Debt-based system has hurtled us into global financial disaster

What it takes? Sarkozy, left, declared an end to free-rein capitalism and Nixon pragmatically adopted the teachings of Keynes, centre

Satyajit Das

11 April 2012

In January 1971, Richard Nixon recanted years of opposition to budget deficits declaring: "Now, I am a Keynesian." In the wake of the Global Financial Crisis ("GFC"), it seems that we are all Keynesians again.

The GFC is really a "Minsky moment". In Stabilizing An Unstable Economy: A Twentieth-Century Fund Report (1986), Hyman Minsky outlined a hypothesis that excessive risk-taking, driven in part by stability, leads to market breakdowns - stability is itself destablising.

The current crisis is financial, economic, social and increasingly ideological. Nicolas Sarkozy, the French president, has pronounced the death of laissez-faire capitalism: "c'est fini".

Dead economists have been resurrected in support of political positions. As Keynes himself observed: "The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood.

"Indeed the world is ruled by little else. Practical men, who believe themselves to be exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back."

Criticisms of the ancien régime are substantive and deserved. There have been undoubtedly egregious market failures, management excesses and errors in the lead-up to the GFC. But the key lessons of the crisis might be subtler than at first appear.

All brands of politics and economics have been informed by assumptions about the sustainability of high levels of economic growth.

The ability of governments and central banks to control and "fine tune" the economy with a judicial mixture of monetary and fiscal policy became an article of accepted faith. Voters were lulled into false confidence by a mixture of rising wealth, improved living standards and stability.

The key lessons of the GFC may be that the current economic order is "built to fail". Like an athlete using drugs to enhance performance, the global economy used debt and financial engineering to enhance global growth.

Increasing stimulus was needed to maintain performance in an unsustainable Ponzi scheme.

The ability to sustain high rates of economic growth, decreed by governments and central bankers, is questionable. The aggressive increase in debt globally resulted in a sharp increase in sustainable growth rates. Between $4 and $5 of debt was required to create $1 of growth. Approximately half the recorded growth in America over recent years was driven by borrowing against the rising value of houses (mortgage equity withdrawals). As the level of debt in the global economy decreases, attainable growth levels also decline.

The world used debt to accelerate its consumption. Spending that would have taken place normally over a period of many years was squeezed into a relatively short period because of the availability of cheap borrowings.

Business over-invested, misreading demand and assuming that the exaggerated growth would continue indefinitely, creating significant overcapacity in many sectors.

Growth in global trade and capital flows was also "built to fail". It was built on a financing model where sellers of goods and services indirectly financed the purchase. As the risk of trade and financial protectionism emerges, globalisation of trade and capital flows is reversing - the "flat world" is rapidly going "pear-shaped".

Slowing exports, lower growth and loss of jobs are encouraging trade protectionism. Several countries have implemented trade barriers (import tariffs and export subsidies). The fiscal packages in many countries are "economic nationalist" encouraging spending on domestically produced goods and supporting national champions and local industries.

Financial protectionism has also emerged. Governments are supporting domestic banks and increasingly "directing" lending to domestic firms and households.

National and international "committees to save the world" have implemented a bewildering and ever-changing array of measures to try to stave of economic collapse. The actions - dubbed WIT ("What it Takes") by Prime Minister Gordon Brown - have been focused on trying to stabilise the financial system and maintaining growth in the real economy.

Current initiatives resemble the "hair of the dog that bit you" cure where ingestion of alcohol is the treatment for a hangover.

The current problems can be traced to high levels of debt accumulated by banks, consumers and companies. In effect, this debt is now being replaced by government debt. Simultaneously, the debt-fuelled consumption of consumers and companies is being replaced by debt-funded government expenditure.

The debates miss the point that debtors still have too much debt, and are not able to service it. Until the debt is written down and restructured, credit growth may not resume.

Adjustment in the level of debt and asset prices is part of the process through which the global economic system re-establishes itself. Like King Canute, central bankers and finance ministers cannot hold back the tide.

Sigmund Freud once said: "Illusions commend themselves to us because they save us pain and allow us to enjoy pleasure instead. We must therefore accept it without complaint when they sometimes collide with a bit of reality against which they are dashed to pieces."

The GFC was the reality on which the fake pleasure of the Goldilocks economy and the fake promises of politicians were smashed.

Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall)

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