The cause of the crisis

Amidst all the confusion, finger-pointing and bad news, we forget to realize that this recession has a reason - a fairly deep and simple one, at that; a contradiction, a false assumption that led the world into this. In the acuteness of a suffering state, the true reason is harder to see, because unexpected suffering begets indignation, indignation begets anger, and anger requires an external cause to be angry at. But the true deep reasons for this crisis are not negative aspects of human nature such as greed, or misaligned incentives of financial managers, or the policy of Federal Reserve, although for sure all of these played a part.

The true deep reason is a benign, yet shortsighted and naive, desire that most people would consider justified. It is the desire for a secure and prosperous retirement.

What fails to be emphasized is how both the tech stock bubble and the housing bubble could not have happened if it was not for an overwhelming deluge of funds, a deluge which exceeded the supply of worthwhile assets to invest in. These funds came from all over the world and were, all things considered, money belonging to savers everywhere. It was money belonging to people who would not consume today the results of their work, but wanted to postpone their consumption until tomorrow, or the day after tomorrow. In the case of the tech stock bubble, it was money that people hoped would be multiplied. In the case of the housing bubble, it was money that people hoped would be invested safely until it's needed.

The lesson to be learned from this crisis is that the safe and lucrative investments that savers everywhere are looking for, do not exist in numbers large enough to cater to all.

When a large population is being persuaded that they should invest someplace and get a long-term return larger than GDP growth, it is a hoax. It is physically impossible for an entire population of savers to enjoy future returns that are better than GDP growth.

As a saver, one is staking out a piece of the future economy, and wants to get as large a slice as possible. It is not possible to get a slice larger than the entire economy. But the entire population, as a whole, owns the economy. It is not possible for the entire population today to own more than the entire economy of the future. Hence, everyone's investments, on average, cannot grow faster than the economy.

This crisis has a reason, and the reason is... everyone was trying to find a place to invest their money and get safe, above-average returns. It turned out that such places are illusions. Yes, production capacities still exists; yes, factories still stand; yes, we have the means to create everything we were creating before this. But what we were creating was consuming the money of people who thought they were saving, but were in fact giving it away.

If no government had intervened, this lesson would have reached the ultimate causers of this crisis: the hundreds of millions of bank depositors who think that saving is as simple as stashing your income at the bank, and seeing interest roll in. As it is, governments did step in; as a society, we apparently want depositors to be able to maintain this illusion.

This is bad. If people understood that it is their propensity to save that caused this crisis - that the problem is the world's inability to accomodate that many savers and give returns - they would not react to this crisis by saving more. Instead, they would spend. And spending today, not tomorrow, is exactly what is needed to make the economy zoom again.

But given that governments are committed to sparing depositors, the state of the economy makes people save more, so more of their money stays in banks. This money could again be spent, to get the economy going, if only the banks would lend. But the banks have been burned, so they lend less than they used to, and the money just sits there. This will make the economy grind quite a bit slower for a while, until banks become confident enough to lend again.

Comments

Anonymous said…
Please excuse the probable idiocy of my question but why would people not save money for their retirement or for when they are too old to work ? They are going to need it, don't they ?
Anonymous said…
The problem is not in saving actually, but in lowered production or "wrong production". World produces goods that are not stimulating economic wealth of people, which would cause they could earn more and spend more as the consequence. In this crisis the whole world should be understood as a comunnity that suddenly doesn't produces enough for their desired life. The whole economy only redistributes the wealth in some specific way.
Anonymous said…
> World produces goods that are not stimulating economic wealth of people, which would cause they could earn more and spend more as the consequence.

Are you refering to economic goods like bonds, stocks etc ? Or goods that makes life easier or cheaper (a better car engine or a better sewer system or a better medecine) ?
But even if such "production of appropriate/adequate goods" was happening, it wouldn't prevent people to save money for when the time the can't work anymore comes, right ?

I have a hard time figuring out what kind of goods should be produced in a more stable society (stable and peaceful of course).
denis bider said…
The first anonymous: "Please excuse the probable idiocy of my question but why would people not save money for their retirement or for when they are too old to work ? They are going to need it, don't they ?"

