Different Choices in Revaluing the World Economy

Quickly is best...

A child, when removing a band-aid from a hairy extremity, has a number of choices. She could yank it off rapidly, jerking out the hairs in one go, causing a short-sharp-shock of pain. She can pull it slowly, and try and sneak up on the hairs but resulting in an extended and even more painful period of anguish as the hairs are dragged out one-by-one. She could even leave it on to avoid the pain, but that would result in a nasty infection as the old band-aid festered.

Now we have to deal with the consequences of the credit crunch and, like removing a band-aid, the choices we face all have a degree of pain associated with them.

The process of banking, for all its modern complexities, still involves taking in deposits from individuals and companies, and then lending out those self-same deposits to borrowers. The money that is loaned is paid back over an extended period, while the deposits are available any time.

American banks have lent out 94 cents for every $1 that they have on deposits, meaning that they have only 6 cents of depositors’ money available in case you spontaneously decide to buy your spouse some flowers on the way home. European banks are in even more trouble, having lent out $1.40 for every $1 they have in deposits.

The reason banks can happily pay out your savings is that they, in turn, borrow money from each other or from their Reserve or Central Banks. This is why repo-rate hikes so quickly become interest rate hikes on your home loan. Everyone is borrowing from everyone else.

As long as the real economy grows fast enough to cover all that credit, everything works fine. However, if too much credit is extended, then it is almost like too much cash has been printed and is now circulating in the economy. The world economy could be as much as 30% smaller than it appears to be and there are several ways to bring this back to a proportional value.

The prices of the things that do exist could rise until they reach the value of the credit; this is inflation and means that your money buys less and less. The amount of money in circulation could be cut by destroying some of it; this would be like checking your savings account and discovering that it had been unilaterally cut by a third. Or we could pretend that there isn’t any immediate problem and hope that it sorts itself out over the long-term. That usually results in excessive taxes being levied on your grandchildren, while the underlying financial mess gets worse. This is fine, as it goes, as long as you didn’t like the little carpet-rats in the first place.

Europeans and Americans don’t like inflation and have chosen to destroy the perceived value in the market by buying it up with taxpayer’s money. The trillions of dollars that has mysteriously vanished from the world’s stock exchanges is exactly like bringing in virtual cash and setting fire to it. It is a short-sharp-shock and should allow their economies to start a slow, and painful, process of recovery within a few months.

The Japanese, who had a similar housing-led collapse in the 1980s, chose to ignore the problem in the hopes that it would go away. Relying on a population of savers allowed their banks to keep their bad loans from having to be written off. The legacy has been 20 years of stagnant economic growth in which real property prices haven’t changed at all.

The worst choice, though, is the inflationary one. As Zimbabwe is experiencing now, uncontrolled inflation extends the pain indefinitely and becomes ever more difficult and expensive to stop.

Not only does it punish savers now, but the cost of fixing it has to be paid for by future taxpayers.