Issue 61

Will this Crisis Never End? Causes, policy responses and the outlook

By William R White
Former Chief Economist, Bank for International Settlement


Things look really interesting in the gold market. However, just because things look good, it does not mean they are going to continue to be good.

You will remember Donald Rumsfeld a while back saying: “There are things we know we know; there are things we know we do not know; but there are also things we do not know we do not know.” People initially thought he was silly and pretentious, but I thought he was pretty wise. That is one form of uncertainty; the things that creep up on you from behind.

There is a second form of uncertainty. Mark Twain got it right, about a century ago, when he said: “It ain’t the things that you do not know that getcha; it is the things that you know for sure what ain’t so.” A second source of uncertainty is that we may believe things that are not true.

Is there room for gold in an uncertain world? I think there is.

The Nature of the Crisis

Everyone, including the policy makers, thought the great moderation was going to go on forever. Accordingly, there was general surprise when it began to unwind. Right at the start of the unwinding process, Ben Bernanke said: “This is a $50 billion problem, but it is going to be confined to subprime.” Do you remember that? After a time, they said it was going to be bigger than that, but that it was confined to the financial system; moreover, it was a liquidity problem and it could be solved. After a further period of time, they admitted that it was not a liquidity problem; it was actually a solvency problem, but this too could be resolved. A year into the crisis, as the economy was starting to collapse worldwide, they realised it was not just a financial thing; it was a real thing. Fortunately, however, they said it was a demand-side problem and they could fix that as well. Even now, policy makers and others have not yet fully understood that it is not just a crisis with profound implications for demand; it has profound implications for supply as well. The fact that most policy makers felt that a big crisis was effectively impossible implied that they did not forecast it. As they did not forecast it, they did not try to prevent it. Further, they made no preparations for handling it when it did happen.

Finally, when the crisis did hit, I would contend that policy makers did not handle it as well as they should have done. For example, things were treated as liquidity problems when they should have been treated as solvency problems right from the start. We have a deep-seated economic and financial problem, and it is not at all clear that the reaction to it has been optimal.

The Development of the Crisis

You will remember that this thing started in the summer of 2007. The interbank market seized up; the mutuals started to withdraw from the SIVs (Structured Investment Vehicles); many of the obligations of off-balance sheet vehicles fell back into the banks; banking difficulties got progressively worse and then the real side took a big hit. At the same time, you may remember that, as recently as the summer of 2008, we were really worried about inflation even as real demand and output were beginning to collapse around us. Now, of course, in light of that collapse, we are more worried about deflation. We have had a recovery in the real economy since then. Yet the underlying truth is that an awful lot of people continue to be enormously uncertain about what is going to happen. I would have to include myself among that group of enormously uncertain people.

“It ain’t the things that you do not know that getcha; it is the things that you know for sure what ain’t so.”

Mark Twain

The Causes of the Crisis

There are two schools of thought about what underlies our difficulties. The first one is what I call the comforting ‘school of what is different’. This school points to all the things that were new in this crisis – rating agencies, SIVs, conduits, the originate-to-distribute model, CDOs (collateralised debt obligations) and CDO2s. A lot of people would claim that these played a material role in what has happened and what is still unfolding, and I do not deny that. It is sort of comforting, though, to be able to put the blame on new things, because it allows everyone to say that they could not possibly (or even reasonably) have been expected to see all the material implications of this brand-new stuff. There is a second school of thought, which I think is less comforting. I call it the ‘school of what is the same’. Ken Rogoff and Carmen Reinhart have documented this very well in a recent book, Eight Centuries of Financial Folly. To be concise, we had a huge recession in 1825, another one in 1873 and again in 1929. We had the South East Asian crisis and the Japanese crisis; we had so many of these things, and they all look the same. They start off when something new happens, such as some new technology, and the optimism begins. People go the banks and take out loans, because the opportunity to make money is there. They get the money and spend it, so the economy booms and some of it goes into asset prices, which in turn provide more and more collateral. There is more lending and more optimism; the rational optimism gradually turns into irrational optimism and then the whole thing collapses.

Why is that less comforting? Because this big cycle was essentially the same as all the earlier ones and you missed it.

