what george osborne should know


Robin Matthews

I wrote three years ago that the probability of a double dip recession was about 50%. Now this looks like an underestimate. The Bank of England estimates the cost of the Great Recession to the world is between 60 and 120 trillion dollars; between one year and two years worth of global GDP and probably an underestimate too.

The Great Recession

The Great Recession first became apparent in the housing markets, especially in the USA and UK in 2007, spread throughout financial sectors of the world, then percolated through to non financial sectors, slowing growth and increasing unemployment globally.

Governments bailed out banks, because they were insolvent and too big to fail. Where they did fail, as with Lehman, it threatened global finance, entirely. Global Depression on the scale of the 1930's did not follow. This was largely due to bailouts and fiscal and monetary stimulus especially in the US and UK, both of which became like Soviet Socialist Republics, except that the scale of their bailouts made them bigger owners of industry in real financial terms than the USSR ever was.

Now we know that the Great Recession has spread to sovereign states; first the PIIGS (Portugal, Iceland, Ireland, Greece, Spain), now probably Italy, perhaps France and maybe the EFSF (European Financial Stability Facility) the Eurozone bailout fund itself.

To bailout Spain, a reduction in the net present value (NPV) of Spanish debt by 50% was required. In fact the bailout amounted to less that 30%. So a further bailout will be necessary. But the EFSF fund is less than a trillion dollars and Germany is unwilling to sanction further increases at this stage. Though it will relent, reluctantly but not sufficiently to provide the funds required by Spain, and certainly not for Italy or for the other PIIG nations, when they ask for more.

Whereas in the first part of the twentieth century, Germany strove for political dominance of Europe, in the first part of the twenty first century, Germany strives to avoid the consequences of its economic dominance. The Euro is strong because Germany is strong; high productivity, low unit labour costs and a current account surplus; meaning that countries that need to revive their industries and reduce unemployment, are burdened by an overvalued euro, which reduces their competiveness.

Demand not supply is the problem

Not only demand in Europe depressed, demand is globally depressed. Why?

Demand is depressed partly because governments, especially in the UK and more important, in the USA, are obsessed with reducing government debt and financial deficits: deficits that occurred largely because of the bailouts of the financial sectors. The bailouts are forgotten. Representatives of the financial sector and regrettably many economists, lecture governments on financial probity and the need for cutbacks; belt tightening, good housekeeping, doing more with less, many clichés masquerading as economics. In the UK the fallacies are that recovery will follow from exports, creation of jobs by the private sector at a time when demand is depressed, partly by the cutbacks, and the destruction of jobs and income: ignoring the fact that cutting the deficit destroys jobs, reduces the tax base, increases the bill for benefits and makes it more difficult to reduce the deficit.

The casino

Now countries are losing their triple A rating; the PIIGS, the USA maybe France and the ESFS too, since the ESFS operates at the moment like an SPV (Special Purpose Vehicle), issuing CDO's (collateralized Debt Obligations) securitized on its bailouts.

Loss of triple A rating means that refinancing debt and deficits become more expensive. But it seems to be forgotten that de-rating is instigated by the same ratings agencies that gave triple A ratings to the assets of financial institutions when they were on the verge of insolvency, in the period leading to the Great Recession. Rating and de-rating follows the judgment of the markets, we are told, by governments, pundits from the markets and by institutions such as the London Economist pretend (to their readers and themselves) that their opinions are sound economics. But what kind of judgment is it?

Financial markets provide a way of channeling saving into productive investment; first, leveraging their deposits (savings) so that the funds available for investment are a multiple of savings and second, leveraging bank assets, so that funds available for investment are a multiple of bank assets. The first multiple determines bank liquidity, the second multiple determines bank solvency.

Leaving aside the question as to what multiples are sound (multiples of 10 and 15 respectively are good approximations of what on average is safe), as an issue for regulation issue, we concentrate on other functions of financial institutions; speculation and gambling (which are not exactly the same thing but nearly the same thing). In other words, financial institutions are gambling institutions, casinos, or betting shops. They are special casinos, privileged betting shops because governments provide them with a guarantee that if they do become insolvent, they will be bailed out; because governments guarantee to issue them with what is effectively a CDS (Credit Default Swap), on the behalf of the taxpayer.

Returning to the question; what kind of judgment is the judgment of financial market and the ratings agencies that are hired help of the financial markets? As Keynes pointed out, it is the judgment of the casino (at the time betting shops were illegal).

So government policy is determined by the norms of the casino. More absurd, corporate performance is evaluated by share price performance. How can this happen? Because of the too big to fail (TBTF) problem, but the too big to fail problem not as it is usually understood as the interlocking assets of the big financial institutions, but because of the political power that their huge size and their wealth gives them. The big financial institutions are monopolies (more precisely oligopolies) and the real problem of monopolies is not their economic power but the political power that results from their wealth and economic power; their power to shape how we think.

China and the Eurozone

There is another reason why the Great Recession has not turned into a Great Depression; the Chinese investment boom. China devotes nearly half of its GDP to capital investment, thus increasing potential supply at a time when there is insufficient demand. The state of the global system is that of too little demand and too much supply, worsened by the attempt by many governments to deleverage; a vicious circle, reducing demand and as a result of unemployment, slower growth of GDP, a reduced tax base, pressure on governments to deleverage and so on. Where does the pressure to deleverage come from? The financial markets whose own insolvency triggered the problems in the first place. Note the word is triggered not caused: things are so interdependent that it is impossible to isolate a single cause.

