Keynes’ unwanted children: Chan Akya

There is an awful irony when one evaluates the consequences of all the Keynesian[1] actions since 2001; unfortunately matters of good taste and this publication’s writing standards disallow the use of many of the more colourful phrases that are entirely more appropriate to describe them. For now, let’s just call them the illegitimate children of Keynes.

  1. Global financial crisis
  2. Climate change
  3. China’s recent reversals
  4. Europe’s refugee crisis

Let us consider these individually below.

Global financial crisis

While the media would have you believe that it was Wall Street greed and delusional credit investors who brought down the global financial system in 2007, a closer and more dispassionate examination clearly reveals that the root causes were:

  1. US Fed easing from 2001 to thwart the after-effects of the dotcom bust (with some of it disguised as a post 9/11 stimulus) that led to significant monetary expansion in the US
  2. Chinese and Japanese intervention in the currency markets that led these countries to amass significant USD reserves (as a natural consequence of Fed easing the USD tended to fall, this further accentuated the intervention)
  3. Basel II capital standards that propelled European demand for securitized bonds. While this wasn’t strictly Keynesian, it was partially driven by the lower returns on corporate and individual credit risk in Europe that were in turn a product of Keynesian stimulus programs

The net result was excessive demand for highly rated bonds backed by individual mortgages. As most Western countries (except for the US and Denmark) had failed to develop a broad base of mortgages, the net results were

  1. Excessive demand for the current stock of USD and Danish Kroner or DKK mortgages[2]
  2. A palpable increase in the issuance of USD mortgages, primarily driven by fraud and misrepresentation around the ability of borrowers to repay such mortgages

Sure there was a racket involving Wall Street, the rating agencies and various mortgage originators including banks and brokers; but the fundamental reason for investors to lower their guards was the desperation for yield (or more correctly, risk adjusted yield where both the risk and the yield were mispriced due to regulatory reasons).

To ignore this primary motivation is to gloss over a key causal element of the financial crisis.

Climate change

Would you believe it if I told you that global central bankers may be responsible for up to 50% of climate change effects observed over the past 10 years? This may appear a scaremongering statement but let’s look at the logic below:

  1. In a typical financial crisis, particularly when brought about by excessive leverage, markets adjust by rapid deleveraging
  2. Deleveraging reduces the prices of highly leveraged companies and other securities as investors would demand a higher return for these assets
  3. In turn the higher return expectations (or lower bond prices, which is the same thing) would shut off refinancing opportunities for the sectors and countries in question
  4. With refinancing shut off, the sector and countries in question refocus efforts on productive and profitable capacity. This means all unprofitable capacity is shut down or scrapped

Instead of the above process, generally described by academics as ‘Schumpeter’s creative destruction’, we had the Keynesian response since 2001:

  1. The dotcom bubble would ‘normally’ have resulted in wealthy Americans monetizing their other key assets namely their houses which would have crashed house prices and reduced homebuilding, while making housing more affordable in general
  2. To thwart the GDP declines presaged in this arrangement, the US Fed eased up monetary policy wherein real interest rates fell sharply; thereby propping up all leveraged assets – including housing
  3. There was therefore a boom in housing prices, which in turn created a fashion for second and third homes; lavish and over-appointed primary homes. At this point, its probably useful to mention that American homes are built with tremendous amounts of plasterboards, over-insulated wiring and various other plastics products; all producing a carbon footprint that’s virtually unequalled in the world
  4. The rise in home prices also produced a wealth effect that increased demand for high-end consumer durables including cars[3] and boats (A number of such products thus duplicated the working life of existing capacity (in other words, overcapacity). So instead of using a car for 10 years, people flipped to a new car within 3 years, in effect creating demand for 2 new cars). This comes at the cost of significant extra emissions and energy[4]
  5. Higher factor costs in the US and EU thanks to monetary easing also made manufacturing and various related activities fairly uneconomical, thereby pushing production to the rest of the world especially China. While none of this started in 2001, it is fair to say that trends were accentuated by the declining competitiveness of these countries after asset prices were propelled “artificially” higher thanks to monetary policies. That trend in turn resulted in higher economic growth in less energy efficient economies; and substantial increase in infrastructure spending that also increased energy consumption
  6. Post the global financial crisis, these trends only worsened. China attempted to thwart its own economic risks by engaging in a rapid stimulus programme in 2009, essentially building roads to nowhere. Monetary easing by the Fed, Bank of England, Bank of Japan and European Central Bank all followed
  7. Fiscal deficits from various governments in Europe as well as the rest of the world have only worsened in the presence of a ready phalanx of investors namely the central banks. While the US Fed has barely stopped its direct bond buying programme, others such as the ECB are looking to increase their own intervention to keep rates lower for longer
  8. Artificially low interest rates have allowed European governments to keep up welfare payments, free schooling, health services and various other adornments such as support for loss making businesses that are all reminiscent of a wasteful past. As we will see below, this in turn played a part in the refugee crisis
  9. The net result was sharply lower interest rates; which prevented the ‘creative destruction’ process that would have normally occurred after a debt crisis. By some estimates, the world economy is about 25% larger than is strictly justified by economic profits; this number could well be an underestimate if we arrived at any normalized rates of interest globally

