Friday, 2 March 2012





Why did this crisis occur? The answer often depends on who you ask. For some, it’s all about greed. Those greedy bankers, they ruined everything. Or maybe it is incompetence. Those incompetent regulators, central bankers and politicians, they ruined it all for the rest of us. If you’re morally inclined, you can say it’s the general populace’s fault as they wanted to live the life of Riley, wanted to spend, consume, and feel rich and they recklessly borrowed to do so. If you’re more technically minded or financially savvy, you can also blame CDOs, maybe CDSs and, in any case, all these fancy derivative products.

While any or all of these explanations may be partially right, they fail to go deep enough and really explain what went wrong and how we ended up with the worst deflationary crisis since the 30s, something we thought we had vanquished long ago.

In this article, we will explore what really went wrong and how it helped generate all the behaviours described above.


Here is the first chart, courtesy of Thomas Piketty & Emmanuel Saez

As you can see, this now infamous chart (and many variations thereof) shows that the top 1% is grabbing and has been grabbing an ever larger share of the total income since 1978.

The results are just as staggering if we were to consider the top 0.1% (see graph below). Clearly, the old adage that the rich are getting richer has never been truer. Well, actually, it was just as true in… the 1920s (and prior when we consider the top 0.1%).
Top 0.1% Income Shares in the U.S.France, and the U.K.,1913-2005

It is hard to underestimate the amount of things that a highly unequal income and wealth distribution screw up for a country.

While the mathematics used within “The Spirit Level” by authors Richard Wilkinson and Kate Pickett has been contested, plenty of studies have showed that the US and UK, with their high inequality level have had worse outcomes in public health care outcomes, criminality and a host of socio-economic factors than more equal countries.

But what has been somewhat ignored is the great imbalances that this inequality creates in terms of aggregated demand in the economy. With the middle (and working) classes being so harshly constrained and indeed more or less excluded from the growth of the last 30 years and its benefits, it seems clear that aggregated demand should have suffered vastly. After all, the propensity to spend of the richest is more or less mathematically guaranteed to be lower than that of the poorer members of society. But aggregated demand did not collapse. Why? Well, that third graph below shows clearly why…

Faced with stagnating income growth, people, by and large, resorted to borrowing in order to finance their lifestyles – and thus sustained or indeed even increased the level of aggregated demand thus allowing the whole economy to keep growing.

Of course, the policies of low interest rates practised by many central bankers during the last 30 years are directly linked to that phenomenon. Indeed, Albert Edwards, economist for the Global Strategy Team at the Societe Generale, goes as far as saying “Some recent reading has got me thinking as to whether the US and UK central banks were actively complicit in an aggressive re-distributive policy benefiting the very rich. Indeed, it has been amazing how little political backlash there has been against the stagnation of ordinary people’s earnings in the US and UK. Did central banks, in creating housing bubbles, help distract middle class attention from this re-distributive policy by allowing them to keep consuming via equity extraction? The emergence of extreme inequality might never otherwise have been tolerated by the electorate”

I wouldn’t describe the situation (and Mr. Edwards doesn’t really either) as a conspiracy or as central bankers being “complicit”. Simply, with inflation vanquished and with some periodic thunder storms (the Asian crisis, LTCM collapse, the dotcom crash, 9/11…), the temptation to keep interests low was overwhelming. And, as in any bubble, the increasing asset prices (be it internet stocks or property) dissimulated for a time the fact that incomes were not rising in line. And the capital gains on these assets were then used to justify the rising amount of debt – until debt levels rose so much that servicing it became a hardship and people started to notice the unsustainable nature of the bubble.

Suddenly, liabilities overwhelmed the asset side of people’s balance sheet and many discovered that they were either virtually bankrupt or, at the very least, within negative equity territory. Their reaction has been, overall, to stop borrowing and start repaying debt as fast as their income allows them to. While this is obviously sensible at the individual level, it represents a serious destruction of private demand – And thus plunge the economic into a deflationary spiral not unlike that experienced by our great-grandparents in the 30s… or Japan more recently.

