posted March 31, 2010
Epic Recession: Prelude to Global Depression, Part 1 (The Theory)

Jack Rasmus, copyright, January 2010

In the depths of the economic crisis, in early 2009, ten leading economists attending the annual American Economics Association conference in San Francisco were interviewed by the Jim Lehrer PBS Newshour TV show. PBS reporter Paul Solman asked each in turn the simple, straightforward question how the severest economic crisis since the depression of the 1930s had happened. Solman then put the question to each of the ten economists: “why didn’t you, the economics profession, warn us?? Their respective replies to the question reveal why nearly all the approximately 10,000 economists in the U.S. ‘got it wrong’, and why they continued to misread the fundamental character of the current crisis over the past year and still fail to understand its current evolution.

Why 10,000 Economists Got It Wrong

One set of replies was provided by economists Alan Blinder of Princeton University, Caroline Hoxby of Stanford, and Zvi Body of Boston University. According to Blinder, the “number of things that have gone wrong and the ferocity with which they have gone wrong, I think, was beyond the imagination of almost everyone?. For Hoxby, the crisis was too complex. It was too difficult to understand how all the elements of the crisis were interacting and “how all the dominoes are going to hit one another?. For Body, it was simply that we can’t foresee deep crises coming. Substituting a tautology for an explanation, Body replied that “Disasters can happen at any time. In fact, what makes them disasters is we’re not expecting them. If we were expecting them, they wouldn’t turn into disasters?.

The conclusion, at least from this initial list of those interviewed, is that because the crisis was too complex or to severe it was simply beyond the comprehension of most of the 10,000 or so economists in the U.S. Which suggests perhaps that most of them perhaps are capable only of grasping simpler, more moderate, and less complicated economic events—but not major crises such as emerged circa 2007.

But not all those interviewed by PBS’s Solman honestly admitted their inability to comprehend, and therefore forewarn us, of the crisis. Some were willing to venture an explanation to Solman’s fundamental queries. Frank Levy of MIT, for example, replied the economic profession’s general failure to explain and forewarn was due to a lack of information. The banks simply withheld the necessary information, thus preventing the profession from predicting and warning of the imminent explosion. According to Levy, if the banks only hadn’t hidden their risky loans the Federal Reserve would have stepped in and done something about it. At that point we would all have known about it. Economists were thus capable of comprehending the crisis. The crisis got out of hand because information about it was kept hidden. The problem with this view, however, is that the Fed did know. So did many government regulators, at the state level in particular. Many of the latter had been warning about banks’ setting up a virtual second set of books in which they dumped their riskiest speculative investments, derivatives in particular. Fed chairman at the time, Alan Greenspan, also knew full well what was going on at the time, as did Greenspan’s successor, Ben Bernanke. The data was there. The Fed, the regulators, and economists either looked in the wrong place, didn’t bother to look at all, or when looking and finding chose to turn away and ignore the facts—often at the Bush administration’s direct request. So much for Levy’s ‘lack of information’ defense for failing to forewarn or predict the coming crisis.

Yet a third group responding to reporter Solman’s challenge attribute the crisis to one of several single causes or, worse, attempt to explain it away by resort to a variety of metaphors.

Favorite among the ‘single causal’ explanations is that ‘the banks did it’. Banks and the financial system are certainly an important element of the crisis but they cannot fundamentally explain it. The ‘banks did it’ argument comes in various forms, most of which inevitably reduce to the explanation that it was simply greedy CEOs and managers pursuing super-bonuses that was the primary cause of the crisis. In other words, it was the behavior of certain individuals, a perspective that conveniently removes all discussion of institutions and any endogenous forces intrinsic to the economic system itself as responsible for the crisis. A popular variant of this line of explanation—i.e. that certain individuals were the cause—was provided by Stanford’s Kenneth Arrow, one of the deans of the economics profession, who replied that he and his fellow economists erroneously assumed the banks would act rationally and correct their growing abuses and problem. “We took it for granted these people protect themselves. We were wrong.?

Individualist explanations of the crisis also take the form of blaming ‘all of us’, collectively, for the crisis. In other words, the victims of the crisis—consumers, unemployed, homeowners facing foreclosures, small businesses facing default—are themselves are as much at cause as perpetrators of the crisis as bankers, government regulators, speculators, corporate CEOs and the like. We were all collectively “overconfident?, according to Yale economist, Robert Shiller; all too “trusting? and not careful enough, according to Nobel laureate, George Akerlof, of the University of California.

