Reading the headlines these days, you’d think Europe (and Greece in particular) was solely responsible for the latest crisis. Unfortunately our financial problems are structural, more wide-spread than the headlines are suggesting. The source of our difficulties, the real villain was (and remains) a deep-seated confusion in monetary policy about the definition of inflation.
Federal Reserve chairmen, like old military generals tend to ignore changing realities; preferring to fight the latest war with the tactics and tools that made them successful in the past. The last time the US experienced a significant inflationary period was during the 1970’s when CPI (consumer price index) rose at an annualized rate of roughly 8%. Gaining control of inflation during the period meant “tough love”, hard monetary medicine was imposed by the Federal Reserve in the United States. Interest rates were driven up to unprecedented levels to fight persistent inflation – causing great pain for business and homeowners.
The major lessons of that inflationary period are generally considered to be the following. One, union power and COLA’s (cost of living adjustments) played a major role in driving up prices. Two, 70’s inflation itself was less a monetary phenomenon that a cost-push phenomenon driven by wage growth that was believed to exceed productivity growth. Whatever the truth of those lessons, they are now ‘givens’, realities governing Reserve Bank behavior in the US and around the world. As a result of this belief system the definition of inflation migrated from its historical meaning, a debasement (devaluation) of the currency stimulating a general rise in prices (i.e. a greater supply of money chasing a fixed number of goods); to any general rise in prices (defined by the CPI) full stop.
Our present dilemma is a direct result of those decisions made long ago. Over the past 30 years while cost inflation linked to the CPI (consumer price index) has remained fairly stable, rising only with a bounded regime, the broad money supply (monetary inflation) has exploded, driven not only by loose monetary policy but by financial institutions and the near banks of the ‘so called’ shadow banking system. The results have been dramatic, consider that in the late 1970’s, the total amount of credit available in most western economies was approximately equal to GDP: just prior to the 07 ‘Crash’ that number had risen to about 350% of GDP.
In other words, with the Fed and other monetary authorities looking the other way inflation ran wild. The global economy was literally swimming in easy credit and it was soaked up eagerly at all levels, sovereign, commercial and personal. Since 2008 the global financial system has stabilized thanks to quantitative easing (near zero interest rates) and massive government simulative spending (almost all of it in excess of revenues) which has sent sovereign debt into the stratosphere. Although we have bought ourselves some time, these emergency measures have only added to the problem: the world has essentially responded to a huge ‘debt drinking binge and hangover’ with a couple of cool ones in the morning.
We’ve basically used a bandage to cover our wounds, but are still left with the underlying disease. The reality is, we’re carrying too much debt at all levels. Greece is everyone’s favorite wiping boy, but its only the tip of the iceberg. In fact we’ve woken to the real risks at play, and our risk tolerances have (essentially) fallen off a cliff. The unhappy consequence, the debt carrying capacity of the system is diminishing rapidly with predictable outcomes for debtors – who are faced with three rather unhappy outcomes, default, restructure or get real creative and institute debt for equity swaps. Not happy outcomes for the global financial system.
This problem is much bigger than Greece or Europe – in fact it’s everywhere you look. Resolving this dilemma will not be easy or without pain.
Things to Think About:
- The one lesson that history teaches us over and over again, is that debt is (almost) never repaid. It’s rolled over, it’s replaced by longer term debt or inflated to a smaller manageable level. What does not happen is a country, corporation or individual sacrificing their present and future for the past. Doesn’t happen.
- The Crisis of 07 was only a warm-up the big one is coming and soon. Its belts and braces time for corporations and individuals.