The Doomsday Cycle

This post's title is taken from The Doomsday Cycle, an article by Peter Boone and Simon Johnson. Their article leaves little doubt that the global financial system has been on an unsustainable path since the early 1980s, which just happens to be when I date The Beginning of the Decline of the Empire. See yesterday's post.

The first graph describes the situation in the United States over the last 3 decades.

Over the last three decades, the US financial system has tripled in size, as measured by total credit relative to GDP (see Figure 1 below). Each time the system runs into problems, the Federal Reserve quickly lowers interest rates to revive it. These crises appear to be getting worse and worse – and their impact is increasingly global. Not only are interest rates near zero around the world, but many countries are on fiscal trajectories that require major changes to avoid eventual financial collapse.

The Fed Funds target interest rate (red line, left scale) versus the credit/GDP ratio (blue line, right scale). You've got to stimulate that puppy (with free money & credit) when it goes awry, and do it over & over again

I think that's clear enough. Let's move on to the highly entertaining Doomsday Cycle itself.

The doomsday cycle has several simple stages. At the start, creditors and depositors provide banks with cheap funding in the expectation that if things go very wrong, our central banks and fiscal authorities will bail them out. Banks such as Lehman Brothers – and many others in this past cycle – use the funds to take large risks, with the aim of providing dividends and bonuses to shareholders and management.

Through direct subsidies (such as deposit insurance) and indirect support (such as central bank bailouts), we encourage our banking system to ignore large, socially harmful ‘tail risks’ – those risks where there is a small chance of calamitous collapse. As far as banks are concerned, they can walk away and let the state clean it up. Some bankers and policymakers even do well during the collapse that they helped to create.

Regulators are supposed to prevent this dangerous risk taking. Adair Turner, chairman of the Financial Services Authority, is calling for more radical change than most regulators. But banks wield substantial political and financial power, and the system has become remarkably complex, so eventually regulators become compromised.

As you can see, most of these "Doomers" are still in key positions—nothing has changed

Peter and Simon say some bankers and policymakers even do well during the collapse that they helped to create. I think they're on to something here!

OK, I'll be serious. It's not just regulators that have been "captured" as the lingo goes. A while back when this blog was in its infancy, I wrote Why I Stopped Reading Baseline Scenario (Simon Johnson's blog).  My point then and now is that our political system has been "captured" by Finance too. See my Financial Reform? The Foxes Are Guarding the Henhouse Again. Boone and Johnson say—

In our view, the long-term failure of regulation to check financial collapses reflects deep political difficulties in creating regulation. The banks have the money, they have the best lawyers and they have the funds to finance the political system. Politicians rarely want strong regulators—except after a major collapse. So politics rarely favors regulation.

Not only do the banks have the funds to finance the political system, but they do finance (bribe, own) the political system. That's all there is to it. I don't see any point in getting hysterical about global Finance if any attempt to fix it will be nipped in the bud by our corrupt politics—it is what it is. 

That's why I call this blog Decline of the Empire, OK? I could be accused of cynicism. I would plead guilty as charged just as long as you remember that my cynicism is based in Reality. Can you smell it? That sweet, alluring fragrance in the room? But inhale this perfume at your peril because you will become bitterly disappointed if you take in too much—it's called Hope.

And one last thing. Shouldn't we look for a deeper reason why the American (and global) economy went off the rails over the last 30 years? Maybe our exponential growth agenda was simply unachievable. This caused institutions, especially in Finance & Government, to bend the rules a little—actually a lot—to keep the impossible party going. If you combine that with the fatally flawed Human Character, you have the makings of a deep explanation for why we're up shit creek without a paddle...

Just a thought.

Comments

[eman]

Dave,

I wonder if you have ever read "Why Stock Markets Crash" by Didier Sornette. (More on Sornette here: http://www.er.ethz.ch/people/sornette )

Mr. Sornette is a Physicist and expert on complexity who has developed models for predicting crashes in markets with some notable successes.

The last chapter of his aforementioned book, "2050: The End of the Growth Era", discusses this issue of the end of our growth based system.

I often wonder if the confluence of such things as peak oil, bad politics, massive debt, and fierce competition for just about any resource will lead to this eventual ending coming earlier than Mr. Sornette thinks.

:-)