This bears repeating: the cumulative effect of all the easing policies for the past 15 years has therefore been the creation of a global economy that is far larger than can be justified by profitable economic activity. This in turn pushes the locus of the crime away from the economic profit makers who profit from environmental destruction to the people who created the profitless growth that’s still burning the world.  

So whenever you see an article or podcast or whatever about the icebergs melting, stranded polar bears and disappearing Amazon rainforests, there is no need to look too far in the search for suspects – all the officials of the big central banks mentioned above are the key culprits behind these crimes.

China’s reversals

Then there is China. While a number of supposed free market practitioners are quick to point accusing fingers at the country on every drop of a hat (or stock market, which appears to happen with the same frequency), the reality is perhaps much more nuanced, particularly since 2001

  • Demand in the US and EU for consumer products was boosted by monetary easing; as this was accompanied by higher asset prices domestically, there was a surge in imports from China and other countries
  • Having established reasonable competitive advantages in the nineties, China benefited the most from this excess demand; in turn posting strong growth numbers averaging over 8%
  • Rising economic growth came at huge environmental cost in China as the coastal regions were overburdened with industry even as Western hinterlands lagged; thereby necessitating both environmental protection moves and increased infrastructure spend in the Western part of the country
  • The government also counted on increased consumption to balance out growth but this simply failed to materialize as a number of social factors (for example: family units being close to places of work) stood in the way of a consumption boom
  • Boosting the real estate market was seen as a way to improve the economic confidence of salaried people, while also engendering entrepreneurship. This policy was akin to the Western policies on home ownership but with the important difference that the starting point of home ownership was far lower. This created more opportunities for mispricing, almost organically a necessity

To a large extent, all of the Chinese government policies to stabilize the local economy ended up being a giant “correlation” trade – at the end of the day, the truly profitable sector remained exports; therefore volatility on the demand side as presaged by excessive monetary policy intervention ended up being for naught thereby imperilling the growth forecasts that underpinned Chinese infrastructure spending.

As I have written before on these pages, while there is little sympathy for government interventions in the economy and market as a broad principle, in the case of the Chinese a number of the actions appear understandable once the full impact of Western monetary expansionism is fully appreciated.

Europe’s refugee crisis

Dead body of Syrian refugee boy washed up on a Turkish beach

Dead body of Syrian refugee boy washed up on a Turkish beach

At first glance, it does appear that trying to link central bank intervention with the European refugee crisis is a step too far. After a detailed examination of the events governing the root causes of the crisis though, it becomes apparent that central banks and specifically the Bank of England and the European Central Bank played a leading role in creating the crisis. Let me explain.

There are two distinct sources of refugees now flooding into Europe – firstly those from Africa (call them “economic” refugees) and secondly those from the likes of Libya, Syria and Iraq (call them “warzone” refugees). I am well aware that many refugees from sub-Saharan Africa are also fleeing religious and political prosecution, at least partially caused by the nexus between commodity traders and governments; therefore there is a monetary policy link in that respect as well. Some of the famines and droughts driving African poverty have been caused by climate change, so there is a link to the second part of this article as well.

