Consciousness of Sheep
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It is a decade since the world was plunged into the worst economic crisis in living memory. Its impact is still being felt today. Most obviously, the election of Donald Trump and the UK decision to leave the European Union would have been unimaginable in the years before the crash. People whose living standards are improving – or at least not declining – do not vote for change; especially dramatic and unpredictable change. People whose living standards and future prospects have fallen through the floor do.
The trouble is that the experience of declining living standards is not reflected in official statistics. Stock markets and asset prices are at an all-time high. Unemployment is at its lowest since the early 1970s. Inflation, while it has risen a percentage point since 2016, is still very low compared to rates in the 1960s and 70s. On paper, at least, the economy is booming. And yet, for a large part of the population the past decade feels like a depression. Moreover, there is a growing sense of foreboding as the value of the currency (pound and dollar) falls, debts spiral upward and a raft of businesses lay off thousands of workers.
It is precisely at times like these that we turn to the high priests of economics to provide us with some insight into where we are headed. But here we experience profound shock. Economists believe the statistical Kool-Aid; they really think the economy is booming. Indeed, not just booming, but overheating.
For the first time in a decade, real wages have blipped upward, and the central bankers are panicking about the return of inflation. Just like in 2006, when Ben Bernanke hiked interest rates to ward off the imaginary spectre of inflation and ended up crashing the global economy instead, today’s central bankers are also raising interest rates into a growing recession. And since none of the fundamentals behind the 2008 crash has been resolved, this time the crisis really could change the world.
Unscientific modelling
Perhaps the most important unresolved 2008 issue is with the models used by economists themselves. In the aftermath of the crash, Britain’s Queen Elizabeth famously asked the esteemed professors and alumni of the London School of Economics why “nobody saw this coming.” All they could do was shrug and talk about “externalities” and “black swans.”
The truth is that a few economists did see it coming. Peter Schiff saw it coming. So, too did Steve Keen, who used complexity modelling of the kind used in physics and engineering to demonstrate the effect of private debt on the economy. But the models used by central bankers and mainstream economists in general not only augured against a crisis, but suggested that the global economy had moved into a “Great Moderation” in which the cycles of boom and bust – which we have experienced for centuries – had finally been overcome.
Hubris indeed!
When a model used by meteorologists or astrophysicists fails to predict events in the real world, it will be revised and tested to destruction. The result of decades of this experimentation and revising is that today’s weather forecasts are very reliable, and various space agencies have provided us with satellite navigation systems that are accurate to within a few centimetres.
When a model used by economists fails to predict events in the real world, they simply blame the world for its lack of conformity and carry on using it. It is for this reason that economics is best regarded as a branch of astrology or faith healing rather than a science.
A large part of the problem of economics is that almost all of the models used today were developed in one of the most unusual periods of human history. As a result, they treat an economic outlier as normal, then wonder why the real world fails to live up to expectation.
The 20 years 1953-73 were truly exceptional. As historian Paul Kennedy explains:
“The accumulated world industrial output between 1953 and 1973 was comparable in volume to that of the entire century and a half which separated 1953 from 1800. The recovery of war-damaged economies, the development of new technologies, the continued shift from agriculture to industry, the harnessing of national resources within ‘planned economies,’ and the spread of industrialization to the Third World all helped to effect this dramatic change. In an even more emphatic way, and for much the same reasons, the volume of world trade also grew spectacularly after 1945…”
They were, in effect, the years when the world shifted to modern (i.e. oil-powered) industrialisation. In 1945, the USA had emerged from the Second World War as the only undamaged major economy on the planet. Europe and Japan were in ruins, the UK was damaged and broke, and the Soviet Empire was embarking on its retreat to backwardness. The rest of the world had only begun to throw off the shackles of a much weakened European colonialism. By 1953, and in large part thanks to Marshall Aid and US loans, the UK, Western Europe and Japan had completed their reconstruction and were embarking on the modernisation of their economies. Meanwhile, funds were pouring into those ex-colonial states that had exploitable resources and/or geopolitical importance.
The expansion was a once-and-for-good binge that, among other things, used up almost all of the easily recoverable energy and mineral resources on the planet. This can be seen in the production of crude oil – which is so ubiquitous that it sets the cost of recovering every other resource:
While oil production continued to rise beyond 1973, the rate of growth declined. Less obviously, the cost of recovering the remaining oil has risen remorselessly. We might be enjoying something of a “shale oil boom” in terms of the volumes of unconventional oil coming out of the ground. But we are investing billions of dollars to recover millions of dollars’ worth of oil – something that investors are not going to put up with for much longer.
Both interest rates and inflation rose to peacetime highs over the same period. In part, this was due to governments printing too much new currency to finance full-employment at home and wars abroad. In part, however, it was due to the drag of increasing production costs and growing resource shortages – one reason that the crises hit in the 1970s was that the Texas Railroad Commission lost control of world oil prices; ushering in a period of price volatility.
