Where Are We Again? (Pre-G20 Pittsburgh summit)

This revision to our Baseline Scenario is required reading for my Global Entrepreneurship Lab (GLAB) class at MIT this week.  For those classes, please also look at these updated slides.

Financial markets have stabilized – people believe that the US and West European governments will not allow big financial institutions to fail.  We have effectively nationalized any banking system losses, but we’ll let bank executives enjoy the full benefits of the upside.  How much shareholders participate remains to be seen; there will be no effective reining in of insider compensation (my version; Joe Nocera’s view).  Small and medium-sized banks, however, will continue to fail as problems in commercial real estate continue to mount.

The economic recovery, in the short-term, may be surprisingly strong in terms of headline numbers; this is a standard feature of emerging markets after a crisis (e.g., Russia from 1998 or Argentina after 2002).  Official short-term forecasts are probably now too low, as the IMF and other organizations make the case for continued fiscal stimulus and very loose monetary policy.

However, a two-track economy appears to be developing: one part will do well (e.g., around big banks on Wall Street), and another part will struggle (many consumers and firms around the world want to reduce their debt; the same thing happened in Japan’s “lost decade”).  During the 1990s, Japan had some years with good growth, but overall the decade was a disappointing deceleration of growth; the same could be true now at the global level.

Longer term U.S. growth prospects remain particularly uncertain – has consumer behavior really changed; if finance doesn’t drive growth, what will; is the budget deficit under control or not (note: most of the guarantees extended to banks and other financial institutions are not scored in the budget)?   The implication, presumably, is higher taxes on the productive nonfinancial part of the economy – to pay for the implicit subsidies and ongoing rents of the financial sector.  While many entrepreneurs understand and resent this math, they are strikingly unwilling to do anything about – or even speak out on – reining in the power of the biggest banks.  Even the smaller banks – who have really been hammered by the actions of larger banks – are only just now figuring this out and beginning to express resentment; sadly, this is too late to make much difference.

There has been a great deal of attention recently on income distribution (WSJ; NYT), with the argument being that the long financial boom made some people richer and the bust is bringing them back down.  But this misses the point that (a) some of the mega-rich will do very well; think about how Carlos Slim took over large parts of the Mexican economy after 1995, and watch Wilbur Ross acquiring assets in the US today, (b) billionaires becoming millionaires is hardly something to get worked up about.

The real damage is for 10-15 percent of American society, mostly without college education, who lost jobs, houses, and education opportunities.  The First Great Depression was a decade of effective poverty and other terrible outcomes for around 25-30 percent of American society.  We have avoided a Second Great Depression but the social costs are still huge.  Think through the political implications of that.

The collapse of Lehman Brothers in particular and the ensuing financial crisis in particular exposed serious weaknesses in our banks, insurance companies, and financial structures more generally.  We were “saved” by radical central bank action and additional government spending.  Over the past 20 years, crises have become more severe and more expensive to counteract.  We are on a dangerous and slippery slope.

Yet there is no real reform underway or on the table on any issue central to (a) how the banking system operates, or (b) more broadly, how hubris in finance led us into this crisis.  The financial sector lobbies appear stronger than ever.  The administration ducked the early fights that set the tone (credit cards, bankruptcy, even cap and trade); it’s hard to see them making much progress on anything – with the possible exception of healthcare (and even there, the final achievement looks likely to be limited).

The latest New York Times assessment of financial sector reforms is bleak.  The Washington Post is running an excellent series on exactly how and why the banks have become stronger (part one; part two).  Big banks have risen greatly in power over the past 20 years and were already strong enough this winter to ensure there was no serious attempt to rein them in.

Financial innovation is under intense pressure in both popular and technocratic discussions, but does not face any effective regulatory controls (our view; Adair Turner).  This is a dangerous combination.  Unless and until there is real re-regulation of finance, repeated major crises seem hard to avoid.  Wall Street responds, “we have changed how we behave,” but this must at best be cyclical – after any emerging market crisis, the survivors are careful for a while.  But then they go on another spree and you re-run the same boom-bubble-bust-bailout sequence, in a slightly different form and with potentially more devastating consequences.  The potential for serious crisis will not decline unless and until you change incentives – and this frequently requires a change in power structure (think Korean chaebol, Thai banks, or Indonesia under Suharto).