The Japanese example is extremely striking because of the overall similarities… except that the main actors in the Japan bubble and disaster were companies rather than individuals. But, barring that difference, the scenario is essentially the same. Similarly, as the two-three graphs above show clearly, the similarities with the Great Depression era are eerie…


If we know how and why the crisis occurred (and I would say we do now), the next question becomes: “How was this ever allowed to happen”? After all, the Central Bankers explained to us that the 1930s crisis was caused by then incompetent central bankers but now that they knew more things, such repeats were impossible. 1987 saw a drop in equity twice as brutal as 1929. But it was overcome by the Fed activism. Then, we had several other crises and, every single time, Central Bankers managed to save the world. Then, Greenspan was heralded a hero, a guru, the greatest Fed Chairman to ever have lived.

Yet, all this extra knowledge did not prevent us from repeating the mistakes of our forefathers. How could that be?

Well, I would postulate that the following took place: After the occurrence of the Great Depression, the ideas of John M. Keynes started to impose themselves, more or less worldwide. And, after WWII, the world economic order was explicitly built on his ideas, however mangled were they by politicians.

But Keynesian theory was ill-equipped to deal with the stagflation that took place in the 70s as a result of the Oil Shocks of ‘73 and ‘79. Up to the 1960s many Keynesian economists ignored the possibility of stagflation, because historical experience suggested that high unemployment was typically associated with low inflation, and vice versa (the famous Phillips Curve). However, in the 1970s and 1980s, when stagflation occurred, it became obvious that the relationship between inflation and employment levels was not necessarily stable: that is, the Phillips relationship could shift. Indeed, the classical “Keynesian-inspired” policy of trying to boost aggregated demand via increased government spending only made things worse because the problems facing western societies wasn’t a lack of aggregated demand but a supply shock.

New theories emerged and old ones were revived. Milton Friedman in particular, in establishing Monetarism, provided an explanation for stagflation while Keynesianism, at the time, couldn’t. Regardless of their individual merit, these theories were the intellectual spearheads of what became known as Reaganomics and Thatcherism.

And so the political consequences of the stagflation were that, in order to break the wage-price spiral, the newly elected conservatives decided to break the unions. Furthermore, they decided to liberalise the economic environment as far as possible – the idea being that ‘flexibility’ would allow for the maximising of growth – and thus employment. Crucially as well, taxation rates were slashed, especially for the wealthier and for the capital-rich. Furthermore, the Federal Reserve, under Paul Volcker, raised rates to a recession-provoking level which finally reined in inflation but also helped destroyed labour organisations. And, finally, globalisation reached levels never reached before, putting yet more pressure on salaries and labour bargaining power. With Labour as with any market, a drastic and tremendous increase supply unmatched by a similar rise in demand tend to lead to a severe drop in price. Said differently, labour got cheap and stayed cheap

Thus, the overall result was that, when stability finally emerged from these 2 chaotic decades and growth started to resume, there was no one left to speak up for Labour and ask for the workers’ piece of the pie. Indeed, salary ‘moderation’, by being anti-inflationary and a boost to competitiveness, was seen as a great boon.

And thus the most fundamental mechanism for this crisis, a lack of solvent demand, was created.


Keynesianism was in part built and certainly achieved political dominance thanks to a back-lash against the foolishness of neoclassic theories’ response to the 1930 crisis. Monetarism and supply-side economics went through the same cycle when Keynesianism couldn’t solve or even explain the stagflation of the 70s and 80s.

But, consciously or not, these policies returned us to a pre-WWI economic set-up. As a consequence, we have recreated the types of crisis of that time. To a degree, better or at least more aggressive central banking and an in-built higher level of public expenditure have mitigated some of the pain. 2008, 2009 and 2010 were awful years but not nearly as disastrous and costly (in human terms) as the early 30s.

Nonetheless, it is clear that “something must be done”. And it is equally clear that this crisis, despite all the political hand wavering, has gone to waste. But solutions do exist, even if my own suspicion is that they will never be implemented. What these solutions are will be explored in further articles.

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