It is true of course that these big booms can manifest themselves in a number of different ways. The implications of unusually low interest rates, unusually rapid credit growth, speculation and leverage, which is the essence of the ‘school of what is the same’, can potentially lead to rising inflation. You do not have to be a ‘monetarist’ to believe that, if you have a long period of very rapid credit expansion and very low interest rates, it will manifest itself in inflation. That is entirely possible. Recall that we were worried about inflation as recently as the summer of 2008, and we may have occasion to be worried about

it again before too long. That is only one possible manifestation of the excessive growth of credit. There is another possibility as well. You do not have to be Fredrick von Hayek to believe that this sort of credit expansion can lead to all sorts of imbalances in the economy, imbalances which can quietly creep up on you but do great damage in the end. What sort of imbalances are these? I am talking about asset prices that got too high; banks that got too exposed; household saving rates in the United States that got down to zero and even less in many other English-speaking countries; global trade imbalances; and investment rates of 50% of GDP in China. These are all unprecedented and completely unsustainable. And if they are unsustainable, they will end. And that is precisely what we are seeing.

At the end of the upward phase of the credit cycle, you get to a tipping point. Hyman Minsky used to talk about this tipping point – the morning when a banker, who has been giving credit for a long period of time to all sorts of people who should not have received it in the first place, gets up and looks at himself in the mirror and says: “Oh my God, what have I done?” If the banker is seriously worried about his own solvency, and in his heart of hearts he truly believes he has been pretty well behaved relative to everybody else, you can imagine how worried he is going to become about the solvency of his counterparties. That moment, when the music and the dancing stop, is now referred to as a Minsky moment.

My point is that the banking problem initially looks like a liquidity problem, but it is actually a solvency problem. That reality is what is lurking behind all the economic and financial difficulties we still have to face.

The Policy Response

We have had this deep downturn and financial seizure, and we have responded to it vigorously. I have been in this business for more than 40 years and I would say that the policy response has been unprecedented. Yet, it is also a bit worrisome, because I think that virtually everything that has been done thus far – monetary, fiscal and structural – has short-term limitations as well as longer-term side effects that could in the end prove rather unpleasant.

Monetary Policy and its Limitations

This is what I call the ‘lean versus clean’ debate. You may be aware that Chairman Greenspan and Chairman Bernanke have repeatedly asserted that it is impossible to ‘lean’ against a credit bubble; they say the only thing you can do is ‘clean up’ afterwards. The first argument they use is that econometric models all say that you can clean up afterwards. Virtually everybody sensible today is re-evaluating the models they use, because most of them are based on assumptions that are patently unrealistic.

A second argument is that ‘cleaning up’ has always worked in the past. They did it in response to actual or incipient downturns in 1987, 1991, 1997 and 2001-2003, and it worked every time. The problem with that argument is that, every time they turned to cheap money in the past, the implication of the lower interest rates was to induce people to spend yet more money that they did not have and to increase their debt levels. In the successive cycles, you can see the effectiveness of monetary policy was increasingly less. Logically, you could say easy money will eventually not work at all and I think that is pretty close to where we are at the moment.

Another argument they use is that, in the US in the 1930s and in Japan in the 1990s, the problem was errors in policy after the recession struck. I think the Americans feel this very strongly and that helps to give us some insights about how they are likely to set policy in the future. I personally do not feel that the 1930s was a by-product of the Federal Reserve raising interest rates by 1% in 1931; nor do I believe that 20 years of stagnation in Japan is a by-product of the Japanese having lowered interest rates too slowly in 1991. It is simply incredible that 20 years of slow growth in Japan could be the by- product of a policy mistake of that nature. I think it comes out of all of the stuff I described earlier, which is the imbalances, structural problems and the unwillingness to face up to those problems. I think the bottom line is that traditional monetary policy is not really going to work.

Of course, this still leaves room for non- traditional monetary policy, like quantitative easing. The Japanese tried it quite vigorously in the 1990s and it did not seem to do them a very great deal of good.