Explaining the crisis by means of metaphor was offered by economists Andrew Lo of MIT and Laura Tyson of the University of California, Berkeley. According to Lo, the crisis resulted from people falling into a kind of “drug induced stupor? when engaged in investing and making money. Recent neuroscience discoveries reveal, according to Lo, “financial gain triggers the exact same reward circuitry in the bran that cocaine does?. It can even produce a financial hallucinogenic experience, where you don’t worry about or “even see the risks?, thereby leading to a “situation where you walk off a 30 story building because you think you can fly?. Presumably this approach to analysis means Lehman Brothers’ Investment Bank CEO, Dick Fuld, somehow got addicted to subprimes while Bear Stearns’ CEO, Jimmy Caynes, became a derivatives junkie, and Charles Prince of Citigroup hallucinated on credit default swaps and stepped out of a thirty story window. Presumably first time homeowners with a subprime loan became ‘spaced out’ on all the free money. But how is their behavior different from banks today getting loans from the Federal Reserve at even less than zero interest rates? Isn’t that free money? Why is it drug-like economic behavior for homeowners to take out a nothing down subprime loan, and not addictive for bankers today to be paid interest by the Fed to take a no cost loan? How is the former a ‘problem of addiction’ and thus a cause of the crisis, while the latter purports to be a rational solution to the crisis? The behavior is essentially the same. Explanation by metaphor quickly reduces to absurdities. Moreover, the drugged behavior metaphor fails to explain how either homeowners or bankers got the drugs in the first place. Or how they became addicted. In short, economic analysis by metaphor only goes far, and not very at that.

Another, even less convincing metaphor explanation was offered by economist Laura Tyson, one time Clinton administration economic adviser, in reply to Solman’s challenge. To Tyson, the cause of the crisis is simply a case of ‘human hubris’. The crisis was just “a kind of Greek tragedy?, explainable by deep human failings. Like all Greek tragedies, the main character simply cannot help himself. And in Tyson’s case the tragic protagonist is us. It is, according to Tyson, “all about us as people?. But if the crisis is just a Greek tragedy, then like all Greek tragedies it was also inevitable, rooted in our intrinsic human nature. Here, once again, the cause of the crisis lies with the individual—not the institutions or nature of the economic system itself. We are all inherently, perhaps even genetically, prone to the tragedy of economic crisis. And if nothing can really be done to prevent such tragic crises, there’s consequently no need to bother to predict or warn of them. If it’s all just a Greek Tragedy, we are simply subject to the economic ‘Fates’ that cannot be changed, which is ultimately where Tyson’s metaphor dead ends.

Single cause explanations of the crisis may also take the form of single nations as the cause. In this case, ‘all of us’ becomes all of ‘them’. Thus Yale economist, Robert Shiller, replied to Solman that population growth in China and India created the false impression that prices would continued to rise, feeding the boom phase that resulted in the financial bust. Other contemporary versions of ‘they did it’ include the view that the offshore ‘global savings glut’ was responsible for the excessive investment in U.S. housing markets. Still others are that China’s continuing refusal to revalue its currency is causing imbalances in the global economy that in turn is causing more financial instability. New York Times liberal economist, Paul Krugman, has recently emerged as a major proponent of this view that it is ‘them not us’ who are the ultimate culprits.

To sum up, the stars of mainstream economics leave us with a series of individualist or single cause explanations. The crisis occurred because people were too trusting, too overconfident, ‘stoned’ on the prospect of money making, ‘tripping’ on the possibility of super profit realization, or were simply expressing their inherently flawed human nature. Overlaid with the individualist perspective is a series of single cause explanations of the crisis—i.e. it was the bankers, ‘all of us’, the Chinese, or ‘all of them’ that were responsible, either directly or by creating the global imbalances that ultimately caused the crisis. There’s nothing endogenous to the economic system itself, nothing inherent or intrinsic to its fundamental processes or institutions that cause the recent crisis, or others similar to it in the past.

Limits of Descriptive-Narration

In the past two and a half years there have been thousands of articles and hundreds of books written describing immediate events related to one or more aspects of the financial crisis and the near collapse of the real economy in the U.S. and globally it provoked. Scores of books have been written on the subprime mortgage problem; on specific bank defaults, like Bear Stearns, Lehman Brothers, and others; on the CEOs of the big banks; on the nature and danger of financial derivatives; the failure or success of Federal Reserve policies; or the failure of markets and theories of markets behavior. But all such essentially econo-journalistic accounts are essentially descriptive narratives of the present crisis or else the very recent past. Few have bothered to explain the crisis from a deeper historical perspective. Indeed, few bother with any historical analysis whatsoever. And fewer still attempt to provide any theoretical framework for understanding the origin and evolution of the crisis—without which any prediction of the future course and direction of the crisis is not possible.