What people are saving is not money.

Literally saving money would be stuffing $100 bills under a mattress. On an individual scale, that performs poorly because of inflation.

On a global scale, if everyone would just hoard cash, it would also be disastrous if some event then triggered everyone to unleash their savings simultaneously. It would drive up prices when everyone attempts to cash in on their savings.

The way saving is done, therefore, is not by saving money. Instead, people stake out a portion of the economy, either directly through the stock market, or indirectly by depositing their money in banks, which invest into business themselves. In so doing, people gain a direct or indirect stake in a small piece of society's productive assets. This stake can later be cashed in for whatever it is worth at the time.

The problem is that there are only so many productive assets, and if people try to save too much, they will cause the prices of these assets to go up, potentially much higher than is warranted by the actual productivity potential of these assets.

In turn, the fundamental value of productive assets actually depends on how many people there are who want to consume what these assets produce. What good is a factory of sausages or BMWs, if no one wants to buy sausages or BMWs?

There is, therefore, an optimal ratio of savings to consumption. If there is too much savings, we live miserable lives while our investments in productive assets also become worthless, since no one will consume the products that those assets make. Meanwhile, too much consumption would mean there would be nothing left to maintain and improve production.

The consumption : savings ratio that matters for the stability of the global economy is not a national but a worldwide average. It does not matter if Americans spend like crazy, when the Chinese more than compensate by saving.


Second anonymous: "The whole economy only redistributes the wealth in some specific way."

This appears to imply that there is a fixed volume of wealth to begin with, which only needs to be "fairly distributed". This is not so. The economy not merely distributes wealth, but creates it, and feeds on itself so it can create yet more. Investment and consumption are both important parts of this mechanism - investment increases production capacity, whereas consumption validates investment and gives value to existing production assets.


Second and third anonymous: By now, I am having trouble making out who is who, and so interpreting your arguments. Please use pseudonyms at least, and state who wrote what, for the benefit of the discussion.
FirstAnon said…
denis bider: In turn, the fundamental value of productive assets actually depends on how many people there are who want to consume what these assets produce. What good is a factory of sausages or BMWs, if no one wants to buy sausages or BMWs?

This is exactly my point. But when considering world crisis, the scope should be turned towards the actual producers and not assets on them self. Assets don't produce anything. They are only setting the conditions in which the true wealth can be produced. Human race is far from the situation, where it could build an industry, which would sense the demands of people and acomodate with no decisive acts, no work and no effort of the human beings.
This is also the point of the second statement. (about economy only redistributing wealth..) All the wealth is at the end actually produced by human (decisions, manual work, services, etc.). Economy only acts as a very efficient tool.
Therefore only the increase of spending doesn't solve the crisis. Stimulating spending has short positive effect, but bad buissnes, bad companies, lazy people, wrong decisions, etc. are still widelly spread. The problematic factor is the human demands vs. human production, (considering the current state of technical capabilities). When this factor is to large, a crisis is about to come. This is exactly what happened in 2001 in USA, where there should be a recesion to destroy bad companies and stimuate good ones, but they forced spending (by cheap credits and advertisement) and consecutively postponed (and deepened) the crisis, which came 6 years later.

The only way to solve this is to increase the cumulative amount of human production. This requires stimulation of the entire world population to work.
The other sad and "God-forbid" options are increased exploitation of weak nations, or at the end a war, which allways solves all crises in the brute "natural" - evolutional way.
boris_kolar said…
FirstAnon: The only way to solve this is to increase the cumulative amount of human production.

Yes, increasing human production is the best and pretty much the only way out of this crisis. Increased production also implies more innovation, new products and services, including institutions that would replace banks (which would provide earnings equal to GDP growth, even when GDP is negative).

One thing is becoming clear now: money will no longer be cheap (as it shouldn't be) and money will no longer "make money" (at least not more than GDP). This is a good thing. It will force enterprises to find a solid business advantage before loans could be given. Eventually, as economy will near its optimal state, GDP growth will no longer be always positive, which will automatically increase spending and decrease savings.