The consensus from conventional macroeconomics is that there can’t be significant inflation with unemployment so high, and the Fed will not tighten before mid-2010.  The financial markets are not so convinced – presumably worrying, in part, about easy credit leading to dollar depreciation, higher import prices, and potential commodity price inflation worldwide.   In all recent showdowns with standard macro models recently, the markets’ view of reality has prevailed.  My advice: pay close attention to oil prices.  The conventional oil market view is that there is plenty of spare capacity so we cannot experience the price spike of early 2008; we’ll see if this proves complacent.

Emerging markets, in particular in Asia, are increasingly viewed as having “decoupled” from the US/European malaise.  Increasingly, we hear that Asia’s fundamentals allow strong growth irrespective of what is happening in the rest of the world.  This idea was wrong in early 2008, when it gained consensus status; this time around, it is probably setting us up for a new round of financial speculation – based in part on a “carry trade” that now runs out of the US.  Most Asian currencies are a one-way bet against the US dollar over the medium-term, as they are already considerably undervalued and their central banks actively intervene to prevent significant appreciation.  The appetite for this kind of risk among investors is up sharply. 

What should we expect from the Pittsburgh summit on September 24-25?  “Nothing much” seems the most likely outcome.  The leadership of industrial countries does not want to take on the big banks, and the technocrats have contented themselves with very minor adjustments to key regulations (“dinky” is the term being used in some well-informed circles.)  The G7/G8/G20 is back to being irrelevant or, worse, mere cheerleaders for the financial sector.

Overall, the global economy begins to recover, but the crisis created huge lasting costs for many poorer people in the US and around the world.  Recovery without financial sector reform and reregulation sows the seeds for the next crisis.  The precise timing of crises is always uncertain but the broad contours are clear – just like many emerging markets over past decades, the US, Europe, and the world economy look set to repeat the boom-bailout cycle.  This will go on until at least until one or more major countries goes completely bankrupt, or until a real financial reform movement takes hold either among technocrats or more broadly politically – and the consensus then shifts back towards the kind of much tighter financial regulation that was established after the last major global fiasco in the 1930s.

By Simon Johnson

36 thoughts on “Where Are We Again? (Pre-G20 Pittsburgh summit)

  1. First Peter Boone’s byline appears on a post, then we see evidence of an actual Entrepreneurship class at MIT. Shame on the doubters!

    Could you fellows arrange some webcams at the BIS in Basel? Would love to see what they’re talking about. Did you know that Hans Tietmeyer at the BIS is on the Pontifical Academy of Social Sciences just like Stiglitz? What is all that about?

    If you would like to know what is really going to happen, at least in the United States over the next few years, check in with the Calculated Risk blog comments. CR himself is very even-keeled generally, but even he seems to be hinting lately that we are toast. The bigger the fire, the bigger the fire sale, what? You can split this Depression up into a V and and L if you want, but it’s really all one. Don’t see your scenario happening at all; it looks like the global economy is being run by out and out criminals.

  2. “We have avoided a Second Great Depression but the social costs are still huge. Think through the political implications of that.”

    I’d love to read some historical/economic perspective on what has happened in the past when the financier class impoverished the rest of a country.

  3. Ferguson’s “History of Money” speaks indirectly to that. The French revolution was caused in part by a financial crisis (IIRC).

    If the current news headlines are any indication, we’ll get more of the same behavior that got us here from the body public – tea party type thinking that just deregulates even more. I’ve run into a few gold bugs that want to return to the gold standard too. Doesn’t seam logical, but then if the news about health care reforms is any indication of how illogical we’ve become, then we are in for interesting times.

  4. Simon,
    Still obsessing about the G-20?? Why don’t you teach them something more useful to their future, like how to fricassee a wolf.

  5. Simon,
    I have come to rely on your insightful and balanced analyses. Please keep them coming! One disagreement, however. You scoff at the need to mourn billionaires becoming millionaires (no argument there) and rightly point to the devastating impact on the (no longer) working poor of the economic downturn, but you ignore the extraordinary WIPING OUT of a decade’s worth of gains on everyone in between. Socially, politically and financially this is the elephant in the room. People know their 401ks got the crap kicked out of them, but millions are still in denial about equity in houses, etc., which have essentially created a “lost decade” already for millions of Americans. Now you say there will be a lost decade for the country. Does that mean many middle class people will effectively have lost 2 decades of their working lives? Again, many of us went to bed one night believing ourselves middle or even upper middle class citizens and awoke to find our financial future in ruin. This doesn’t lead anywhere good.

