Why the pump priming won't help the financial crisis

If it was January 27, 2008 and I made a prediction that every stock market across the world would crash losing 40 per cent in value, major economies would go into recession and face a deflation threat I would be labeled a loony left winger and probably sent to the asylum.

Well here is food for thought while economic pundits are talking about recoveries induced by stimulation packages, there will be no recovery.

Unemployment in the United States by this time next year will reach 20 per cent, the World economy will be locked into a deflationary spiral that will last as long as it takes until the major nation makes fundamental changes to economic structures across all nations.

Why won’t the pump priming work? Its worked for other depressions and major recessions.

The Keynesian response to the Great Depression involved increasing demand by government spending. Essentially, Keynes’s theory that equilibrium between supply and demand could be shifted to establish a new equilibrium with full employment was proven, so why won’t it work this time?

The Keynesian solution occurred when there were fixed exchange rates. In a floating exchange rate environment all the fiscal stimulation packages in the world will have limited effect. Over time those nations that engage in fiscal stimulation packages will see their effectiveness decrease as their currencies devalue.

Is the solution a monetarist response?

No, across the world the central banks’ first response was the traditional interest rate reduction and all that has achieved is locking every major nation into the liquidity trap of zero or negative real interest rates raising the ugly head of deflation.

To look at finding a solution we need to correctly diagnose the disease.

Well we all know the problem right? It was a speculative property market in the United States coupled with lax lending practices after the dot.com boom bust.

Wrong … These are the symptoms of the disease not the disease itself.

The disease is the decoupling of economic policy decision making from democratic institutions.

All round the world a model has been developed where monetary policy has been put into the hands of technocrats not elected by the people, nor accountable to the people.

Fiscal policy has been left with the elected politicians but, effectively, all this has achieved is leaving fiscal policy in neutral in a macroeconomic sense because the political elites have perfected the culture of not being responsible for economic outcomes. Thus monetary policy has been the only vehicle available for economic policy makers.

Thus when speculative bubbles have emerged central banks have been faced with two alternative responses: first, do nothing until the bubble bursts and then utilise loose monetary policy or, second, take pre-emptive action by raising interests rates and bludgeon the rest of the economy.

The problem is exacerbated when the speculative bubble occurs in the nation whose currency is effectively the world’s reserve currency. The second course of action effectively induces a world-wide recession.

If there was no separation of fiscal and monetary policy then the decision makers could have all the economic tools available to them.

For instance, when the dot.com boom turned into a property boom, governments could have reigned in the bubble by increasing property taxes or mortgage taxes or altered capital gains taxes. Alternatively they could have regulated mortgage securities to ensure that prudential practices occurred such as implementing the Danish system where mortgage originators issue redeemable bonds to the value of the loan and not allow cross contamination between institutions.

The Danish system ensures that the risk remains with the lenders and is not transferred to the holders of the mortgage securities and thus guarantees prudential lending. If the bond decreases in value the property owner has the option of simply purchasing the bond and using the bond to redeem the loan on the property. So the individual lending institutions have to pay the piper if they write dodgy loans.

This would have stopped the insane speculation caused by loose monetary policy and would not force central banks to bludgeon the rest of the economy. It also means that the political elites have to accept responsibility and cannot hide behind the faceless technocrats in the central banks.

So why then is a new Bretton Woods Agreement necessary? Why not simply put the elected representatives back in charge of both monetary and fiscal policy?

While restoring economic democracy is vital, that in itself will not fix the problem.

The United States has been living beyond its means; its current account deficit is unsustainable. It simply will not have the economic capacity to ever repay its foreign debt. What will happen once this fact is realised?

The creditor nations will have a firesale of US assets (currency and bonds) to try and minimise their losses before the bonds acquire junk status, thus triggering the biggest deflation event in the world’s history and along with it the greatest depression in the world’s history.

That is why we need a new Bretton Woods Agreement to revalue the world’s currencies in order to enable the current account deficit to become manageable and to establish a regime of fixed exchange rates to stabilise the international economy.

Floating exchange rates have made economic policy makers lazy; when economic problems arise too great a reliance has been placed on the market correcting the issue through exchange rate changes. Again the symptoms become treated but the underlying structural issues are not addressed.

What would the new Bretton Woods agreement need to achieve?

First, a revaluation of the Chinese currency, in exchange the developed world would need to free up agricultural trade and remove the inefficient agricultural subsidies.

A new system of fixing international exchange rates to reduce speculation and regulation of commodity trading particularly in food items to stop speculators in the developed world causing immense harm in the developing nations is also required.

The United States would need to transfer significant proportions of its gold reserves as compensation for the long term restructuring of its current account deficit.

Will the economic policymakers respond accordingly?

Not likely, too much vested interest. So what should you do?

Simple short sell everything because we ain’t seen nothing yet, the real earthquake is around the corner.