I don't see current situation as crisis. It's merely a step towards what economy should have been. There is no need to restore trust in financial institution and no government intervention can make it so. Financial institutions must find a way to earn trust through transparency, solid business models, and true competitive advantages. The government should only focus to improve and enforce laws.
boris_kolar said…
Hopefully mainstream media will soon fail as well. This will radically change advertisement business: now most information we get about products and services come from businesses providing that products and services - such information is obviously biased. A much more useful information can be found on collaborative media such as Wikipedia. It still amazes me how great Wikipedia turned out to be: it seem destructive behavior more often than not cancels each other, while constructive contribution accumulates. Small media, such as this blog, already provides excellent articles and discussion about various interesting subjects. It's already better than some mainstream media like This misleading title from Slovenian newspaper Finance. I believe that with similar collaborative principles Wikipedia uses, we can create trustworthy institutions. Why can't I write on Citibank site they are full of shit?
denis bider said…
FirstAnon: The only way to solve this is to increase the cumulative amount of human production.

Boris: Yes, increasing human production is the best and pretty much the only way out of this crisis.

Apparently I am choosing my words incorrectly, because despite my above article and my lengthy comment afterwards, my point is not getting across.

What the two of you are proposing is, quite frankly, rather preposterous. The whole reason we have a crisis is because our production exceeds our consumption. Because everyone is reacting to the crisis by saving, there's a surplus of production capacity, so not only does the value of existing production assets fall, but further investment is discouraged. Now you want to solve this by further increasing the surplus of production?

Boris: Wikipedia is biased in favor of everything that hobbyist, volunteerist, and non-commercial. Our SSH products for Windows, for example, far exceed the quality of the open source competition, yet guess which products are being promoted by Wikipedia zealots. Wikipedia works, but it works only insofar as you're interested in things, opinions and perspectives that are divorced from business and money.
FirstAnon said…
boris_kolar: Increased production also implies more innovation, new products and services, including institutions that would replace banks (which would provide earnings equal to GDP growth, even when GDP is negative).

The system we have is no doubt the most succesfull system known until now on the world scale, so it is rather rash to expect such radical changes.
It would be enough to globally understand the meaning of recession as the basic principle of "cleaning" bad businesses and bad past decisions.

denis bider: Because everyone is reacting to the crisis by saving, there's a surplus of production capacity, so not only does the value of existing production assets fall, but further investment is discouraged.

The reason for saving is always tied with a purpose to save for. Saving now is buying something in the future. Now, as long as this future product is a consumable, something someone had produced, there is no major problem. The value poeple save is reinvested (through banks, stocks etc.) into the industry that accomodates to produce this long-term consumables, for which people are saving. This accommodation is the needed consequence of recession. When this is happening, short-term prices shock, lowering living standards and redistribution of wealth is being observed. But the major problem appears, when this future product people save for is not a consumable, but is more like "the right not to work". If some significant progress of technology isn't on sight, there is no industry on the earth that could produce this on the global scale. All people simply can't buy this right. People ought and will still ought to work.
verbatim said…
One thing is becoming clear now: money will no longer be cheap (as it shouldn't be) and money will no longer "make money" (at least not more than GDP).

I don't believe in this. This may be the case in short run, but in long run nothing will fundamentally change. You should also take into account bad signals sent by governments with all those bail-out plans, "too big to fail" policies etc.
denis bider said…
FirstAnon: But the major problem appears, when this future product people save for is not a consumable, but is more like "the right not to work". If some significant progress of technology isn't on sight, there is no industry on the earth that could produce this on the global scale.

That much is true. Regardless of how much money or stock we saved up, we cannot just simultaneously decide to sit on our behinds, leaving nobody to work the actual production assets.

The observation I was trying to make about the current crisis, though, is the following:

(1) A global inclination to save (not as much by Americans, but by Asians, Arabs flush with oil money, etc) has resulted in a competition for "safe" investments, resulting in dear price/earnings ratios among favored classes of stocks, and opportunistic inventions of additional "safe" investments for people to load their money into, which turned out to be bunk.