Mark Blyth has reproduced a chart of historical interest rates produced by economic historians at the Bank of Japan. These tell a very different story to the usual economic narrative:
Interest rates in the 1970s and early 1980s were at their highest since the Black Death wiped out two-thirds of the population of Europe. In those days, rates were high because there was no means of offsetting risk. If the king lost his war, the banker wouldn’t get his money back. Indeed, even if the king won the war, he might refuse to pay up. The Dutch invention of derivative instruments to mitigate risk gave birth to the modern financial system. Notably, this served to stabilise interest rates below five percent. Seen in this light, while today’s rates are low, the six percent rate immediately prior to the 2008 crash was actually higher than the historical average; while rates in the 1970s and 80s were extraordinary.
The four most important economic indicators – growth, employment, inflation and interest rates – all experienced historically atypical highs between 1953 and 1973. The overhang of inflation and interest rates continued to rise to their high point in 1979/80. In modelling terms, they are akin to the impact that a large volcanic eruption has on global weather. By treating them as normal, however, economists are like weather forecasters who assume that major volcanic eruptions are a daily occurrence.
Generals fighting the last war
If economists enjoyed the same status as astrologers, their lack of any grounding in reality would be of little concern. Unfortunately, they enjoy the exalted status of the priesthood in an ancient Mesoamerican civilisation. The fact that the human sacrifices that they make to the economic weather Gods never seem to produce the promised bountiful harvest does not stop them from spilling the blood of even more victims.
Today’s human sacrifice is in the form of decimated industrial towns and regions, impoverished populations, and the alarming growth in homelessness and mental illness. For the first time since the Second World War, life expectancy in the western economies is falling.
One reason for this is that, like First World War generals ordering fixed-bayonet charges against entrenched machine guns, the economists and the politicians they advise are still fighting the last war. Economic modelling dictates that in periods of full-employment, wages must rise. This, in turn, risks unleashing the kind of inflation that proved so destructive in the 1970s. The solution – as written in all of the economics manuals – is to raise the rate of interest and cut public spending in order to create sufficient new unemployment to bring prices down. This was what the governments of Margaret Thatcher and Ronald Reagan set about doing in the early 1980s.
Whereas the fear of fascism and communism caused a generation of post-war politicians to focus economic policy on maintaining full-employment; the new generation of neo-liberal economists and politicians of the 1980s regarded inflation as public enemy number one. They actively created high rates of unemployment by cutting public spending and by withdrawing state support from unprofitable industries. The ensuing depression helped to bring inflation down; but at the cost of social division, rioting and widespread strikes – which were brought to an end only when whole industries were offshored.
The accident of financial deregulation – which was not part of the Thatcher/Reagan programme to begin with – finally propelled the western economies back to growth. The reason was simply that from 1986, the banks were able to do what governments refused to do – print new currency out of thin air. The massive splurge of borrowing against rising asset prices from the mid-1980s led directly to the housing bubble and the crash of 2008. But by the time anyone realised there was a problem, all of the mainstream political parties and their economic advisors had adopted the neo-liberal orthodoxy. As Margret Thatcher reflected – New Labour was her greatest success.
Blair’s New Labour, Clinton’s Democrats and various European social democrats accepted what Servaas Storm refers to as the “Nasty Trade-Off” – the supposed fact that full-employment had to be bought at the price of rising inequality. The consequence was that each adopted a programme of social security and employment reforms that blurred the distinction between employment and unemployment.
In the new “Third Way,” governments would be “intensely relaxed about people getting filthy rich as long as they pay their taxes.” The proceeds of those taxes would be recycled in the form of tax credits designed to allow families to take up poorly-paid employment. This additional support meant that they could make traditional social security far more punitive. Work Capacity Tests were introduced for the sick and disabled in order to encourage/force them to take up low-paid work. Unemployed people had to prove that they were actively seeking work, and faced sanctions for failing to do so.
This was the pre-crisis origin of the gig-economy, the growth in self-employment and the development of temporary, part-time and insecure employment that exploded in the post-2008 economy. This has created a vastly different economic landscape than the one that today’s central bankers grew up in and were taught to think of as normal. As Storm notes:
“…decades of labor market deregulation have created what Alan Greenspan (speaking about the U.S. economy) called workers ‘traumatized’ by job insecurity and afraid or simply unable to press for wage increases… recognizing that the bargaining power of flexible workers has, if anything, not improved, it is difficult to see how economic growth and lower unemployment lead to structurally higher wage growth and higher inflation.”
