By Martin Hutchinson
In an interview with Gideon Rachman of the Financial Times, a senior German official described the euro as a "machine from hell that we cannot turn off". Personally, I am more positive than most about the euro, provided it is managed by grown-ups and not by Keynesians.
However, there is no question that our current economic system contains a number of such "machines from hell" that turning them off is at least extremely difficult and that we will be very lucky to survive their combined operation.
One long-standing such machine that has recently reared its robotic head is the Chinese banking system. Ernst & Young estimated as far back as 2006 that that system had US$911 billion of bad debts. Since then, the major Chinese banks have all done immensely successful initial public offerings, with international auditors suggesting that bad debt levels were far below that amount.
Now we are told by the Financial Times that the "stimulus" of 2008-2009, which was mostly financed by the banks, has left them with $1.7 trillion of loans to Chinese provinces and cities, mostly for dud real estate transactions, more than half of which come due within the next three years.
Needless to say, banks have been told to roll the debts over, since a mass default on that scale, 25% of China's gross domestic product (GDP), would be hugely economically damaging. "From a longer-term perspective, the investment projects launched during the financial crisis will have no problem generating a return" we are told. Right!
This is a classic "machine from hell." Writing off $1.7 trillion of loans to provinces and municipalities would be damaging, so like the corporate bad loans that mysteriously disappeared after 2006, these debts will be rolled over and will continue being accounted for in the banks' balance sheets as worth 100 fen on the yuan. The hollowing-out of Chinese bank balance sheets will continue, until eventually the entire system collapses. The machine is from hell, and it is very unlikely to be turned off.
A second machine from hell is quantitative easing, the funding of countries' gigantic budget deficits by central banks. In my years as a US Treasury advisor, this was regarded as a no-no. Emerging markets all over the world were dragooned by International Monetary Fund and US Treasury "experts" into inserting a specific prohibition against extensive government funding into their central bank statutes. Yet now all the major economies are doing it, with Britain and Japan the most enthusiastic, funding more than half their budget deficits by these means, devoting more than 5% of their GDPs to this nonsense.
Needless to say, this machine too cannot be turned off. Once the markets have grown used to central banks as major buyers of government bonds and politicians have got used to being able to spend 8-10% of GDP more than they take in through taxation, neither the financial nor the political special interests will allow them to stop. Federal Reserve chairman Ben Bernanke, already buying more than $400 billion of long-term Treasuries through "Operation Twist II" will shortly begin direct Treasury purchases again, citing the continued weakness of the US economy as an excuse (even though housing, his last excuse, is now showing strong signs of stabilization and even recovery).
In every country, one dreadful specter will keep the purchases going: if they stopped, government bond yields would rise sharply, which would destabilize government finances further and, more important, wreck the world's banking systems, overburdened as they are with decades of reckless government bond purchases.
Eventually we will see Weimar Republic levels of inflation AND banking system collapse, although the politicians may get off lightly because of the collapse in the real value of government's debts. That may appear unfair, but in reality banks and voters are as complicit in creating this machine as the politicians, so the universal misery will be well deserved.
A third machine from hell is the collection of pension and medical systems worldwide that depend on investment returns to fund ever-escalating future obligations. These were mostly set up in eras of rapid economic growth, young populations and political optimism, such as the 1960s. Since then, populations have aged, often with a bulge of workers now entering retirement. However, three additional factors have combined to make these systems unaffordable.
First, since at least 1995, interest rates have been held artificially low by central banks temporarily unrestrained by the fear of inflation (because the Internet and modern telecoms had caused a deflationary force that would have been highly beneficial if it had been left unmolested by monetary policy). Those artificially low interest rates have reduced both individuals' savings rates and investment returns on the already inadequate funds being held to pay for their old age.
Second, the trust funds of these systems have been raided for unrelated purposes. In the US, the surpluses naturally arising in the Social Security system have been used to offset budget deficits elsewhere, and in 2011-12 the premiums themselves have been artificially cut to provide economic "stimulus".
A third factor destabilizing these systems has been the tendency of politicians to load costs upon them that they were never designed to bear. In the United States, the 1986 Emergency Medical Treatment and Active Labor Act forces hospitals to treat the indigent without reimbursement, thus loading intolerable costs onto the rest of us.
Medical malpractice lawyers have been allowed to run riot with frivolous lawsuits, making insurance an enormous fixed cost on every medical practitioner. Drug companies have been allowed to load the entire costs of their research onto US patients and their insurance companies, while receiving reimbursement from foreign payers at much lower rates.
Insurance policies have been forced to cover nonmedical needs, most recently contraception, which are a modest burden on the individual if paid for directly but become a gigantic additional cost on the system as a whole if provided free to consumers, thus making demand and wastage essentially infinite.
