Sunday, June 05, 2011

Natural Recovery Mechanisms

Since political gridlock in the country has precluded much government intervention to facilitate recovery from the financial crisis, we will have to rely on natural mechanisms to recover over an extended period, just as the Japanese have been trying to do for the last couple decades.

So what caused the crisis and what are these natural mechanisms that will allow recovery? For the economy to be healthy, there has to be a balance between saving and spending. Capital and labor are the ingredients for growth. The relatively few, more wealthy, people do most of the saving and middle class labor provides most of the spending. As I have previously discussed here, over the last several decades more of the rewards of productivity have been going to the savers. As the spenders are squeezed, demand wanes and there are fewer opportunities for investment, so the return on investment falls. This results in a search for ways to stimulate demand and increase returns, like easy credit, leverage, and creating derivative instruments that hide risk.

Eventually these mechanisms lead to bubbles of ever increasing asset prices and create a euphoria that perpetuates the growth of the bubble until it bursts, resulting in a financial crisis. First we had the saving and loan crisis, then the dot com bubble and now the housing bubble, which nearly brought the country to ruin. This has resulted in high unemployment, fear of further crises, and stagnated demand because the problem is really that the debt left over from the bubble never has never been addressed. Banks and their investors,  being the primary holders of the debt, have refused to take losses on their bad debts, and the government has stepped in to bail them out, increasing the public debt.

The solution lies in first reducing the debt overhang in the private sector because the private sector is the primary source of demand. Demand must be increased first because the revenue from increased growth is needed to address the public debt. Political gridlock will not allow the government intervention necessary to make this happen. So other mechanisms must be relied upon to correct the problem, stretching out the recovery over the decades ahead.

The primary means for addressing normal recessions is monetary policy, that is, lowering interest rates by increasing the money supply. Lower interest rates means less income is going to savers, and the spendable income to spenders increases because their debt service is reduced. Neither of these these things happen automatically. So it has fallen to the Federal Reserve to insure that low interest rates are maintained. This has not been an altruistic move on their part. Their main interest is in keeping the banks afloat by easing credit and pumping up asset markets, since the government has been reluctant to restructure them. But, a byproduct of the policy has been to ease the burden of homeowners and other private debtors. But, as interest rates approach zero, this mechanism is no longer effective.

The first natural mechanism the comes into play is private loan default. As homeowners and other private borrowers default on their loans, the lenders and their investors are forced to absorb the losses.  Those that don’t default are forced to continue paying off debt rather than spending their income, which reduces the demand necessary for recovery. This prolongs the recovery period. So, defaulting on private debt becomes a mechanism for reducing the recovery time. To the extent that artificial means and deception were used to induce borrowers to borrow, this is a just action and should be encouraged, rather than disparaged.

The second natural mechanism for reducing debt is inflation. As inflation occurs, debts can be paid off in cheaper dollars, erasing debt faster, and promoting a quicker recovery. Controlling inflation falls to the Fed in implementing monetary policy. To reduce the recovery time the Fed needs to allow more inflation in times of crisis, and usually does. The Fed has recently raised inflation targets for this purpose.

The final natural mechanism occurs when flight to safety and political pressure drives funding from institutional investors into public debt at low interest rates. This allows governments to reduce their debt service and spend to increase demand and reduce the burdens of unemployment. These latter two mechanisms are referred to as “financial repression” by savers organizations like the Pete Peterson foundation, who have the most to lose by it. It was practiced extensively after the second world war when large debts had to be liquidated in a timely manner.

It’s unfortunate that these natural mechanisms must be relied upon to get us out of the economic doldrums. They extend the length of the recovery process, when a positive restructuring  of debt by government would have shortened it. But, money is power and it talks in many ways, so we must suffer longer to appease those who refuse to take the hit on their bad investments.