We have described the state of the global system now. What is the future? Certainly surprises. What else? The Eurozone will collapse in the next two or three years. The alternatives to Eurozone collapse are unlikely, or unacceptable, or both.

One alternative is a fiscal union with Germany dictating fiscal policy for the rest of the Eurozone. Another is restructuring in the weaker economies, which means wage cuts, layoffs and probably deflation: all of which worsen the problem of deficient demand.

A way out for the PIIGS and others is to quit the Euro and allow their own currencies to depreciate. This is not an easy way out. Given that debt is denominated in Euros or dollars, its real value is increased for economies whose exchange rates weaken.

What will China do about her overcapacity as a result of over investment? Commentators tend to focus on China's spectacular growth and emergence as the nation with the second highest GDP. But her problems are severe. With a population that is now nearly 50% urban, it is more restive if aspirations are not met. Meeting some aspirations is merely standing still. The urban family with one child policy and an ageing population means that increasing numbers of old people have to be cared for by fewer young people; so state welfare has to substitute for family provision. Adding aspirations for housing and education to this means that a growth rate of 6% is merely standing still; 6% growth is zero growth. Then there are aspirations for consumer goods cars for example to be met. So 10% growth (currently it is less and likely to fall) is not so spectacular as it seems, at least for the Chinese government.

Chinese government knows this. That is why they are repressive over small things. They know that big rivers flow from small streams; as in the Middle East currently apparently insignificant events can lead to major disruptions and perhaps chaos. One response to over capacity in China is to dump products on world markets: then retaliation will follow. Add the temptation of debtor nations to devalue competitively and a universal desire for export led growth, and economic policies become contradictions; aspirations become impossibilities. Problems become like koans, not solvable by conventional thought processes.

The future

Probably the best response to economic predictions is let's see. The problem for causality and prediction in social and economic affairs is that to predict, we have to assume a definite beginning point and a definite end point. Assuming a closed interval in time is social science version of a controlled experiment in other sciences; but in social affairs there is always something before what we designate as the beginning and something after what designate as the end.

So let’s see. Perhaps the scenario I present is pessimistic: perhaps not. The indications are that we are in a 10 year Great Recession. Dating its beginning as 2007 that means an ending in 2017 or later.

All my comments reflect the dynamism and the instability of capitalism in its various forms, including state capitalism: national oil companies are as capitalist as BP, China and Russia are as capitalist as the USA and the UK. Now the unstable face of capitalism is most apparent: a phase in which governments, banks, consumers, corporates are deleveraging; reducing debt and inevitably defaulting on part of it.

Who gains from the situation now? The banks do. They are still profitable. Day after day their representatives are produced by the media to Pronounce on the global situation. Who advises governments on banking regulation? The banks do; which means no regulation: the irony.

It is too easy to blame them entirely though. A more fundamental critique is first, that there is too much emphasis on growth and second, that a better description than capitalism of the current state is mercantalism. Broadly I define mercantalism as export your problems to someone else; one nation, or individual or firm can only benefit only at the expense of some other nation or individual or firm.

To say that there is too much emphasis on growth is not to say that a better standard of living is a bad thing: it is to say that there is enough to go round if wealth and income were distributed more fairly. Differences are inevitable, but they don't need to be so big either within nations or between them. The idea that the lure of billions of dollars are necessary to incentivize people is ludicrous; the power wealth gives is incentive in itself.


One fact of the modern economy, that has probably always been the case, but more apparent now, is interdependence. It is not so much that banks for example were too big to fail but that they were too interdependent to fail. Interdependence has many faces; performing the most prestigious jobs depends on performing the most menial jobs, celebrity is dependent on adulation, the play is dependent upon the audience, success and failure is dependent on luck, profits and losses are often windfall profits or losses, industries and states interdependent. With respect to the current contradictions outlined above, resolution can only come if interdependence is recognized.

This brings us to the second part of the critique; mercantalism. In periods of instability, we never escaped from mercantalist thinking. Illustrations of mercantalism are; desire for export led growth, business schools that advocate competitive advantage and corporates that practice it, emphasis on shareholder value at the expense of employment and environment, emphasis on getting more for less, calling people human resources. The deeper we think into our thinking the more we find mercantalism lurking there, in the cave saying that life is a zero sum game, winners and losers, like the casino.

In some respects thinking about government debt is mercantalist. The assumption is that government debt is not productive, that it crowds out private investment, that it is a burden on future generations. The correct question to ask about debt is; “What is the net present value of the debt?" And the calculation needs to be timed correctly. If one effect of the debt was to prevent the Great Recession becoming a Great Depression and if as seems plausible, some of the investment social projects like health or education or defense, or policing, or social welfare, had positive NPV, then timing the net present value calculation from when the debt was actually incurred, makes it difficult to maintain that the net present value is negative.

It’s a pity though, that so much of the net present value of government debt went to the financial institutions. It’s a pity that they have so much power. But it’s not their power to block reform that is fundamental: it’s their power black-out new thinking, new approaches, like casinos with no clocks, no windows.

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