#8 - Chris Ward 2009-02-26 08:51 - (Reply)

Global Economic Crisis I believe I have an idea which may help. It’s basically very simple and has sound logic though it would be the subject of a book rather than a letter. However I have no time for writing books and I believe people should start thinking and talking about it. It’s a one off because this is a global crisis. It would not work unless all the affected countries acted together. All the developed and developing nations affected by this crisis should allow or encourage wages and salaries to rise. The mechanisms would vary from country to country but in the case of New Zealand it could be through benefits, pensions, minimum wages public servants salaries, award rates etc forcing all wages, salaries, commodities and services up. This would mean that houses and property, shares and other capital assets whose price has been allowed to rise beyond the reach of those who ultimately pay for them are again affordable. It would mean that the market values do not have to fall (as far) to make the assets affordable. Thus many collapses and business failures would be averted and bank loans would continue to be backed by adequate equity. Clearly market restraints including appropriate interest rates and bank lending ratios and restraints on dodgy practices and financial instruments (which should always have been in place) would have to be applied simultaneously. Maybe loans should be limited to a percentage of the “sustainable value” of the asset (meaning that the repayments on the loan should not be higher than the net income possible from the asset). I know this is a radical concept but in principle it’s just a matter of using inflation as a tool to do what it does naturally – distort the economy – back to where it should have been before it was distorted by inappropriate and/or ineffective management of the relevant markets. The alternative for the future is an economic malaise like the one Japan has been in for many years. There’s value in this for all, no matter what their stake in the economy. I can hear all the criticisms and associated problems and the experts who got us into the shambles we’re in saying it’s a stupid idea. Trouble is it’s the best idea I’ve heard of. In fact it’s the only idea I’ve heard of to avert excessive public debt and consequent long to medium term stagnation and failure. Another Version The idea is for all the governments of the countries affected by the crisis to allow/encourage or even force wages and salaries to rise. It is crucial that this would have to be a deliberate Global Process. Thinking unilaterally it makes total nonsense but the one thing which we can all agree on is that we have a Global Problem so we need to think of unified Global Action. This provides the opportunity for lateral thinking. I know it sounds like a crazy left wing plan but consider the following. 1. The core problem behind the current crisis is that market values for crucial assets have exceeded their “sustainable value”. Meaning the value of the assets is not supported by the income they can generate (other than by trading the assets themselves). There are other issues such as dodgy lending practices and financial instruments, but the fundamental correction required is in the value of the assets. Either the assets come down (eroding the equity supporting mortgages and loans and causing the widespread failure and grief which we are currently witnessing) or incomes can come up. This would restore the ability of consumers, property owners, share holders etc to pay for their debt and businesses to generate income and dividends to provide a satisfactory return on share prices. 2. Trying to stimulate economies by lowering interest rates is actually encouraging the problem in “1” to persist. Think of the economy as being divided into two ends: Asset values at one end and the means by which those asset values are supported (the income of the average income earner) at the other. Lowering interest rates is supporting the wrong end of the economy (the asset end for which values are already too high). It’s the income end which needs supporting. Also lowering interest rates clearly has limited effect as demonstrated by the UK and US because at even minimal interest rates things are not really turning around. 3. Low interest rates drive deposits away from banks making it difficult for them to provide the loans necessary to support business and investment and generally making troubled banks less viable. In fact under my plan interest rates would have to be raised and other controls on lending would have to be tightened. This would restore banks’ liquidity and viability. My plan would greatly reduce the government support required by the banks because many non-viable loans would become viable. 4. Increasing incomes will increase tax income (other things remaining equal) which will reduce governments’ fiscal deficits resulting from all the stimuli (this one included) being used to retain or create jobs. All the government loans to banks etc would be able to be paid back faster. Notes and observations 1. A basic observation is that markets tend to boom and bust. It has happened time and again. What amazes me is that: a. Economists have not found a solution to this b. Governments permit it to happen. Basically once a market has boomed beyond the “sustainable level”, further “growth” in the market actually turns the assets into chain letters or partially so anyway. Basically the market just goes on trading up until it runs out of confidence or “takers” and the “bubble bursts”. Sounds just like a chain letter to me! I thought this type of trading was illegal? Maybe you could even construct a legal case against the Stock Exchange and others around this. 2. Consider a market like an aeroplane which we all know needs appropriate controls all properly designed and tuned to work properly so that the aeroplane can be flown smoothly and safely in the desired direction and at an appropriate height and level. In the case of markets we clearly either don’t have the appropriate controls or we don’t know how to use them. It’s almost as though we’re trying to fly the aeroplane backwards. Thank God economists and politicians don’t design aeroplanes! 3. I personally believe we need a further control on lending. I hate controls and rules because they encourage delinquency. However I suggest lending against assets should be limited by the income available from the asset (other than income achieved by trading the asset itself, of cause). I know this would have all sorts of implications such as restricting the trade in gold, bonds etc, but when you think it through, maybe that’s not such a bad thing. We definitely need to encourage productive investment rather than hoarding investment and such a control would have that effect. I also realize that all sorts of auditing and policing would be necessary (most of it would be automatically achieved by the bank’s computer system). Anyway auditing and enforcement is necessary for the controls we have now. 4. As interest rates are increased to rein in lending, the opposite actually happens if markets are rampant. More money is attracted to banks so they have more to lend. So long as the “growth” in the markets is fast enough the high interest rates don’t matter and the banks become more reckless because their loans are always supported by the rising value of the markets and they enjoy huge profits etc etc. High bank liquidity and reckless lending were prominent phenomena during the last months before our current troubles. 5. Markets can actually rise with almost no influence from interest rates or money supply. Consider the following hypothetical situation: You have a “market” consisting of 100 investors who own 100 properties between them each property worth $10,000. “007” can agree to buy the property of “99” for $11,000 without borrowing, finding or earning a cent provided another investor will buy his property for $11,000. All the investors can do the same deal between themselves and no money needs to enter the system (apart from bridging loans which act as the “lubricant”). These trades can go on and on until the values are out of reach of anyone outside the system. This is, of cause, a grossly simplified model but it highlights one of the factors which renders interest rates and monetary policy ineffective and in fact inappropriate in times of inflamed markets. 6. Inflation: We seem to have an obsession with it ever since we discovered monetary policy and the OCR. What we seem to have forgotten is the reason we need to control inflation. Inflation is bad not just because its damned inefficient having to adjust for it all the time but because of the distortions it causes in the economy. We need to be like Einstein and focus on relativity, not just inflation for its own sake. What has happened lately is that inflation has been reasonably (though not rigorously enough) controlled but we have allowed relativity to sneak through the cracks. We’ve forgotten the key objective of what we set out to achieve by controlling inflation in the first place. However, having reminded ourselves which is the objective and which is the tool we can use the tool to restore relativity to the economy. I.e. introduce an appropriate degree of inflation at the correct end of the economy to restore relativity between incomes and asset values. This is the crux of my suggestion. The Three Key Elements to this idea that you have to combine to see the merits and possibilities: 1. The relationship between wages and asset values is economically very important and has gone out of kilter. (Think of why houses are unaffordable). It must be restored before recovery can be achieved. Either wages must rise or values must fall. 2. Wages could be raised globally in a synchronized manner so that competitiveness does not alter significantly. 3. Inflation is abhorrent mostly because of the distortions it causes, but for that very reason it can be used to correct distortions as well. We hear economists talking of “the elephant in the room” being inflation. But because they have a fixation with inflation they have forgotten the reason they don’t like it and they are missing the opportunity I have seen. Chris Ward