Why we are not on the brink

Lamb chops and "secular stagnation" — Peter Lyons considers financial armageddon and the barbecue season.

I got cornered at a barbecue recently. I was trying to ingest my third fatty lamb chop. The earnest gentleman was concerned about the impending financial armageddon. I generally try to avoid economic discussions, non-alcoholic beverages and green salads at these events. I’ve learned that lengthy digressions on economics invite long periods of solitude.

Economic history is poorly understood and seldom taught these days at tertiary level. But it offers some very valuable insights into what is occurring at the moment. History may not repeat, but it certainly rhymes.

I do not believe there is an impending financial armageddon. I do not believe we are heading towards another 1930s-type Depression with massive unemployment, bank failures, deflation and widespread despair.

I do believe we are suffering from what is referred to as ‘‘secular stagnation’’ with little or no real income growth for most people. I believe asset prices in property and shares have been artificially inflated by ultra-low interest rates. I believe inequality of wealth and incomes is a serious social and economic issue that is distorting our society and economy. I believe there is a strong redistribution role for government. But it needs to be done smartly.

The main reason I doubt there will be a financial armageddon is because central banks have shown they will not allow this. They managed to avoid this scenario in 2008 by flooding their financial sectors with easy money. This narrowly averted widespread banking collapses as occurred in the early 1930s. Central banks showed they would rather risk inflation than financial armageddon. They will not allow widespread bank failures.

Ben Bernanke, the chairman of the Federal Reserve in 2008, was an expert in the history of the Great Depression. In 1963, Milton Friedman and Anna Schwartz published A Monetary History of the United States. Not a popular best-seller or light reading. But in their book they showed fairly conclusively the main policy mistake that contributed to the 1930s Great Depression. The Fed had allowed the money supply in the United States to fall dramatically.

The reason money disappeared was because of widespread bank collapses in the early 1930s. Most modern money is made up of bank lending. In the early 1930s, the banking system in the United States imploded because of a huge loss of confidence. The Fed failed to back the banks by providing access to cheap new money. As more banks collapsed there was mounting fear of more collapses and more bad debts. Banks cut their lending and demanded loans be repaid.

This created a negative feedback loop. It became self-fulfilling. The financial sector ate itself. President Roosevelt famously said: "We have nothing to fear, except fear itself." He was referring to this process.

Our reality is hugely shaped by our thoughts, both individually and collectively. This often becomes self-fulfilling.

This key lesson from economic history has been learned. But it has created a big new problem since the 2008 Global Financial Crisis. Central banks have shown they will not allow the banking system to fail. But banks have also known this and this invites a renewal of reckless lending in the competitive pursuit of profits and further asset price inflation.

This is a key reason why our Reserve Bank is requiring the banks to hold more capital. Bank shareholders are being required to have more skin in the game.

I didn’t bore the guy at the barbecue with this lengthy economic homily. I just mumbled sagely that it’s all very grim and it was time for another lamb chop and a stiff drink.

  • Peter Lyons teaches economics at St Peter’s College in Epsom.


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