The Longer-Term Side Effects of Monetary Policy

What we are doing now could potentially lead to further bubbles. The monetary easing in 1987 led to the property bubble of the late 1980s and early 1990s. I think you could make a case that the easing in the early 1990s led to the Asian crisis and that the easing of interest rates after the Asian crisis led to the problems of LTCM (Long-Term Capital Management). It is a story of one bubble leading to another, and judging by what is now going on in the emerging market economies, the story may be ongoing. If you have very low interest rates for a very long period of time, you end up with lower saving rates, which is not good for growth. You wind up with zombie companies and zombie banks, which is not good for growth. You subsidise debtors at the expense of creditors, which is not good for growth. There are a lot of downsides to easy money. Lastly, of course, there is this business about quantitative easing and higher inflation. I think there are two risks. One is that, at a certain point, inflationary expectations are going to come unstuck. I do not think it is likely, but it is possible. We have seen this process at work many times in Latin America. The fact that you have lots of unused resources does not preclude high inflation once people’s inflationary expectations start to come unstuck.

The second risk of quantitative easing is simple policy error. At the moment, with all of these balance sheet effects, nobody really knows where demand is going. Moreover, with all of the changes that are taking place on the supply side, nobody really knows what ‘potential’ growth is either. On top of that, you have to add in the fact that, at some point, we will have to rein in past quantitative easing. However, what the effect of this will be is hard to determine since everything we are doing in this domain is essentially unprecedented.

Fiscal Policy and its Limitations

Do you remember that US fiscal policy was to be “timely, temporary and targeted”? Where that came from? Timely – we did not use fiscal policy in a countercyclical way for 20 years because people believed it was impossible to get the timeliness right. Now, all of a sudden, we can do it. Temporary – when I was a graduate student, I was taught that fiscal policy/fiscal expansion had to be permanent to get people to think they were permanently wealthier. Now, all of a sudden, it is temporary that works, not permanent. And targeted? To whom or to what has never been made clear.

The principal limitation of fiscal policy is, of course, that it can engender negative financial market reactions. You are seeing it play out on the front page of the Financial Times every day. I am thinking particularly about Greece, Ireland and Hungary today, but similar financial market worries could eventually affect much larger countries.

Lastly, there are fears of currency crises. You cannot have a currency crisis in Greece, but I guess you can have a currency crisis by proxy in the Euro. You can have a currency crisis in Hungary and this has been a source of real concern. You could have currency crises in other currencies as well, if people start to worry enough; if people start to believe that the fiscal house is a house of disorder.

The Longer-Term Side Effects of Fiscal Policy

When we think about fiscal expansion and traditional, countercyclical policy, we have to remember that in the advanced market economy countries, our demographic starting point is almost universally bad. Looking at unfunded pension liabilities, both from the public and private sector sides, we already have a real problem in terms of affordability. Now, of course, still more debt is being piled on and I think that could be a real problem as we start to look at interest rates and interest rate differentials going forward.

Structural Policy

If one of our big problems is excessive debt, one answer to the problem is to write it off. The difficulty of doing that today is that there are millions of people in the United States whose mortgages are underwater. It is enormously difficult just to put in place the underlying infrastructure to manage something like that. It is not like the old days when there was a sovereign debt crisis. Bill Rhodes of Citicorp would go into a room with ten of the most senior bankers in the world and sort out the problem. Today, how big a room would you need? Moreover, many of these troubled mortgages are encumbered by second mortgages or wrapped up in CDOs, which legally proscribe changing the conditions of the underlying securities. The legal aspects of debt forgiveness are now absolutely daunting. Finally, even supposing we could write off all this debt, the first thing you would worry about would be moral hazard, to say nothing of the political difficulties associated with bailing out the profligate.

We have in fact done a great deal to help the financial sector cope with bad assets and prospective insolvency. Is it enough? The honest truth is nobody really knows. People are still backing away from the valuation of toxic assets, and a further economic slowdown could bring more bad loans in turn. Could we do more? It is highly unlikely. The central point about everything we have done is that the banks now are bigger, more complex and more interrelated than they were before.

So, we have done all of this stuff to support the financial system and it has helped avoid the worst, but it has also left us in a situation where we have some significant problems. If you look at the big banks that still remain, some of them are healthy and some are not. If natural selection is anything to go by, the healthy ones are going to try to eat the unhealthy ones, and then the ‘too big’ problems are going to be even bigger.