Again this machine, having been set in motion, cannot be turned off. Opinion polls show that even the most ardent Tea Partiers are prepared to cut government spending on everything except their "entitlements", which they believe have been fully paid for. Since the mid-term elections of 2006, attempts at actuarial soundness have infallibly led to electoral disaster, and this unpleasant backlash effect is becoming more extreme as the systems become more actuarially unsound.
By the early 2020s, collapse will be both inevitable and universally visible - the Baby Boomers are destined for a poverty-stricken and unpleasant old age, relieved only by premature death from some readily treatable medical condition.
As if there were not enough machines from hell in the economy as a whole, the financial services industry has in the last couple of decades gone to great lengths to create new ones. Originally, the derivatives markets of forward contracts, swaps and options appeared harmless hedging mechanisms, making the financial world more efficient and earning modest competences for their practitioners.
However, since the middle 1990s, the markets have metastasized into gigantic risk creators. Securitization, if it allows banks to get rid of the loans they originate altogether, creates moral hazard and therefore risk. Collateralized debt obligations, by allowing the creation of artificial securities, provide mechanisms for banks to create $10 of risk for every $1 of loans and bonds. Credit default swaps allow banks to take short positions on credit risk, then stand around yelling "Jump, jump!" when a borrower gets in any difficulty.
Fast trading allows its practitioners to trade on inside information of deal flows, thereby destabilizing markets and creating both bubbles and their inevitable busts. Finally, modern risk management systems, based as they are on simplistic and inaccurate premises about financial market risks, allow banks to pretend to control risk without actually doing so.
Like the other machines from hell, those in financial services cannot be stopped. There are too many bankers making money out of them and too many lobbyists obfuscating the issues and paying off politicians through campaign contributions to allow their extinction. Obvious tax loopholes like the "carried interest" tax treatment of private equity funds and obvious regulatory loopholes like the zero-rating of government debt in bank capital requirements are allowed to remain in force for year after year, under Republicans and Democrats alike. Thus the regulatory system's ability to prevent rent-seeking at taxpayer expense has effectively been nullified.
Two questions remain. First, why has our generation seen the creation of so many and so varied "machines from hell?" Mad scientists have been with us since Frankenstein; why has this era been so fertile of their economic doomsday machines?
The central answer appears to lie in the area of fiat money and its cousin, bank deposit insurance, which a decade ago seemed unassailable and benign parts of our modern economic system. Under a gold standard without deposit insurance (or under any other monetary/banking system that ensures quasi-constant monetary values without state risk assumption) most of the machines break down before they can do too much damage.
Greek budget deficits would have become impossible to finance long before 2008.Chinese banks that created excessive bad debts would have suffered bank runs back in 2005-06. Quantitative easing would quickly have caused an exodus of gold supplies, creating a massive deflationary recession. Equity returns would consist primarily of dividends, and debt yields would be stable, so actuarial black holes in pension and medical insurance systems would become apparent while they were still manageable.
Financial engineering and creative risk management would be so obviously dangerous to a bank's well-being that sophisticated depositors would withdraw funding well before retail depositors began to panic. Machines from hell were always in danger of appearing in a fiat money system, but their proliferation derived from the burst of money growth and speculative activity after 1995, which was caused by central bank laxity in the face of internet-driven deflation.
The second question, and the more difficult one, is what we can do to prevent the machines from hell from destroying our economy. In most cases, the cure is still available, albeit painful.
Greece must be thrown out of the euro (thereby halving its living standards but restarting its economy) and draconian deflation imposed on the other country in the PIIGS group - Portugal, Italy, Ireland, and Spain - under the threat of similar retribution. China must recapitalize its banks, borrowing the money from international markets to do so (thereby liquidating its $3 trillion of foreign exchange reserves).
Quantitative easing must be replaced by Volckerite monetary policy, with the chips falling where they may in government financing and banking systems. Social Security and Medicare eligibility must be delayed until recipients are aged 70 (easy) and the various scams and "free lunches" in the medical arena must be ended - bringing major short-term pain but a long-term fall in medical costs that will benefit everybody.
Volckerite monetary policy must be combined with a tight "Volcker Rule" separating deposit-taking from speculation (and tax incentives for setting up mutualized deposit-taking institutions similar to the British building societies). Above all, "too big to fail" most be abolished, deposit insurance cut back, the government removed from housing, and rules established to ensure that the Fed (if it is allowed to exist) follows monetary policies equivalent to a gold standard in their effect on prices and markets.
Most likely, the machines from hell will be allowed to rumble on unchecked. In that case, collapse of our economic system is inevitable....