The arrogance of lecturing Europe with the wrong lesson

The month of October, this time around dressed in the clothing of the European Sovereign Debt Crisis, brings once again to the forefront fundamental questions on the future of western world banking.

Since 2007, what originally started as a “housing bubble” in the United States and the United Kingdom quickly became a widespread credit crunch; was followed in September 2008 by an unprecedented crisis of confidence in world’s banks, central banks and the governments behind them; was later succeeded – and still is –   by sovereign debt worries for developed countries, while inevitably pointing to the next waves of uncertainty: exchange rates and global trade.

What was most noteworthy last week was the dismissive European reaction to the advice dispensed by U.S. officials for decisively embracing a much larger rescue fund comparable to TARP. Who can blame them? It isn’t like TARP worked magic: it simply bought more time without properly addressing the underlying systemic deficiency issue with banks which I have addressed in one of my previous articles  here    and for a more detailed version of it here .

The one thing everybody agrees on is that the Great Recession of 2008 was unlike any other experienced in recent memory: it was global (it touched every single country on the planet) and it was disastrous (with $35 trillion of wealth evaporated at its peak in March 2009). But there was – and still is — considerable divergence on what caused it, let alone providing a lasting solution. Unless they don’t care about credibility and the associated accountability, how can government officials anywhere recommend a solution to a largely misunderstood problem?

Pinning the problem on US subprime mortgages, as had been the immediate and impulsive explanation back 4 years ago,   fails to explain how this financial disaster reached all the way to Russia in the ensuing year.  After all, the latter had apparently no banks exposed to subprime or to other toxic paper: subprime mortgages were just a bad symptom and not the root cause.

The “mispricing of risk” argument proposed by former Fed chief, Alan Greenspan, did not address the dangerous role that the “shadow banking” system — the non-bank financial institutions that defined deregulated American finance — played in this debacle. They, and not the conventional commercial banks with deposits-based lending, are behind the $7 trillion “debt bubble” which erupted in the U.S. financial sector in the decade starting in 1997.

“The failure of laissez-faire U.S. capitalism”, suggested by the former E.U. President Sarkozy, does not illuminate how Europe’s largest universal banks were also equally devastated in 2008, and look even sicklier now that the sovereign debt problems threaten their very solvency.

It is now increasingly clear that the Great Recession of 2008 was rooted in world’s biggest credit surge in the recent history of banking. That surge, which happened primarily in the preceding decade, was facilitated by central banks in the western world – predominantly the US and the EU– of which the Fed still is the largest and the most influential. Whether central banks led their supposedly regulated commercial banks into this binge, or were led by them, is still unclear; but that is another topic altogether and will not be addressed in this paper.

Instead, since sovereign debt is the current preoccupation, let’s focus on a question that has been around for a while without a definitive answer:  have the Fed’s monetary policies help or hinder the accumulation of U.S. public debt now near the precarious level of 100% of the GDP? 

The question has two components: a direct one and indirect one. On the direct side, it is important to recognize that government spending was nowhere near “bubble” territory between 1997 and 2007, the decade preceding the Great Recession. The Fed’s own statistics document that the tech bubble of 2001 and the real-estate bubble of 2007 were not accompanied by inordinate ramps in public spending; if anything, on a comparative basis, government debt did not keep pace with GDP growth in all these years.
The problem with debt “explosion” lied elsewhere: the private sector.

click on the image to enlarge
 It was indeed indirectly and in the private sector –mostly banks, but also consumers — that debt was allowed to rocket and outdistance GDP growth, in the years preceding the Great Recession.

Had the Fed pursued more consistent and disciplined monetary policies in the decade preceding the Great Recession, the bubbles of 2001 and 2007 could have been contained, preventing as a result the Great Recession and the Keynesian government overspending that followed it.  The accumulated government debt is not a cause per se, but a consequence.

To summarize, is there a cause and effect relationship between the Fed’s lax monetary policies and the huge US government deficits that followed them?  The answer is indirectly affirmative. But, it is perhaps as important to realize that central banks – whether in the US or EU – do not make legislation, especially on what is permissible leverage for banks and what needs to be way better regulated to prevent lending risks from being nationalized while profits are privatized.

Let’s hope that as we explore solutions to lingering problems that we are learning from past mistakes: in economics — much like in medicine –prevention is vastly superior to rehabilitation, even if takes regulation to enforce it.   But to get there, key concepts resting on the notions of “efficient markets” and “self-governance in banking” must be reexamined for their potential to misguide and undermine economic stability.

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