Without bothering to define their terms, the crisis has been alternately called the ‘great recession’ or a ‘near’ or ‘mini’ depression, as if it is sufficient simply to identify the crisis as something worse than a typical post-1945 recession but not yet equivalent to the depression of the 1930s. How it has been ‘worse than’ a typical postwar recession, but not yet ‘as bad as’ a depression is left unexplained. Why it has been worse than a typical recession, and why not yet a depression, is never asked. Where it may be going is never even considered. Descriptive and narrative accounts of the crisis, while necessary and useful to a point, after two and a half years are no longer sufficient. It is not enough just to describe what has been happening. It is necessary to understand fundamentally how and why it has been happening and where it is all going.

Lack of Programmatic Discussion

A third defining characteristic of contemporary analyses of the current crisis is the general lack of discussion about programmatic solutions. This is a limitation shared by both a good part of the economics profession as well as the journalist school of crisis narration. Fundamental crises require fundamental solutions. And neither the economics profession nor journalists associated with major media are inclined to tread there, lest they appear too ‘radical’ in either their analyses or their proposals. But the lack of program discussion is a limitation also shared by progressive or liberal writers and commentators—the reasons for which are not totally clear. Perhaps they have become too immersed in the American tradition of muckracking, where radical analysis is limited to describing current conditions but not extended to theory or programmatic recommendation. In any event, after two and a half years of what nearly all admit is most severe economic contraction since the 1930s, it is remarkable that so little is still debated or written on proposals for resolving the crisis.

What follows in the remainder of this article, therefore, is an excerpt of a preliminary theoretical framework for explaining the current crisis. A subsequent article, Part 2, will address historical examples in the U.S. that represent similar crises in U.S. economic history—crises that have been neither normal recessions nor yet classic depressions. A third article in the series, Part 3, will then provide a detailed set of proposals and program necessary for confronting the current crisis.

A Preliminary Theoretical Framework

One of the great failures of contemporary efforts to explain the current crisis is the inability to distinguish between causes that are fundamental versus those that are contributing or just precipitating—as well as the dynamic interactions in turn between the three. Fundamental causes are those without which an Epic Recession could not occur. Enabling are causes that accelerate the evolution and development of the crisis event, as well as exacerbate the rate of spread and depth of it. Contributing are personal and policy factors that influence the outcome without determining its inevitable course or pace of development.

Fundamental causes include the forces behind the massive accumulation of excess global liquidity in recent decades, as well as the network of speculator-investors, shadow banks and institutions, and the new speculative instruments and markets they have spawned. The new institutional network serves in turn as the conduit for a ‘speculative investment shift’ that has been expanding in relative weight and influence compared to non-speculative forms of investing in recent decades. Together these investors, institutions, and the new financial instruments and markets constitute what is called the ‘global money parade’—which controls a flow of about $20 trillion at minimum worldwide that now sloshes around from one speculative investment opportunity to another, from currencies, land, real estate, to global stock markets, stock and emerging market funds, commodities futures of various kinds, and the ever-proliferating list of derivatives and other forms of financial asset securities.

Capable of generating far more profit in a much shorter period of time, the shift to speculative investing not only diverts increasing amounts of capital to financial asset creation, but does so as well at the expense of potential real, non-financial asset creation that produces jobs and income for the general workforce and the economy at large. Capital thus flows into an ever narrowing funnel, benefiting a smaller proportion of the populace at a growing rate, at the expense of a growing proportion of the remainder of the economy. The consequence is not only increasing income inequality but a secular decline in consumption and real investment while financial instability grows proportionately as well.

The explosion in global liquidity available to the global money parade has various sources. One obvious source is central bank (i.e. Federal Reserve) policy. However, today’s revolution in credit and new forms of credit creation is at least as great a source—a source that lies increasingly beyond the control of central banks. Shadow banks and other speculative investing institutions arise and multiply in order to exploit the exploding liquidity made possible by unrestricted credit creation. New financial instruments and markets are created by the growing number of financial institutions dedicated increasingly toward speculative forms of investing. As other sources have noted, in 2007 these institutions’ total assets available for investment in the U.S. at $10.5 trillion exceeded assets available to the traditional, commercial banking system at around $10 trillion. Much of the former is increasingly committed to speculative forms of investing, and a significant part of the latter as well. And that’s only U.S. totals, or about 40% of the global total. The total globally is thus conservatively around $20 trillion.