When we look at Europe, it is obvious that there are (again) two fundamental errors of commission at the centre of this crisis

  • Firstly, the support given by the UK and EU to toppling the regimes of Libya and Syria
  • Secondly, the overly generous and under-reformed welfare systems at the heart of the “European dream” which attract these refugees in the first place

I have already addressed the second point above in the ‘Climate Change’ section wherein the unaffordable welfare state in Europe has driven the size of GDP to unsustainable levels; there is a limited need for another diatribe here. That said, clearly the attraction of universal healthcare and free schooling was captured by Bloomberg in their article “Refugees Brave Europe’s Deadly Seas Over Arab Neighbours” dated September 4, 2015 which quotes a Syrian refugee:

“In Europe, I can get treatment for my polio, educate my children, have shelter and live an honorable life,” said Batal, as he left a United Nations office in Beirut, the city that’s been the crossroads for more than a million refugees since the violence started in March 2011. “Gulf countries have closed their doors in the face of Syrians.” .. Stories of fellow refugees suffocating in trucks or small children drowning in the Mediterranean Sea are doing little to tarnish the allure of Europe and the struggle to get there. As countries argue over how to cope with the scale of the tide of humanity, safer routes to the Gulf states remain blocked because of the difficulties gaining entry and concern over how migrants would be treated there.

Despite strong regional, religious and ethnic ties, the fact that Middle Eastern refugees would flock towards Europe is perhaps no surprise when we consider the sheer generosity of the welfare system at the heart of the attraction.

Even this though glosses over the primary cause namely the war efforts of the European nations in the case of Libya and Syria ostensibly aimed at dethroning tyrant regimes. It is a different matter that the good governments of Saudi Arabia and its neighbours do not qualify as tyrants for the Europeans; but let’s leave that for now.

How did the UK and EU fund their misadventures in Libya and Syria? Through their budget deficits, which were obviously helped by loose monetary policies that did not punish excessive risk taking on the debt side.

More to the point, the entire history of banking in Europe – for example that of the Rothschild family – is replete with anecdotes about the role of financiers in funding various war efforts across the colonial Empires. The fact that this “discipline” from loss-bearing creditors is longer imposed could end up being a really bad thing for Europe. We have already seen the bumbling and amateurish efforts in the case of European intervention in the Ukraine; what happened in the Middle East was a mere extension of this policymaking bereft of managing consequences be they financial or humanitarian. Simply put, Europe is now run by academics.

Having caused the war in these countries that had mixed results (regime change in Libya, a fractured regime in Syria), Europe then couldn’t deal with the secondary effects which was the creation of local militias and terrorist groups such as the Islamic State. These groups have in turn forced people to flee the region, usually in the direction of Europe.

Conclusion

Somehow, central banks have succeeded in uniting a bunch of people who otherwise are indifferent to each other: free market practitioners, environmentalists, anti-globalization protestors, liberals, human rights activists and so on. Pretty much every item in the headlines today can be traced back to the poor monetary policy decisions of the past few years.

Who would have ever thought that a bunch of boring academics with seemingly limited powers could wreak so much havoc globally?

[1] As with my other articles, the reference to ‘Keynesian’ pertains primarily to the current narrow interpretation of his ideas with respect to economic stimulus during downturns; as the current orthodoxy doesn’t permit a broader and more nuanced appreciation of his ideas nor do they allow for changes in demographics and other underlying assumptions in his works; neither shall I.

[2] Interestingly enough, Danish mortgages had already sounded the proverbial “canary in the coal mine” warning many years before the Global Financial Crisis – after all, the implosion of these mortgages was the primary factor behind the collapse of Long Term Capital Management. See an excellent summary from Berkeley : http://eml.berkeley.edu/~webfac/craine/e137_f03/137lessons.pdf

[3] This trend for booming demand in cars can be seen in both the US and UK, with the German car industry being the primary beneficiary thanks to brands like BMW, Porsche, Mercedes Benz and Audi

[4]This is generally estimated at over 20k Million joules of energy or more

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