US debt, GDP and assets

Thanks to a reader for drawing attention to the following highly interesting graph on the relation of US debt to US GDP which appeared on the London Banker blog. It is clearly highly relevant to the discussion of debt-deflation and the present financial crisis which has appeared on Socialist Economic Bulletin.
The only caution that must be introduced in interpreting this graph is that, as Socialist Economic Bulletin has pointed out, the crucial figure for the economy is not that of the total level of debt but the ratio of debts to assets. This graph does not show this directly but illustrates the ratio of debt to GDP - not the ration to assets. Nevertheless the extremely high ratio of debt to GDP indicates clearly that extraordinarily, indeed implausibly, high levels of asset values in relation to GDP would have to exist to sustain this debt level without 'over indebtedness' occurring.
The build up of US debt in the run up to 1929 is clearly shown, as well as the reduction of debt level created by the Great Depression of the 1930s. The much higher ratio of US debt to GDP by 2008, compared to 1929, is similarly evident from this graph.
As the the London Banker is a blog which is not sympathetic to socialist opinion it was not one we were following, and we would like to thank our reader for bringing this information to our attention.

Derek Wall comments on the Socialist Unity site

Derek Wall has published a comment on the site Socialist Unity, with some praise and some criticism, of Ken Livingstone's article in Comment is Free and Socialist Economic Bulletin on the nationalisation of failing banks. Readers can find it, with comments, here.

New York Times tells actual history of Swedish bank rescue

Socialist Economic Bulletin has pointed out that although a number of people are claiming the bank rescue package proposed by the government is based on the experience of Sweden in the early 1990s it in fact has nothing to do with it.
In Sweden the principle was that the shareholders equity was first used to cover debt - that is it was eliminated and the rest of the economy thereby safeguarded to the maximum degree possible. In the UK proposal, on the contrary shareholders, are to be propped up by injections of government finance and debt and risk passed to taxpayers.
It may be thought, however, that Socialist Economic Bulletin, an explicitly left wing publication, might be misleading its readers as to what actually occurred in Sweden. Therefore they may be interested to read the account in an impeccably capitalist publication - the New York Times. This will show that Socialist Economic Bulletin's account is entirely accurate. Under the title 'Stopping a Financial Crisis, the Swedish Way' it notes:
'A banking system in crisis after the collapse of a housing bubble. An economy hemorrhaging jobs. A market-oriented government struggling to stem the panic. Sound familiar?
'It does to Sweden. The country was so far in the hole in 1992 — after years of imprudent regulation, short-sighted economic policy and the end of its property boom — that its banking system was, for all practical purposes, insolvent.
'But Sweden took a different course than the one now being proposed by the United States Treasury. And Swedish officials say there are lessons from their own nightmare that Washington may be missing.
'Sweden did not just bail out its financial institutions by having the government take over the bad debts. It extracted pounds of flesh from bank shareholders before writing checks. Banks had to write down losses and issue warrants to the government.
That strategy held banks responsible and turned the government into an owner... Urban Backstrom, a senior Swedish finance ministry official at the time [said]. “The public will not support a plan if you leave the former shareholders with anything,” he said... By the end of the crisis, the Swedish government had seized a vast portion of the banking sector, and the agency had mostly fulfilled its hard-nosed mandate to drain share capital before injecting cash. '

The Sunday Herald on bank nationalisation

Readers may be interested in the following article that appeared in Scotland's The Sunday Heerald by Ian Bell dealing with bank nationalisation - its title 'What do we want? Nationalisation. When do we want it? Any minute now' is rather clear. It concludes:
'Nationalisation, they say, "distorts the markets". Anyone observing the markets last week might view the possibility with equanimity. Nationalisation, we are told, is inefficient. Which yardstick for the efficient distribution of capital are they employing on Wall Street and in the City these days?''
The article can be found here.

The fall in asset prices is causing the liquidity crisis, not the liquidity crisis the fall in asset prices - by John Ross