The global money parade of speculators, institutions, their products, new markets, and the speculative investment shift they create, are all fundamental causes of epic crises. They produce increasingly frequent and severe cycles of financial instability, booms and busts. They lead to excessive financial debt accumulation and asset price inflation during the run-up to crises, and in turn drive extraordinary debt unwinding and asset price deflation in the downturn.

Debt accumulation and financial asset inflation in the boom phase also creates a condition of ‘financial fragility’, which grows in the boom phase and then collapses in the bust phase. Financial fragility occurs when institutions’ debt rises as their available cash and liquid assets on hand to make rising debt payments declines. Banks, shadow banks, and other financial institutions become ‘fragile’ in the sense that debt loads and debt repayments cannot be covered, or serviced, during the contraction phase. In severe cases, the unwinding of excess debt leads to financial asset collapse which, in turn, leads to financial defaults—i.e. bank suspensions, bank failures and reorganizations, mass withdrawals from and closure of hedge funds, and the like. Asset collapse and defaults by banks and other shadow bank financial institutions leads to a severe contraction of loans and bank credit to non-bank companies which then become financially fragile and begin to default as well. The prospect of imminent default leads companies to sell remaining assets at firesale prices and/or to take on additional debt to service existing debt. Thus, default in turn exacerbates deflation and debt in turn. A process of interacting debt-deflation-default begins to occur, not only in the case of financial institutions but eventually nonbank businesses as well. Absent in normal recessions, there is consequently a dynamic in Epic Recessions that involves feedback effects between debt, deflation, and defaults. A vicious, downward spiral occurs in which all three feed upon and exacerbate each other.

The unwinding of debt following an initial financial crisis starts the process. Deflation follows, first with prices of financial assets, then spills over to product price deflation and wage deflation (i.e. layoffs, wage cutting, benefit cutting, hours cutting, etc.). Defaults thereafter spill out from banks and financial institutions to nonbank companies and to consumer households and workers. The defaults exacerbate the deflation, and the deflation in turn exacerbates debt repayment further in a series of multiple feedback effects.

This process of debt-deflation-default is thus also a fundamental causal factor of epic contractions, set in motion in the bust phase by the unwinding of the excesses and instability created in the boom phase by the growing shift toward speculative investing. The speculative investment shift is thus the linkage between the global money parade on the one hand, and the processes of debt-deflation-default on the other. But the process of debt-deflation-default serves as a linkage as well—i.e. between the global money parade and the speculative investment shift, on the one hand, and conditions of financial fragility and consumption fragility on the other.

Similar to financial fragility, consumption fragility involves households, consumers and workers, whereas financial fragility involves banks and businesses. The two forms of fragility are similar, however, in that they can be expressed as ratios of debt load, debt payment levels, in relationship to available liquid assets that might be used to pay debt. For banks and businesses, it is a ratio of debt servicing (i.e. debt repayment) to available cash flow. For households-workers, it is expressed as a ratio of debt servicing to available real disposable income. For either banks-businesses or households-workers, if debt servicing requirements rise, fragility grows. If disposal income-cash flow falls, fragility also grows. If the former rises and the latter falls, then fragility—whether financial or consumption—grows even more severe. Epic recessions are characterized by high levels of both financial and consumption fragility. That is why, when a crisis erupts, the financial system collapses deeper, faster and more widely when financial fragility has become severe. And why, when consumption fragility is high, consumption collapses more deeply when the real economy eventually contracts sharply following a financial crisis.

Thus, both financial fragility and consumption fragility are also fundamental forces driving epic recession, just as the process of debt-deflation-default are fundamental, and the global money parade and speculative investing shift are fundamental.

It is the dynamic interplay and causal interdependencies between these various fundamental forces that differentiates epic contractions of the economy from normal recessions. None of these forces are significant or play a defining role in normal recessions. When debt-deflation-defaults are allowed to continue to deepen, and their feedback effects allowed to worsen, both financial and consumption fragility are in turn deteriorate further. It is possible to have more than one ‘fracturing’ of financial and/or consumption fragility. For example, it is possible to have a banking crisis followed by a second and third banking crisis. That represents multiple ‘fracturing’ of financial fragility. Similarly consumption fragility may experience several ‘fracturing’ events over an extended economic downturn. Put another way, a possible downward spiral of debt-deflation-default can lead to a continuing deterioration of financial-consumption fragility. Deteriorating fragility can exacerbate debt-deflation-default, just as debt-deflation-default can lead to a further deterioration in fragility.

