what they call ‘the banking view’ of the Great Recession.
Instead they focus on household and small business spending, analysing US data on a county-by-county basis. These counties were graded on their pre-crisis borrowing record and the post-crisis real estate falls they experienced.
This approach has delivered a very different view of the economic health of the US after 2009 than that viewed through banking glasses.
They note that data on credit spreads suggested that the financial system was fully repairedby 2009 – a description rather different from that provided by household balance sheets where many have still not restored their full health.
Their methodology also revealed that spending on housing and durable goods such as furniture and cars decreased sharply in 2006 and 2007, well before any financial institutions looked vulnerable.
Another indicator that the recession began in the housing sector and not the financial system was provided by small business, a sector most dependent on bank finance. These small businesses attributed their plight to a lack of customers rather than banks’ unwillingness to lend.
Customer numbers were down, more sharply amongst those suffering the greatest loss of wealth, because excessive mortgage lending during the pre-crisis boom had left them overleveraged.
Presumably a policy of quantitative easing, which resulted in lower interest rates and a contraction in household earnings from its savings pool, would also encourage reduced spending.
Mian and Sufi’s findings do not constitute a Eureka Moment in that the role of debt at the household and small business level has been identified by others such as Irving Fisher back at the time of the Great Depression.
Nomura’s Richard Koo has been arguing for some time that the global financial crisis is a balance sheet recession that will take more time to heal than the more common cyclical recession.
Mian and Sufi have underpinned what were unproven hypotheses with persuasive data.
Lawrence Summers describes what they have done as a major contribution that furthers our understanding of the crisis.
He writes: “And it should influence policies aimed at crisis prevention by demonstrating the insufficiency of keeping institutions healthy and making a case for macroprudential measures directed at preventing runaway growth in household debt.”
Lord Turner is more blunt, saying: “If eurozone policy assumes that fixing the banks will fix the economy, the next ten years in Europe could look like the 1990s in Japan.”