The following article appeared on the blog Key Trends in the World Economy

* * *

The announcement that the US government is to follow the example of the British government, and buy shares in US banks in order to recapitalise them, brings to the fore one of the most important issues in the present financial crisis -one which has major financial and policy implications.
The international financial crisis is at present focused in two areas – asset values (share prices, house prices etc) and liquidity (drying up of interbank lending leading to a paralysis of the financial system). But the analysis of the interrelation of these two processes is vital in understanding how to tackle them.
The decisive question is whether it is the fall in asset values that is driving the liquidity crisis, or it is the liquidity crisis that is driving the fall in asset values? Different measures, with hugely different financial implications, follow from the two different answers.
The real cause of the crisis is that assets in the US are overvalued – in the end due to the overvaluation of the dollar. That is, if real market process were allowed to develop, and in the end no one will be able to stop them from operating in some form, these assets will be shown to have less value than their former and present prices.[1]
As these assets devalue down to their competitive market values this weakens, or renders insolvent, the balance sheet of institutions directly or indirectly holding them – that is they suffer loss or bankruptcy.
As these assets fall in value this necessarily produces a liquidity crisis - as financial institutions cannot lend, due to their overstretched balance sheet, nor are they willing to lend to other banks who are also greatly overstrained and may therefore not be able to repay loans. That is, the fall in asset values drives the liquidity crisis.
The present financial crisis logically started in the weakest and most overvalued part of US assets – the sub-prime mortgage market. But it is not confined to them and therefore spreads through other parts of the financial and asset system – the crash of share prices on Wall Street during the last week being the latest manifestation of this.
The policy conclusion that flows from this is that as the assets were overvalued, therefore someone will inevitably suffer loss as a result of their decline - this is unfortunately unavoidable. The only economic question is who will suffer this loss?
The aim of policy must be to ensure that this loss is concentrated as narrowly as possible on the source - that is those institutions most economically responsible for the crisis. If this is not done losses will necessarily spread through the system and those not responsible (viable firms, taxpayers etc) will suffer higher than necessary losses. In this case economic rationality coincides with morality.
This means shareholders in financial institutions which took the wrong decisions, that is who bought/created such overvalued assets, should not receive funds from those who were not responsible. If shareholders in institutions which made wrong decisions are safeguarded then others who bear no responsibility for this failure - viable companies, taxpayers, depositors etc - will suffer corresponding losses.
The government must naturally be prepared to step in to ensure the functioning of the banking system, but it should not be bailing out bank shareholders. This model was used, for example, in the rescue of Swedish banks in the 1990s and was also carried out in the nationalisation of Fannie Mae, Freddie Mac, and AIG in the US and Northern Rock and Bradford and Bingley in the UK. This will involve the state taking over these failing banks to ensure the functioning of the banking system.
Liquidity in this situation will be maintained by two steps. First, immediately, central banks must substitute for the frozen lending markets by themselves lending or using existing nationalised banks to do so – Northern Rock can be used in the UK for this purpose. Second, after nationalisation of the insolvent parts of the banking system, these banks can recommence interbank lending. This route will minimise losses for ordinary depositors, tax payers, consumers, and viable companies.
However consider the policy implications if, on the contrary, it is believed that it is the liquidity crisis which is driving the fall in asset values. In this case the first step is the same – the money markets are flooded with liquidity. But the second step is totally different and will result in losses being spread through the system to taxpayers and viable companies.
If it is believed that it is the liquidity crisis which is driving the fall in asset values then, as the liquidity crisis is overcome through injections of money, assets would rise in value. In particular bank shares will rise in value. It is, therefore, rational for taxpayers money to be put into bank shares, that is to ‘recapitalise’ the banks - indeed it is conceived this may even lead to a profit in the medium term. This is what the UK government proposed and it is now announced the US will follow this. However consider what will occur if this analysis has got the dominant direction of causation wrong – that is that it is the fall in asset prices which is driving the liquidity crisis and not vice versa.
First, despite the liquidity injection, the money put into bank shares will not halt the fall in asset values as this is not being driven by liquidity problems but by a quite other mechanism. Falls in asset values will therefore continue – that is the taxpayer will suffer big losses on the sums put into bank shares (this may be worsened by existing shareholders selling shares at values that have been temporarily artificially inflated by the capital injections). These losses will then make it much harder to indemnify deposit holders, tax payers, maintain public spending, assist viable companies etc – in other words those responsible for the crisis will haved been safeguarded at the expense of those not responsible for the crisis and losses will be spread through the system.
Second, the interbank lending market will have a strong tendency to jam again or to remain jammed – because the downward pressure on asset values means that banks will not be able or willing to start large scale lending. It is quite probable that in the end, to unjam this situation, the banks will have to be nationalised anyway but by this time large amounts of the taxpayers money that had been put in to 'recapitalise’ the banks will have been lost.
The mistake of believing that it is the liquidity crisis that is driving the fall in asset prices, rather than understanding that it is the fall in asset prices that is driving the liquidity crisis, will therefore lead to major losses for the taxpayers and viable companies and also fail to resolve the banking crisis.
To look at the real world, it is quite clear from the facts that it is in reality the fall in asset values that is driving the liquidity crisis and not vice versa. The crisis started in asset values, in sub prime mortgages. This, in turn, revealed that other assets, in the first places the shares and other holdings of US financial institutions, were themselves overvalued. It was this that then created the freezing of interbank lending and the other aspects of the liquidity crisis. In short it is the fall in asset prices that created the liquidity crisis, not vice versa.
Governments will not succeed in overcoming the present situation until they analyse correctly its dominant direction of causation and adopt the appropriate policies.

Notes

[1] This working out of market forces could theoretically take many forms. One, which did not occur, was a gradual devaluation of the dollar over a prolonged period of years. A second would be a sudden drop in the exchange rate of the dollar - that is nominal dollar prices might not fall but their real international value would be cut. A third would be that the exchange rate of the dollar remained the same but that the nominal dollar price of assets fell sharply. But in all cases the price of the dollar denominated assets will fall. Which of these variants occurs depends on other, more short term, factors. In the present phase the dominant process is the third.