    Final thought: timing (i.e. sheer dumb luck) appears to be unusually important in this crisis. If you started making and investing real money about a decade ago you are especially screwed today. Your investments went nowhere and you were on your 2nd or 3rd house (now very much underwater) when the crash hit. Older people generally have a better prognosis because of greater equity, though many of them were slammed by investment losses. Younger people with jobs are relatively benefitted by the crisis as they don’t make enough money to be pushed out the door (so stay employed), the government is bending over backwards to get them into a starter home which has dropped massively in price, and they didn’t have much in the market yet. Recent and soon to be graduates, on the other hand, are screwed by dearth of jobs. By my reckoning that adds up to the big losers: under 22s, 35-early 50s. Relative winners: early 20s to mid-30s, retirees with secure income and low fixed expenses.

    I don’t know how this compares with past recessions/depressions, but it seems curious to me.

  6. We need to develop a high school or middle school curriculum that explains how modern Finance works. It can explain how risk is sholdered by government, and the taxpayers, but how reward is private. We can show the interplay of donations to politicians and parties and how that effects regulation. We could do a website and have multimedia and bells and whistles. We could have bios of selected bankers and financiers and how they made a fortune by serving as gatekeepers or simply churning investments.

    After all, if this is the system we have shouldn’t we teach it to our students?

  7. Anything that happened in Germany between 1930 and 1933 would show that pretty well. It’s so interesting to watch the political factions on all sides get more and more radical, and as they did, to watch the Weimar government consider them ever more irrelevant.

    It’s unnerving to think a government could just go about its business and ignore the wackjobs like that, right up until the moment when the craziest of the wackjobs gains power.

  8. But how would telling people about it help the elites pillage the country?

    We’re more likely to see classes explaining the Tea Party version of economic nonsense to students. Some of the kids I work with already have teachers who want to be doing that. (If they aren’t already.) I’ve had kids come ask me if Democrats really did want to destroy the country.

  9. One thing about the Austrian economic folks, they have some great historical literature out there (although the search tools could be better).

    For your students interested in history – here is a great read (from 1833) by one of President Jackson’s financial advisers on the history of money in the US and the fights over controlling the power of banks.

    Click to access shorthistorypapermoney.pdf

    What goes around, comes around.

    I imagine the Great Moderation is done and over with and the Great Restructuring is underway.

  10. Oh, p’shaw. Don’t write them off just yet. I think the G-20 will finally propose something pathbreaking, like a color-coded Financial Security Threat Level indicator.

  11. Mr. Johnson,
    With no regulation on the horizon for the “too big to fail” thinkers and another “crisis” looming, I’m not comfortable watching our 401/403s taking another dive. I feel like we are “along for the ride” and the driver is making me nauseous as we watch our diversified mutual fund investments decline 40%.
    We have a CFP (w/VALIC-AIG), nice guy but like many people and advisers was not ahead of the curve.
    Any suggestions to get prepared for the next big thing or is a diversified mutual portfolio the best option for 401/403s?
    I have been reading here since I saw you on Bill Moyers Journal and alot is over my head but I appreciate your opinions. I realize you don’t have a crystal ball, I’m just getting paranoid.


  12. two anecdotes.

    I bought a house three years ago and it was assessed at $330k. I just had it re-assessed at $290k. Given that there are houses for sale in my area that haven’t sold in ~2 years, I would suspect that the real price of my house is near $250-270. I’ve been a homeowner since ~98 and I just got all my equity wiped out.

    The job market for new grads is really tough. At least in engineering fields it used to be that modest grades (at least a 3.0-3.2) and good internships landed a good job at a major multinational firm. Now you need close to 4.0 and great internships as well as real interview skills etc. It’s not unusual for solid students to hunt for jobs for months post graduation. That is going to have real, long term, consquences.

