The Credit Crunch: Where did it all go wrong? Part Two (1997 – 2008)

New Labour’s chosen theme – I REALLY dislike this track

The 1990’s were an unusual time. Both the US and Britain elected nominally left-wing governments, largely in a reaction to the perceived “nastiness” of the Reagan/Thatcher era. In practice, both the Clinton and Blair administrations adopted the neo-classical approach to economic management (leave it to the markets), and concentrated their reforming energies on social and welfare policy.

One policy of the Clinton administration is worthy of note – his National Homeownership Strategy of 1994 “encouraged” banks to expand into the sub-prime market, viz.:

Banks were given strict new numerical quotas and measures for the level of "diversity" in their loan portfolios. Getting a good CRA rating was key for a bank that wanted to expand or merge with another. Loans started being made on the basis of race, and often little else.
Investors Business Daily, 24th September, 2008

At the macro level, US monetary policy remained under control of the Fed, with Alan Greenspan continuing as chairman. The major shift in the Fed’s policy was Greenspan’s abandonment of monetary targeting in 1993, instead targeting inflation directly. The introduction of “hedonic pricing” into the inflation calculation made this an easier target to hit.

In 1997, one of New Labour’s first policies was to grant nominal independence to the Bank of England. Using the Fed as its model, the Bank’s terms of reference also targeted inflation directly, using the new CPI model, which excludes items such as house prices. The Bank’s old banking supervisory role was also passed to the new FSA.

In practice, the economic conditions of the mid-to-late ‘90’s were extraordinary benign. Economic growth was strong, while reported inflation rates remained low. While this was (as noted above) partly a result of the US and British governments moving the goal-posts, it was also a very real result of the dramatic deflation in the price of manufactured goods, as a result of the out-sourcing boom. Commodity prices also continued to fall, as Russia’s former strategic stockpiles were dumped on world markets.

The road to the Credit Crunch began in earnest with the 1998 Russian Financial Crisis, which lead to the collapse of the LTCM Hedge Fund. Fearing a systemic collapse of the world financial system, the Federal Reserve Bank of New York organized a bail-out package. In addition, the Fed also cut interest rates, from 5.50% to as low as 4.75% in November 1998. These measures were successful in avoiding disaster, but also served to fuel the emerging US stock market bubble.

The dot-com bubble began in 1995, and was based on the notion of a “new economy” generated by the internet. It was, quite simply, the greatest speculative share boom in history, with the Nasdaq composite index advancing from 755 in January 1995 to 4,572 in March 2000. Like all such bubbles, it eventually collapsed, partly from its own dynamics, but also because the Fed finally started raising rates from June 1999, to a peak of 6.50% in May 2000.

At the peak of the mania, in November 1999, the US Congress also passed the Gramm-Leach-Bliley Act, which undid much of the Depression era Glass-Steagall Act. US banks were now allowed to offer combined investment, commercial banking and insurance services.

The dot-com bust was exacerbated by the September 11th terrorist atrocities of 2001, and the subsequent Enron and Global Crossing financial scandals. At the time (and I remember it well) there was real fear that this was it: the start of a 1930’s style deflationary collapse. In practice, the “real economy” recession of 2001 was mild in the extreme, and barely noticed by the average consumer.

That the dot-com bust paralleled 1929 was very obvious to policy-makers, and Greenspan’s Fed acted aggressively to mitigate the deflationary impact. US interest rates were reduced to 6% in January 2001, and then all the way down to 1.75% by December of that year. A further reduction to 1.25% was made in November 2002, and then down to 1% in June 2003, a trough which was held through to the June of 2004.

These were unprecedented reductions, and they sparked a new speculative boom of their own: residential property. It was possible to sustain such low rates because of the absence of inflation – the accelerated shift of manufacturing to the far east continued to deflate the price of consumer goods, while the huge asset price increases in property and the rejuvenated stock market were not included in the inflation indices.

The period of 2002-2007 was governed by a destructively unstable dynamic: unsustainable asset price growth fueled by central bank credit creation. The central banks (chiefly the Fed, with the Bank of England doing its bit for Blighty) encouraged excessive borrowing with artificially low interest rates. The resultant asset price inflation (chiefly residential property) encouraged increased consumption, often fueled by “equity removal” through re-mortgaging (real average incomes were at best stagnant, due to the global labour arbitrage exercised by emerging markets and immigration). Increased US consumption created a massive US trade deficit, and a booming Chinese manufacturing sector, with the Chinese buying little in return except for enormous piles of US Treasury and agency debt.

Eventually, the party had to stop: economic growth based on an edifice of increasing debt is ultimately unsustainable (as interest payments will eventually consume income). In addition, inflation in those items not “made in China” was starting to appear, notably in commodities such as oil. The banks, encouraged as they were to lend as freely as possible, discovered that return of capital was more important than return on capital. So, here we are.

I’ll leave the “blame game” to others with a more political agenda. What is clear to me is that the problems now faced by the world economy are a direct result of the unsustainable practices of the preceding five years; what happened in 2000-2002 is that the “bullet” of serious economic downturn was dodged, but only at the cost of building up an even greater speculative bubble than that of the dot-com stocks. Now, it seems from the evidence of the past two days (spiking stock markets; falling LIBOR) that the immediate threat of a “near term systemic financial meltdown” has been averted. Perhaps. However, any idea that we can go straight back to partying like it’s 2005 seems like nonsense to me. No matter how successful the various banking bail-out measures will prove, there is no way that credit growth will return to its preceding levels, and no way of avoiding the serious shake-out that the US and Britain, in particular, require to put their economies back onto a sustainable growth path. Growth based upon rising real incomes, rather than increasing debt.

That this shake-out will also affect the rest of the world is inevitable.