In other words, raising interest rates just because the official unemployment rate is the same as in 1973 is to fight yesterday’s war. The measure of unemployment in the early 1970s – when far fewer of us were self-employed and most employment was full-time – was so different to today as to make comparison irrelevant. As John Mauldin observes:
“If you argue that we are at ‘full employment,’ then it follows that you are expecting wage inflation. But that is not what we’re seeing. Eighty percent of workers are seeing very little wage growth at all… For there to be demand-led inflation, consumers need to actually have some of that wage growth in order to be able to spend more money. Yet real savings as a percentage of disposable income is down to just above 2%, a long way from the long-term average of 8%. And credit card debt is still rising while disposable income is flat.”
According to Maudlin, the true rate of unemployment in the USA – if we include people who have simply dropped out of the figures together with those who would take on extra hours if they were available – is around nine percent; almost double the official rate. The same is true across the western economies.
In the UK, much of the apparent wage growth in recent months is the result of a rise in the Minimum Wage for the lowest paid – but often least secure – employees. In the modern, “flexible” labour market, this is more likely to result in more employers turning to agency and gig-economy workers to fill these roles in future than to an inflationary jump in long-term wages. But will economists see it that way?
Causing a crisis to prevent a crisis
According to Chris Giles in the Financial Times:
“Growth in the average living standards of British households has been slower over the past decade than previously thought because official figures give too much weight to rich people… research confirms that UK households suffered their worst decade of income growth for 50 years during and after the financial crisis, and suggests that living standards of ordinary households were hit even harder than originally thought.”
A quarter of UK households have no savings to fall back on in an emergency; and 28 percent have precarious outstanding debts. Unsecured debt in the UK has risen far faster than wages, suggesting increasing numbers are turning to credit to make ends meet. A similar picture can be seen in the USA. Falling currency values have caused the price of imports to increase on both sides of the Atlantic, and oil and other commodity prices are rising again (like they did in 2006) adding to the cost of living woes of a large part of the working (and partially working) population.
In this climate, we might expect a degree of caution on the part of the central bank economists. Maybe now more than ever would be a good time to be “data dependent.” And among the data they might want to consider is the recent rise in unemployment resulting in part from the swathe of retail job losses that followed one of the most dismal Christmases in living memory.
The central banks, however, have a problem. The tool with which they attempt to batter the economy into the desired shape is the overnight bank lending rate. Their belief is that if this is set lower than the rate of inflation, banks will make loans to you and I rather than leave funds on deposit with the central bank. In fact, there is little evidence that this has happened in the decade since 2008; but then economists seldom let the real world intrude on their modelling. Crucially, the models say that to ward off another crash, central banks will need to be in a position to cut interest rates by at least three percent… which is something of a problem for the UK (0.5%) and the US (1.5%).
This is why central banks are currently talking up the strength of the economy, raising interest rates and promising (but not yet actually implementing) to cut their balance sheets – something that would crash the price of government bonds and send interest rates soaring. The problem is that economies that have been on life-support for a decade are simply too weak to withstand the shock. A mere sniff of inflation at the beginning of February resulted in a ten percent stock market correction based on the fear that interest rates would have to rise.
If the central banks persist in ignoring the weakness of the real economy, the interest rate rises they claim to need to ward off a crisis will more than likely cause the crisis they seek to avoid. This, after all, is what happened between 2005 and 2008. As former bank chief economist and oil industry expert Jeff Rubin explains, while we think of 2008 as a sub-prime mortgage crisis, it was actually an oil shock.
Central bankers wrongly believed that rising oil prices after the peak of conventional crude oil production in 2005 would translate into generalised inflation. To prevent this they began to jack up interest rates. Up to that point, sub-prime borrowers had been able to manage their repayments; although – like today – rising oil prices forced them to switch spending away from discretionary items:
“If the price of oil goes up and if people continue to use the same amount of oil as before then this means that people are now forced to allocate more money for oil. If people’s money stock remains unchanged then this means that less money is available for other goods and services, all other things being equal. This of course implies that the average price of other goods and services must come off.”
If the central bankers had done nothing, rising oil prices would have translated into falling prices elsewhere in the economy. However, by raising prices just at the point that household spending was already being squeezed, the central banks forced US sub-prime borrowers to default, and set off a chain of events that very nearly destroyed the global banking and finance system.
None of the problems of 2008 were fixed. Instead, trillions of dollars of bad private debt was transferred to the public. In effect, the chain of dominoes that connected sub-prime borrowers to private banks and insurers in 2008 extends to currencies and governments in 2018. The risk is that this time around, a “preventative” hike in interest rates will trigger a collapse that not only takes down multinational banks, but destroys national currencies and bankrupts national governments. If this were to happen, then everything that was “too big to fail” in 2008 will prove to be too big to save this time around.
In the event of that chain of dominoes falling, we can only hope our new Chinese overlords treat us better when China emerges as top dog than our forefathers treated Chinese people back when we held the number one spot.
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