  13. Sebastian Haffner says somewhere that the ground work was laid with the wiping out of the middle class due to the 1923 inflation. You seem to agree that right now a weakening of the middle class is happening. Let’s hope you are wrong …

  14. I have argued on my sites that the centuries long crash of the Roman republic, and then of the Roman empire can be mostly attributed to the Roman plutocracy having captured the Roman republic.

    The present capture of the American republic by the American plutocracy is a remake of what happened with Rome, with a difference: when Rome went plutocratic, a seething Greece was occupied by fascist Macedonia. This time, Europe is playing the role of Greece, but it is not occupied, and is strong and independent.

    This will hopefully allow an alliance of the People to force back the plutocratic hydra into compliance with civilization.

    Patrice Ayme

  15. My kid came home (we live in a very liberal state) and told me that many of the kids were saying that Obama is going to put the white people in concentration camps. I asked if they were saying this seriously, and the answer was yes.

  16. I have a question…
    Page 24 of the slides suggests the Financial sector as a share of GDP is about 30 percent. But in “The Next Financial Crisis” one finds; “Since the early 1980s, the Fed has gone back to its origins as the bailout machine for the financial sector. The only difference is that this sector has become much larger since 1907 or 1913. Back then, it accounted for around one percent of GDP. Now it is closer to 8 percent.”

    Are there different definitions/calculations used? Or have I mis-read something…I also looked through the primers but couldn’t find any detail on this one…

    Page 41 of the slides has a very cool graph! I like that one – Lots to think about when we look at the cycles from that dimension!! where to next??

    Thank you!

  17. I’ve read somewhere that Eisenhower spent a lot of time by today’s standards a huge amount of time, playing golf
    – I assume that you would never tolerate that in a president today so you get the kind of president who can function without it or who has to replace it by emergency s…x
    – you want to see him/her sweat and labour and cut short on sleep just like you do – the media seem to be always full of praise for gruelling schedules which actually tend to play havoc with human sanity

    – the Greeks used to have philosophers called peripatetics – I don’t remember what their specialty was but I tried their favourite walk way and a golf course probably wasn’t a bad replacement for it.

    But people leisurely strolling while thinking and talking about important major AND minor things or the other way around in full public view, would they be tolerated today? and I do not mean the short for the camera walks with the thoughtful faces – I mean hours and hours of them with nothing happening for the media to feed on

  18. I remember a time when the last president spent more time on vacation than actually working. I was happy about that because it seemed like he could do less damage on vacation.

  19. I would have betted quite a bit on you or somebody else pointing that out – there has been enough grumbling about that during his reign – but how were Eisenhower’s outings reported at the time? also as something reprehensible?

  20. Yes, Simon, as always very educational. Sad story, though. Aren’t you just a bit sorry that you are such an expert that you have to endure the continual paint of watching the world’s socioeconomic systems overwhelming much of what we spent the time since the last Great Depression recovering. As an educated observer of this evolutionary spiral, I have deep fears for the future, so deep that I am glad to be old, because if I were young I would be so depressed about the future as to be nearly suicidal.

    I still think maybe, as usual, humanity will recover from its selective intellectual blindness just in time to save itself. As shame though, to have to rely on our survival instincts just to survive.

  21. Can someone check the slides as it appears that some text may have been cut off at the bottom in translating to PDF (see for example, slide #2)

  22. Simon,
    Greenspan must have channeled my comments from class yesterday:


    Inflation is what we should be most concerned about because it is an insidious tax and allows our politicians to spend money without owning up to the political ramifications of paying for their spending (indeed, borrowing from foreign governments is not free or sustainable over the long-term and neither is printing money to finance deficits).

    By the time that inflation starts to show up in the #’s it will be too late for an appropriate policy response because the economic response to interest rate changes has a lag.

  23. It IS run by “out and out criminals.” One hundred and fifty or so of the wealthiest people in the world run this country and every other country. They are members of the Bilderbergs, Trilateral Commission, and The Council on Foreign Relations(fancy words for a thug gang.) Obama is one of their puppets and so was Bush.

    Watch this video and pass on the info. It’s a long video and slow to get to some real info, but well worth the time. It opened my eyes.