When the downward spiral of debt-deflation-default accelerates, and multiple fracturing of forms of fragility occurs, an Epic Recession transitions to a bona fide classic depression. When this happens, it is called a ‘Type II’ epic recession, in contrast to a ‘Type I’ epic recession. In ‘Type II’ the dynamic processes are not checked and contained, and lead to depression. In ‘Type I’ the spiral of debt-deflation-default levels off and multiple fracturing of fragility does not occur. The outcome is an extended period of economic stagnation—neither further decline nor sustained long run recovery of the economy either. As will be described in Part 2 of this article, Type I occurred following the financial panic of 1907 and led to a prolonged period of relative economic stagnation. Type II occurred in 1929-1931, and led to the great depression of the 1930s.

To summarize to this point then, the key fundamental forces that differentiate an epic recession, such as has occurred since 2007, include the explosion of global liquidity and credit, the global money parade, and the speculative investment shift which together create unprecedented financial and consumption fragility. When the upward cycle busts, leading inevitably to a financial crisis and eruption, it sets in motion a dynamic process of debt unwinding-financial asset deflation-financial institution defaults. The process spills over to product and wage deflation, and in turn defaults of nonbank businesses and households. Defaults in turn exacerbate both deflation and debt, and a downward spiral ensues that causes a further deterioration of financial and consumption fragility, resulting in subsequent series of financial crises and consumption collapse. The following graphic illustrates in rudimentary form the various relationships between the fundamental forces and causes of Epic Recession.

Fundamental Forces & Relationships of Epic Recession

Global Liquidity Explosion

Global Money Parade

Speculative Investing Shift

Debt Deflation Default

Financial Institutions Asset Price Banks & Finance
Non-Financial Business Product Prices Non-Bank Business
Consumer-Household Labor Wages Consumer-Household

Financial Fragility Consumption Fragility

Declining Real Economic Indicators

Real Asset Investment
Household Consumption
Global Trade & Exports
Industrial Production

The fundamental forces depicted above determine the pace, rate of spread, depth and trajectory of the economic crisis, both in its financial and real economic aspects. They are quite different from what might be called ‘enabling’ causes of epic recession, which are often mistaken for fundamental causes. Typical among enabling causes, for example, is financial deregulation. It is often argued that financial deregulation since the late 1970s, and in particular the repeal of the Glass-Stegall Act in 1999, is the primary cause of the financial crisis that erupted in 2007. But whereas deregulation may have enabled the crisis, it did not fundamentally cause it. Speculative investing and the global money parade typically finds a way around regulatory constraints. The lifting of those restraints may enable an even greater relative shift toward speculative forms of investing. But they would occur in any event.

A similar argument is sometimes made that too liberal Federal Reserve monetary policies since the 1980s led to excessively low interests rates of 1% in 2003 that provoked the subprime and housing bust of 2007 that set off the current crisis. But that is inaccurate. The speculative shift and housing bubble began well before the Fed’s 1% rates, as early as 1998 in fact. Other enabling causes include technologies that have made possible the globalization of finance capital in recent decades. Enabling causes influence the magnitude and rate of spread of financial instability and epic recession, but do not fundamentally set either in motion.

Contributing causes can also play a role in the general evolution of an epic recession. These include the influences of personalities and the decisions they make, or don’t make. What Fed Chairman Greenspan did or didn’t do, what Treasury Secretary Henry Paulson did poorly or negligently, the strategic errors of Fed Chairman, Ben Bernanke, the 2009 bank bailout proposals of Treasury Secretary Geithner that left bank bad assets essentially unaffected and did little to bail out residential mortgage markets, all have some influence. But their actions would not have even taken place were it not for the fundamental forces that distinguish and differentiate Epic Recessions and severe economic contractions from normal recessions.

The foregoing is admittedly an all too brief explanation of the fundamental, enabling, and contributing causes of extraordinary economic contractions called Epic Recessions, which include the current crisis. Hopefully it will stimulate further discussion and debate on a new theoretical framework for understanding the unique form of economic crisis in which the U.S. and global economy now finds itself. In Part 2 of this series, a brief consideration of the Epic Recessions of 1907-1913 and 1929-1931 will be undertaken as evidence of the preliminary theoretical framework proposed above.

Jack Rasmus

Jack’s forthcoming book, Epic Recession: Prelude to Global Depression, will be available from Pluto Press in the U.K. and from Palgrave-Macmillan in the U.S. this coming April. It can be preordered now on Amazon. His website is:

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