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New Analysis of the Financial Crisis

Nobel laureate Joseph Stiglitz reviewed and applauded the latest book by Martin Wolf, chief economics commentator at the Financial Times. Inside finance ministries, few are cited as often as Wolf, according to the Economist.

The book is entitled The Shifts and the Shocks. The review appeared on Aug. 29-30, 2014 in the weekend edition of the Financial Times.

See Stiglitz' review.

Quoting Stiglitz, "The dismal picture painted by The Shifts and the Shocks is a forceful warning against the unfounded optimism that has episodically struck each of the countries in the north Atlantic as they grasp at any wisp of positive news: we are mired in a malaise, from which we are not likely to emerge any time soon."

(Also, see the Economist's review, which I discovered after the fact.)

(Also, see the book's other editorial reviews, which were also discovered after the fact. For example, George Soros writes, "The crisis is not yet over.")

The Cause: Excessive & Rapidly Growing Private Debt

Reading Stiglitz' review led me to the subsequent discovery -- don't ask me how! -- of Richard Vague, former banker and credit card expert, and co-founder and CEO of three companies. He has authored a book entitled The Next Economic Disaster.

Vague has done his own analysis regarding the primary cause of the financial crisis of 2008/2009.

He says the primary cause was rapidly growing private debt which reached excessive levels. This has always been (and will always be) the primary cause of major financial crises, he says.

Today, U.S. private debt stands at $26 trillion compared to public debt of $16 trillion, according to Vague -- see reference below. Today, U.S. private debt-to-GDP ratio stands at 156%, down from 170% at its peak before the financial crisis. In 1950, it stood at 56%.

Vague claims that the following rule may be used to predict future financial crises, a claim which is based on having studied 22 major financial crises.

When private debt relative to GDP grows more than 20% over 5 years and when private debt relative to GDP exceeds 150%.

Today in the US, the second criterion has been met but not the first one. However, in China, both criteria have been met and make the situation alarming: private debt relative to GDP has grown by at least 40-50% over the past 5 years and the private debt-to-GDP ratio stands in excess of 180%.

The basic message is the following: Excess private debt creates too heavy of a burden for servicing that debt. This then puts a dampener on economic growth.

For example, today in the US and Europe, the consumer is overburdened with underwater mortgages, which means that he cannot spend as much on goods and services. (In Japan in the late 80's, the problem was excess debt on commercial property, and Japan's economy is still suffering after 25 years.)

What has been missing from public policy since the financial crisis is a comprehensive plan for restructuring private debt (i.e. reducing the debt burden).

To prevent future financial crises, one would have to curb the rapid growth of excess private debt.

To further explore Richard Vague's thinking, please visit:

Home page for Richard Vague's analysis.
A good starting point is his interview: sections of it (3 minutes); full version (26 minutes).
The article from the Atlantic is noteworthy as well as the one from the Financial Times.
There's also a report and a book.
There's also lots of historical data and charts.

An article on Yahoo's finance web-site dated Sept. 18, 2014 quoted an article just published in Foreign Affairs which argues that the Fed could have given money directly to the people instead of following QE (quantitative easing). This seems consistent with what Vague is advocating. (1) Link to summary article on Yahoo. (2) Link to original article in Foreign Affairs, which is authored by a Brown University political economist and a hedge fund manager.

Private debt is to be distinguished from public debt. Private debt consists of debt held by individuals and businesses. Examples of debt held by individuals are: home mortgages, consumer loans, car loans, credit card debt, and student loans. Examples of debt held by businesses are: business loans and corporate bonds. Public debt consists of government issued bonds (e.g. what are known as Treasuries in the U.S.)

Elements of the Malaise

Perhaps the malaise described by Martin Wolf and confirmed by Joseph Stiglitz could be shortened if Richard Vague's policy recommendation was enacted.

Stiglitz points out some of the elements of the malaise as being:

high income inequality
high unemployment rates
dysfunctional banking sector
investor focus on speculation instead of investments in infrastructure and global warming solutions
insufficient progress on health and education

The Wall Street Journal had an article detailing the weakness in median household income growth as a long-term historical phenomenon in the US. See article here, as published by Yahoo on Sept. 24, 2014. The same topic was picked up by the Financial Times on Sept. 16, 2014 in this article.

The Other Cause: Psychopaths in Wrong Playground

On Sept. 2, 2014, the Financial Times published a letter from an 80 year old retired physician formerly from Las Vegas who now lives in Switzerland. The letter was a response to Joseph Stiglitz' review.

The physician argues that the financial crisis was caused by psychopathy. See the letter here.

The Solution (Part I)

If we could agree that the true cause of the financial crisis has been precisely that which was identified above, then the solution would lie in removing these causes. In doing so, we'd be relying on nothing more than the relationship between cause and effect, which means that if we know that the thing called "cause" produces the thing called "effect", then in order not to have "effect", we would need to eliminate "cause".

(Of course, there may be another cause, albeit unknown, which we'll name by "cause 2", which could also produce the same effect called "effect". To the extent that such "cause 2" may exist, the proposed solution -- which consists of eliminating the thing called "cause" -- would be incomplete. Added later: Please see below for Part II of the solution.)

The causes that were identified above were twofold:

Rapidly growing private debt which reaches excessive levels
Prevalence of psychopaths within the financial industry, and who aren't required legally to take personal responsibility for their actions, unlike in the medical field

Afterthought: The Geneva Report

The 16th annual Geneva Report was just published, as of Sept. 29, 2014. One of the report's authors is Luigi Buttiglione, head of global strategy at hedge fund Brevan Howard.

The report warns of high world debt - private and public combined. World debt stood at 215% of GDP in 2013, up from 200% after the 2009 crisis, up from 160% in 2001. The message is that the world hasn't deleveraged since the financial crisis!

The report predicts that interest rates worldwide will have to stay low for a "very, very long" time to enable households, companies, and governments to service their debts, according to an article in Financial Times.

It warns that record debt and lower growth form a "poisonous combination".

See news coverage of the Geneva Report here. See the report's overview here with interesting charts, and the report itself here.

The Solution (Part II)

Who is the Economy Working For?

Amir Sufi, who holds a PhD in economics from MIT and is a professor of finance at the University of Chicago School of Business, prepared a statement for a hearing of the US Senate Committee on Banking, Housing, and Urban Affairs, dated Sept. 17, 2014.

A summary of Sufi's statement is as follows:

The economic recovery since 20090 has been "dismal".
The reason is due in part to the lack of any rebound in wealth among middle and lower income households. This matter is related to real income shrinkage among all but the top 10% of households.
What triggered the Great Recession was the massive pullback in spending by indebted households.
Two important lessons from their research are:

Encouraging borrowing by lower and middle income Americans -- as has been the case since the crisis, and as witnessed by growing auto loans and credit card lending -- may temporarily boost spending, but is not a path to sustainable economic growth. Instead, stronger income growth is necessary among this group, and the best way to achieve it is to improve the productivity of workers.
The financial system in its present form concentrates risk on lower wealth households who are least able to bear it.

It is a matter of certainty that stagnating income growth for the majority of American households is a "serious economic threat".
Financial reform ought to entail introducing so-called "flexible debt contracts" which would allocate risk between debtor and creditor in proportion to the ability to bear risk.