  24. Austrian Economists have been accurately predicting boom/bust cycles since the 1920’s and for the same reasoning noted in “The Next Financial Crisis” in TNR refered to in the above piece. And while I agree with the policy prescriptions noted in the article I wish the radical idea of “sound money” had been at least mentioned, even if the prevailing wisdom pooh-pooh’s the idea of a commodity based monetory system as an anachonism. Maybe so, but when the next crisis comes along, it could be so devastating that perhaps people will taken a second look and listen to the only economists who have been correctly predicting these boom/bust cycles….the Austrians.

  25. Urgent – America, the problem is “democratic egalitarianism”– which references all those issues of economics and democratic sustainability that are worthy of our consideration as we struggle to sustain our democracy in the face of a corporatist agenda (i.e., an agenda that privatizes and deregulates; that grants control over much of what matters to us in our daily lives to multinational corporations with no loyalty to our country or our people or the public good; that makes greed good, redistribution upwards meritorious, and redistribution to care for public needs and those who need a safety net to protect them somehow morally questionable).

  26. Yes this posting summarizes my understanding of what is happening. And the politicians are bribed by coporate money. I’m retiring this year,(67) hope my health gives me about twenty more years. I was “comfortable middle class” due to affordiable university education, always employed, had sick time paid. I don’t think there is going to be a middle class in twenty years in the USA. Just the coporate finance and business rich thieves, technocrats and undereducated poor citizens. Hope I can afford a decently staffed skilled nursing facility and still have the basics–food, clothing shelter and water. Oh and security–Maybe by that time the police will be paid by the coporations—the security guards like Blackhawk in New Orleans. Maybe I should just die a bit younger.

  27. The mythic logos of the eternal return appears to permeate these “recovery cycles” as some kind of cognative suspended animation. But these recapitulating sequences are consequential and revisional not corrective and provisional.

    The rates of exploitation grow proportionately with the scope of global expansion and technological intensification (on the one hand), and the inverse scale of ecological degragation and environmental depletion/exhaustion with the consequential reduction to service to demographic redistribution. This, in turn, can be neatly solved by simply cutting the pie values into class segments (like tranches) and politicizing the “stabilization” of shareholders to stakeholders at inverse proportions.

    The “political economy” therein, is a self sustaining (status quo / laissez Faire) syndication of interests that provide a fortress of institutionalized self preservation for its lucky owner membership as an imperative of primal survival necessity. One might say that it grows nearly to the degree of cannibalistic towards the rest of the demographic world in pursuit of its one track and zero sum renditions of what is acceptable and what is expendable.
    The pressure over time, however, is not only between the perennial exclusions but in the competitive fight for inclusion and the coallitions or factions that are formulated.
    That is essentially where we are at right now in terms that are “other” to the normative classifications and genre in economic speak. It is not about a “factory economy” assemblage seeking balance, so much as it is a contest of power for the core alignment of global group/scope and domestic scales. Interexpansionary collusion is economizing duplicity in global political inter-relations, while politics is historicizing (sorry..ah..let’s say retooling the ideological justifications for) the new “realism for a domestic intersubjective economy of atonements. The “market” equilibrium theory of balance can’t decide between efficiency and effectiveness or deficiency and affectiveness; but nowhere is a cost/ratio interaction truly the decisive factor…that just simply gets adjusted to suit the primal order of “established” society.

  28. If real healthcare reform happens, it will be the result (IMHO) of Obama shifting the message to one that concerns the majority of voters (it’s the insurance companies, stupid) rather than the minority (those without adequate healthcare). the same has to occur with financial reform. As long as the majority of americans have a job, they will not vote for something that benefits the minority UNLESS they see something in it for them. this is human nature, like it or not. Those with the ability to express the impact of “two Americas” on the majority will do a great service.

    Who is up to the task?

  29. Big fan of Mr. Johnson. One comment on his Bill Moyers appearance…I wish he would not refer to the bankers as “incompetent.” They were very competent at getting massive amounts of money out of the system and into their personal bank accounts without going to jail. Very competent indeed.

  30. To watch the sale of America and the looting of the American taxpayer is horrifying. by the corporations owning Congress.
    a short term profit at the long term rip off of all Americans. Then the corporations will just up and go find another country to bleed dry.

    socialism for the few at the expense of the rest.
    Socialism American Style. Freedom.. nothing left to loose.

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