Why I'm Now Less Optimistic About Credit Crisis

by: Edward Harrison

I have taken a less optimistic view of the credit crisis’s workout phase as evidenced by recent posts like Wood: “The endgame will be a systemic government debt crisis in the western world” and The mindset will not change; a depressionary relapse may be coming. So I want to give you a bit more color into what I am seeing and why my tone has shifted.

I have been quite sceptical about the economic policy response to the credit crisis offered up in the U.S. and elsewhere. The general theme seems to have been:

Wow, this subprime crisis has really exposed some glaring weaknesses in our financial system. We could end up in a depression. Luckily, because of the great work of people like Milton Friedman, Anna Jacobson Schwartz and Ben Bernanke, we actually know how to defeat a depression. Let’s not sit on our hands the way policy makers in the 1930s did. Let’s flood the global economy with money and use deficit spending to prevent a repeat of that.

But, now that the crisis has abated, it seems to be business as usual. Mind you, there are some changes coming. But, the feeling in policy circles is that the system is sound but in need of tweaking. We experienced [past tense] a liquidity crisis, we are not experiencing [present tense] a solvency crisis in the financial system. The recent announcement that the Federal Reserve is going to receive regulatory authority over too-big-to-fail banks tells you that this is the prevailing view.

The medicine seems to have worked… temporarily

I don’t share that view – never have. However, I do have a lot of faith that stimulus can arrest an economic freefall – if only temporarily. In October 2009, I outlined why stimulus works – and can lead to a multi-year recovery despite systemic problems.

The problem I have with the recent history of growth in the United States, the United Kingdom, Spain and Ireland in particular is that the growth was underpinned by high debt accumulation and low savings. As debt is a mechanism through which we pull demand forward, the debt and consumption has meant we have been growing today at the expense of future growth.

Low quality growth can go on for a long time

This dynamic can continue for a very, very long time. In the United States, by virtue of America’s possession of the world’s reserve currency, an increase in aggregate debt levels has been successfully financed for well over twenty-five years. Mind you, there have been a number of landmines along the way. But, time and again, these pitfalls have been avoided through asymmetric monetary policy and counter-cyclical fiscal expansion.

So, poor quality growth can continue for very long indeed. And it is this fact which allows the narrative of easy money and overconsumption to gain sway.

The boy who cried wolf

A soothsayer who counsels against this type of economic policy, but who warns of impending collapse will surely be seen as the boy who cries wolf. Think back to 2001 or 2002. Did we not witness then the same spectacle whereby the bears and doomsdayers were let out of their holes to warn of impending doom from reckless economic policy? By 2004, unless these individuals changed their tune, they were long forgotten or even laughed at – only to resurface in 2007 and 2008 with their new tales of woe…

The fact is: low quality growth does not lead to immediate economic calamity. It can continue through many business cycles. Even today, it is wholly conceivable that we could experience a multi-year economic expansion on the back of renewed monetary and fiscal expansion.

Marc Faber: “Don’t underestimate the power of printing money”

You will recall that I wrote a post at the depths of the market implosion highlighting a phrase by Marc Faber, “Don’t underestimate the power of printing money.” This quote has stuck with me as asset markets have soared in the intervening time. What Faber was alluding to was the fact that printing money works. It does goose the economy as intended and it can induce a cyclical recovery.

Nevertheless, the recovery is likely to be of poor quality due to significant malinvestment. Debt levels will rise and capital investment will be directed toward riskier enterprises. Look at what’s happening in China. Are you telling me stimulus is not working? It most certainly is.

-Is economic boom around the corner?, Oct 2008

That’s exactly why the U.S. economy grew at a 5.9% annualized pace last quarter. And that’s why GDP growth will be high yet again this quarter.

But let’s forget about the short-term for a moment. Let’s think about the long-term. And I want to focus on three issues: The complexity of the financial system, the lack of financial reform and the growth in debt.


The global financial system is a byzantine maze of different companies, domiciled in different countries, competing in different arenas, all regulated by an amorphous set of regulation across a panoply of different national, state and local regulators. It is the definition of a complex system. Some complex systems adapt, reform and continue. Others do not. They fail.

Interestingly, Wikipedia has defined the stock market – a subset of the financial system – as one of the former adaptive systems as opposed to the latter:

Complex adaptive systems (CAS) are special cases of complex systems. They are complex in that they are diverse and made up of multiple interconnected elements and adaptive in that they have the capacity to change and learn from experience. Examples of complex adaptive systems include the stock market, social insect and ant colonies, the biosphere and the ecosystem, the brain and the immune system, the cell and the developing embryo, manufacturing businesses and any human social group-based endeavor in a cultural and social system such as political parties or communities. This includes some large-scale online systems, such as collaborative tagging or social bookmarking systems.

-Complex adaptive systems, Wikipedia

And I suspect this is how much of our political elite view the global financial system, the main reason reforms have been limited.

Maladaptive complexity

I would like to argue that we are living in a complex maladaptive financial system with an extreme status quo bias and an extreme lack of reform. This is exactly why I see problems ahead. I wrote a few posts on a recent conference on financial reform that I attended (see here, here and here). And while I fully support these efforts, I do not see any traction for financial reform whatsoever. In the U.S. the focus has mainly been to increase liquidity to support asset prices.