(2) When unrealizable investment expectations finally met reality, the whole investment chain began to unwind. Lacking government intervention, it would have unwound to its very beginning, down to all the depositors who have been overly inclined to leave their money in banks. Lacking government intervention, those depositors would have been unable to withdraw their money, banks would collapse. Some of the depositors would possibly receive back some portion of their deposits, in installments, years down the road.

(3) Since #2, if left unchecked, would have probably collapsed the world's financial system entirely, generated deep upset, and led to no one knows what consequences, governments intervened by saving depositors and banks, at the expense of taxpayers.

(4) Because governments have done #3, depositors have not received the signal that over-saving is injudicious, which would have caused them to spend more in the present, and save less. Instead, depositors continue to save, even more so due to fears of financial insecurity.

(5) Because depositors are now saving even more, there is even less consumption in the present, which threatens viability of various classes of production assets. (E.g. car manufacturers, where even Toyota is posting losses, let alone Detroit, which is going under entirely. Tech companies are cutting jobs, revenue has fallen in all sectors, etc.)

(6) Because of #5, consumers are experiencing yet more hard times and are saving even more, and leaving yet less in circulation to sustain the economy.

By not punishing depositors for excessive saving in step #3, the only remaining options that governments have to rein in saving and encourage present consumption are less powerful ones:

(a) Decrease interest rates. They have done so.

(b) Cause inflation. They are trying to do so, but the effect of printing money is much smaller than the effect of banks not lending and the velocity of money slowing down.

(c) Stimulus in the form of increased government spending. This is a form of (b). It has limited effects, and even those only if stimulus is given to people who would otherwise be without income, so the extra money will go into consumption, not savings. There is no multiplier because as soon as the first recipients pay their money to others, the next person in line will save the extra income rather than consume it.

(d) Stimulus in the form of tax cuts. This would have worked in normal circumstances, but in crisis circumstances it cannot work at all, because people will save the tax savings instead of spending them.

(e) Force banks to lend. This could get a recovery started, but is dangerous. Who knows what business models are worth investing in at this point? If the forced investments fail disproportionately, the cycle is just going to repeat again.

See the issue?

If we knew that the world was not going to collapse, that riots and war would not erupt, if we just let all the banks fail and let all the depositors deal with their losses, then that would be a painful but effective way to deal with the true cause of this crisis: it would discourage the global savings glut that has accumulated over the past several decades, which led to the overwhelming U.S. foreign trade deficits.

But no one can be sure of this, so governments are doing their best with wimpier solutions in an attempt to preserve order.

Hopefully, the wimpier solutions will not be worse in the long run than just letting the banks fail and sticking it to the depositors and investors.
tim said…
I limit my comment to the american economy, where too much saving is not the case. Americans as a whole are largely in debt. I would argue that the problem is saving (assets) was being misallocated to specific sectors in the attempt to gain greater returns. unreasonable returns in fact. the tech bubble was a case of money being thrown at unproven companies instead of proven producers because of the huge (false and temporary) returns. The housing bubble was similar, except this time caused by the u.s. government which strongly persuaded banks to lend, or invest in, homeowners who were high risk. The government wanted to increase the level of homeownership past its natural market level. they accomplished this through lawsuits and legislation attacking so called redlining, to the implied guarantees of freddie mac and fannie mae. Banks were willing and persuaded to lend to these borrowers both to avoid litigation as well as the fact that they were operating on the assumption that they could just sell the crap to fannie and freddie. When that turned out not to be the case and the arms started being adjusted, the dominos started falling.
i'm convinced that the current problem is not excessive saving or investment, but an artificial market caused by the government.
with all these millions of new buyers, not only was housing prices shooting up, but production of all sorts of related goods was greatly increased. copper, lumber, steel, appliances, textiles, electronics etc. etc. which of course drew massive foreign investment.
and then all of a sudden millions of borrowers could no longer pay the expected returns, and voila, crash
tim said…
In other words, although many are guilty, a large part of this current crisis, or at least the start of the crisis, can be traced back to the actions of one very powerful man. and that would be........BARNEY FRANK
denis bider said…
tim: "I limit my comment to the american economy, where too much saving is not the case."