Finally, there is this whole business of measures to support industrial sectors. Governments have used many measures to support jobs directly. In particular, we have had extensive subsidies to support short-time working, which seems to have been successful in keeping down rates of unemployment, especially in Europe. Yet the countries that have used short-time working the most are in the main those countries that already have huge trade surpluses. These countries are protecting jobs that, in the longer run, are jobs that have to disappear anyway.

Given everything I have said about the short-term and long-term effects of these different policies, who really knows what will happen. It should not be at all surprising that the G20 is having trouble getting its act together. Given all these uncertainties, it is perfectly normal for thoughtful people to come to different conclusions about what is desirable. It is also perfectly normal for some people to be more worried about the short-term fix, while others are more concerned about getting it right over the long term.

We have in fact done a great deal to help the financial sector cope with bad assets and prospective insolvency. Is it enough?

The Outlook

Three years into the downturn, all the initial imbalances I talked about are still there and that worries me. It leads me to the conclusion that some kind of double dip is more likely than not.

That having been said, it is also possible that the current recovery will continue. I think there are two ways it could continue. One way is a natural and sustainable recovery, where we work off these imbalances in a gentle way. In the States, for example, the saving rate has been higher than anticipated and consumer debt is being written off faster than people thought it would be. It may be that we will get a sustainable recovery in that way. It will be a long period of very slow growth, but it is possible.

Another possibility is that we will get another bubble-driven recovery. We may, in fact, already be seeing this in the emerging market economies. A good chunk of what appears to be robust demand may be due to relatively low interest rates and exchange rates. While in a longer-term sense, such demand might prove unsustainable, it might be enough to keep things going for quite a long period of time. In the advanced market economies, that is precisely what happened from 2003 to 2007. Growth was policy- driven, and unsustainable, but it went on for a long time. It is not impossible it could happen again, although I do not think it is likely.

Lastly, we have deflation, which I think is the more likely outcome. However, it is not impossible that inflationary expectations will come unstuck and that money will start heading for the exits or at least start to head for real things like gold. In this case, we could find ourselves in a significantly more inflationary environment. there a place for gold? It would seem to me, in a world of more common ‘tail events’, the answer has to be yes.

Policy Going Forward

If the green shoots continue, I think policies will tighten. Fiscal policy will probably move more rapidly than monetary policy, which will exit only very cautiously. Ben Bernanke is a keen student of the Great Depression, and from everything I have seen and read, he truly believes that policy mistakes caused the Great Depression. He has no intention of going down in history as making the same policy mistake twice. I think you will find monetary policy will be very easy in that environment.

If green shoots do not continue, monetary policy will not tighten and that will simply make things worse over time. Even if there was moderate fiscal tightening in such circumstances, there are such significant problems that we could see sovereign rates go up in a number of countries, with currency problems thrown in for good measure.

In this environment of enormous uncertainty, is there a place for gold? It would seem to me, in a world of more common ‘tail events’, the answer has to be yes. But, of course, the much harder question is what that role might be? I would have to say that is for you rather than me to decide.

William R White is from Kenora, Ontario, and now lives and works in Basel, Switzerland. He is currently Chairman of the Economic and Development Review Committee, which provides policy recommendations to members and aspiring members of the OECD, in Paris. The views in this text are the author’s own and do not necessarily reflect those of the OECD.

He is a member of the Issing Committee, the Advisory Board of the Globalisation and Monetary Institute at the Federal Reserve Bank of Dallas, as well as that of the Institute for New Economic Thinking, recently established with the support of George Soros.

A career central banker, Mr White held the position of Chief Economist at the Bank for International Settlements (BIS) in Basel for 14 years. He publicly predicted the current financial crisis, well before the subprime meltdown, noting that the long-standing deterioration in credit standards had global implications that would extend far beyond the US mortgage market. At the 2003 conference sponsored by the Federal Reserve Bank of Kansas City in Jackson Hole, he famously challenged the Federal Reserve view that central bankers cannot “lean” against the build up of dangerous credit and asset price bubbles, but that they can easily “clean” up afterward.