Look at some of my comments from February 2009 to the policy proposals of the new Obama Administration in the United States.

late [in 2008], I predicted that the Obama Administration would not change course significantly on the economic policy front. This was largely due to the make up of his proposed cabinet and their previously stated positions on economic policy. Frankly, they are subject to cognitive regulatory capture and beholden to the same special interests in the financial sector that the Bush Administration were.

Geithner is unwilling to nationalize any banks, preferring to roll the dice on a scheme whereby the Fed and the Treasury buy up toxic assets in order to provide liquidity to the market for those assets. The theory here is that these assets have fallen in value by much more than is necessary…

But, is that really true?…

President Obama has a limited window of opportunity here. He will need to decide the correct path and delegate appropriately. Sidelining Paul Volcker for Larry Summers does not leave one with a good tingly feeling. Bailing out banks when populist sentiment is rising shows a tin ear to the shift in national sentiment. On the whole, I am very worried that Obama does not see the poor optics of all of this. Politically, this is not a good plan.

-The Obama-Geithner Plan will fail, February 2009

So you have the Change President instituting a massive transfer of wealth from the taxpayer to bankers and rolling the dice on a plan that basically depending on providing enough bailouts and liquidity to get the financial system re-started. Bank profits are sky high as a result as are bonuses. Meanwhile, unemployment and foreclosures are rising, credit growth is not happening, and securitization markets for mortgages are still frozen. Does that make any sense? I didn’t get it. So I tried to look at it from the other side’s view in Channeling my inner Larry Summers. But that only led to the same conclusion: Obama is trying to increase asset prices in order to return to the status quo ante.

Stimulus is the only thing going in the U.S.

But then you turn to the data and you see that the only thing between the U.S. and another recession is federal government support.


In creating the chart above, Tim Duy says:

I took the difference of nominal personal income and current transfer payments and deflated the resulting series by the personal consumption expenditures price index. I then estimated the (log) linear trend over various time horizons. We are currently well below the trend extrapolated the from Jan-91 to Dec-07 period.

What this means is that U.S. economy is afloat only because of government largesse and huge deficits. Duy goes on to reveal that:

Importantly, the gap between trend and actual real personal income less transfer payments has reached its widest since 1975:


And we used to think the late 70s were bad! (The same qualitative result holds using the Jan-75 to Jan-10 sample).

The end game

When I wrote The recession is over but the depression has just begun, one of my most read posts, in October 2009, my implicit assumption was that we lived in a complex maladaptive system and that policy makers would assume the worst was over too soon and fail to follow through on more substantive enduring measures of reform and economic healing. This is exactly what is occurring.

But all evidence suggests, politics or not, stimulus is out and deficit reduction is in. But I have long since decided on Moving away from stimulus happy talk to focus on malinvestment because that is the crux of the problem. This is what the Christopher Wood piece was all about. It’s not about whether stimulus works. It’s not about whether there is some pre-defined sovereign debt level where things go kaboom. It’s not about whether a sovereign issuing debt in its own currency can default. It’s about whether the entire world can prop up malinvestments indefinitely without a collapse in the current financial system.

Can everybody do the bailout hustle simultaneously? The answer of course is no. You have to meet the problem head on – and the problem is the debt and leverage. The bailout hustle leads to transferring what were private debt into public debts while leaving the financial system’s leverage and undercapitalization in place. And that eventually leads to a systemic crisis.

How does this end then? I focus less on the sovereigns than on the maladaptive financial system. The financial system is fundamentally unsound because it depends critically on large connected financial institutions who have scaled up in a way that magnifies any localized financial problem into a systemic problem. Think of it like this:

We have had a long hot and dry spell. The forests are in a critical state where anything could tip us into a major forest fire. We could have 100 different forests across which there are minimal opportunities for the localized fires to jump. But, alas, we have one big interconnected forest with many fingers of instability. So, when the fire hits, it does major damage. Luckily, our firemen are able to douse the fire, which alleviates the pressure on the forest. But, this is only a patch. The fingers of instability remain – which is the real problem, of course. Then, another hot and dry spell hits. This time, however, the firemen’s solutions are ineffective.

Replacing a few words, it reads like this.

We have had a long spell of increased leverage and risk. The financial system is in a critical state where anything could tip us into a major financial sector meltdown. We could have 100 different financial systems across which there are minimal opportunities for the localized credit crisis to jump. But, alas, we have one big interconnected financial system with many fingers of instability. So, when the credit crisis hits, it does major damage. Luckily, our policy makers are able to stop the credit crisis, which alleviates the pressure on the financial system. But, this is only a patch. The fingers of instability remain – which is the real problem, of course. Then, another spell of increased leverage and risk hits. This time, however, the policy makers’ solutions are ineffective.

Interest rates are at record lows worldwide. Our financial system cannot stand another shock – whether it be sovereign debt, double dip, commercial real estate or some other as yet undiscovered instability. My fear all along has been that policy makers were myopic and the system is maladaptive. Increasingly, my fears seem justified.