Restricting your comment to just the American economy is like restricting your view of a car to just the left third of its engine. This crisis is global by cause and nature. The U.S. is where it became visible first, but it is not where it was created.

Global savers created the savings glut that led to this crisis. Americans just provided the "safe" destination for everyone to invest in.

The size of foreign demand for U.S. assets is reflected by the U.S. trade deficit, which has been accumulating at an ever faster pace for the past two decades, and has recently approached almost $1 trillion per year. Ignoring this is like investigating a fire while ignoring the fuel.
denis bider said…
Basically, the demand for U.S. assets has been such that it overwhelmed the functioning of a healthy U.S. economy, and stimulated it to develop all sorts of dysfunctional pathologies, much like those developed by a spoiled child. The flood of overseas investment overrode domestic moderating forces. The continuing of this situation over a span of decades made it seem like financial freebies are a sustainable and normal course of things, until finally, all these delusions ran into wall.

You could say that the spoiled child is at fault when their expectations fail to meet reality, but really, it's the fault of those who created the circumstance. People won't resist spoiling.
JohnC said…
@denisbider&firstanon:
To make things clear, I am the first and third anon. I don't know why the other person is acting as "firstanon". I'll be posting as JohnC.
@firstanon:
Why are you acting as "firstanon" ? Clearly you have a better understanding of economy than me (as everyone else in this post)
@denisbider:
Thanks for your answer. It makes things a little bit clearer for me. But I still have a hard time grasping some economy concepts. Could you recommend any "economics basic facts" books ?
denis bider said…
JohnC: I would welcome recommendations for good macroeconomic literature myself. My experience is that books written to be popularly readable tend to oversimplify, or cover only slivers of the subject area; whereas other work can be dry and incomprehensible. I think that a readable, but complete and accurate, book about the macroeconomy would be most valuable. As it is right now, a person just has to spend years reading stuff like The Economist, as well as various books and online sources that touch the topic, in order to build up a clue.

The internet is here to help though. Perhaps we could attempt to write a series of blog articles that would explain things, and get some professionals to review them in case we commit any griveous mistakes. The perspectives of people who are still trying to grasp the concepts would be most welcome here, to illuminate what it is, in fact, that needs to be explained.
boris_kolar said…
Increasing production will decrease prices and increase spending. People will always buy or sell anything when the price is right.
tim said…
for cryin out loud, give me a break denis! I limit my comment on saving to the u.s. because that is my point of contention about saving. The U.S. does not save. As far as the rest of the world as a whole, I assume, but do not know, that it does not engage in the same ridiculous borrowing mode of operation.
I wan't trying to ignore 2/3rds of an engine, just commenting on what i feel was the initial cause of the whole unraveling.

To take your spoiled child analogy to a micro example, lets bring up the Madoff scandal. According to your position, I would be wrong in stating that Bernie Madoff was at fault in the 50 billion dollar fraud. Instead the real blame should be layed at the feet of his investors? Sorry, I don't buy it. Sure, they should have been more diligent, but in this case I'm throwing the vast majority of blame right on the spoiled child's shoulders.

The world then would be like the Madoff investors, while the U.S. would play the part of Madoff. There are some similarities, it is almost a global ponzi scheme. But it all started to unravel when the money (returns on american mortages) slowed coming in, thus causing a domino effect spreading from sector to sector and affecting the entire global market.

I still hold that saving is not the problem, but where that saving was put; ultimately in a "not so safe" America. The spoiled child. I further argue that America was not spoiled in this case by excess demand for its assets, but by government interference in how that excess demand(investment) should be used.
The Tech bubble I would side a little more with your view, but the market corrected (or spanked the spoiled child!) and the world didn't collapse
tim said…
Sorry to get so long, but i wanted to clarify,

"The flood of overseas investment overrode domestic moderating forces"

Not in the American real estate bust in the 80's, or the S&L scandal, nor in the tech boom and bust. The market corrected. (Okay, the govt stepped in on the S&L thing).
The moderating forces did their job then. This time is different because the moderating forces were held back allowing the problem to build to such a great level. You had entire new classes of investments being created based on bad assets. leveraged many times over, creating even more fiat capital spreading everywhere. And the leveraging was so high (and allowed) because it was based on an asset class that is historically fairly safe.
Except this asset class had now been polluted, and wasn't nearly as stable.
tim said…
Here's an article that explains my position better.
its like the 80s except the u.s. government now was actively pushing the sub-primes
http://www.azstarnet.com/sn/fromcomments/279222.php
Wei Dai said…
Denis, you may be interested in this speech, which makes many of the same points you've made on this blog. (I learned, for example, that "lend long/ borrow short" apparently has the technical name of "maturity transformation".) It also includes a number of interesting slides.

But according to that speech, most of the savers were not trying to get a return above GDP growth, but simply doing a bit better than the really low yield of 1.5% on government bonds. I don’t think having a lower expectation on investment returns will reduce the global savings rate.

From personal observation, in China, where much of the growth in savings occurred in recent years, the real rate of return in a bank deposit is negative (the interest rate is lower than inflation) but people save in huge amounts regardless, and that money eventually gets invested in U.S. government bonds and shows up as a trade surplus. I think this is caused by a combination of cultural traditions and lack of social safety net. If this is a main cause of the current crisis, it’s not clear what can be done to address it directly.

I wonder if when it became apparent that China/Japan/Oil exporters were driving the yield on government bonds down to 1.5%, the U.S. should have lowered taxes drastically, and issued more bonds until the yields went back up to 3-4%. Given that Americans want to borrow, and others want to save, why doesn't the government do it for them, at a much lower price than the market imposed in the end?

(Anyone who doesn't want the forced borrowing implied by the tax cut can simply buy government bonds, and use them to pay off anticipated future taxes.)
denis bider said…
tim: Comparing the U.S. to Madoff, and the rest of the world to Ponzi scheme investors, seems somewhat apt. In both cases, the failure to catch the crook allowed the scheme to go further and increased eventual losses. In the case of the U.S., the crook would be not any individual person, but more so a financial system that rewarded (or still rewards) people for strategies that work in the short term, while carrying a risk of big losses. This bonus system definitely needs to be fixed, and now probably there is sufficient pressure to fix it.

With regard to excessive leverage contributing to this, I assume it's understood that excessive leverage is the default free-market behavior, unless the government limits it? So when you're saying that the government helped in creating the problem, and then citing over-leveraged financial firms, you're basically saying that U.S. government should have acted sooner to prevent excessive leverage.

Wei: That tidbit about Chinese saving is a fascinating point. I can see how a lack of a social safety would cause people to save up even when real interest rates are negative. I can understand that from own experience, since a substantial part of why I spent the first 10 years of my adult life working and saving is because I do not trust the social safety net.

It appears though that if everyone does this, it's inefficient, and in fact that we may need a social safety net in order for people to feel secure enough to spend in the present, to provide the consumption part of the "investment+consumption" fuel mix that economic growth requires.

It does not seem quite a libertarian conclusion, but then again, perhaps a social safety net does not necessarily have to be imposed on everyone, or even, perhaps, be government-driven. (?)
Anonymous said…
An interesting idea: use islamic economic model. (in Slovene)
denis bider said…
Ugh. Many statements in that article are a bunch of nonsense.

Islamic banking is hypocrisy for the religiously handicapped. They still charge interest, it wouldn't be a workable business model otherwise. They just avoid calling it interest, and instead use different names.

There is nothing wrong with interest in a voluntary contract between two entities. An outright prohibition of interest is tantamount to prohibitions on condoms, smoking weed, premarital sex. It is the raping of an individual right for the benefit of a crazy, deluded ideal. It is throwing out the baby with the bathwater.

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