The Current Financial Crisis — and After

Mises Daily: Friday, April 09, 2010 by Kevin Dowd

[This talk was first presented at the Paris Freedom Fest, September 13, 2009.]

My main topic this morning is the resolution of the current financial crisis, and what might be done to fix the
financial system and help avert another crisis in the future.
If this sounds like good news, it is indeed. But you should beware of economists bearing good news on a
beautiful Sunday morning: economics isn't known as the dismal science for nothing.
There is also the bad news — and then there is the very bad news.
The bad news is that the authorities badly botched it, at massive cost to us all — except to the bankers, of
course, who are laughing all the way to what is left of our banks. And we are not out of the woods yet, by any
means, and the authorities' responses to the crisis are already sowing the seeds of a new, probably worse
crisis down the road.
That is pretty bad, to be sure, but that's only a preamble to the very bad news. The really bad news is that,
even if we get through our current problems in half-decent shape, there are some disturbing storm clouds on
the horizon, and these are much more ominous than the current crisis itself.
Keynesian Economics
The first thing to appreciate is the power of ideas. And one point that this crisis has conclusively
demonstrated is the enduring hold of Keynesian economics. People now forget that Keynesianism didn't work
well, even in the 1930s; its short-term focus and its failure to deal with the monetary side of the economy led
to inflation and, ultimately, to the miseries of stagflation in the '70s. Keynesianism's failure was then
manifest, and it was rightly repudiated. Fiscal and monetary extravagance were then reined in, inflation was
painfully brought down, and the economy boomed.
And then comes the next big crisis, and Keynesianism is suddenly respectable again —and back with a
vengeance. We are now told that Keynesian solutions are the only solutions. And it's not just Keynesianism,
but Keynesianism on a mass (or should I say, crass?) scale: massive fiscal stimulus, regardless of the cost;
and loose monetary policy, regardless of the inflationary dangers.
This reminds me of an old joke: Keynes was once giving a lecture and noticed that one of his students had
fallen asleep. So Keynes asked him a direct question, which woke him up. The startled student responded:
"I'm sorry, Mr. Keynes, I didn't hear the question. But the answer is that we need more stimulus."
One size fits all, basically.
We have been here before. Writing in 1940, Friedrich Hayek gave perhaps the most perceptive critique of
Keynesian economics ever mounted:
I cannot help regarding the increasing concentration on short-run effects … not only as a serious
and dangerous intellectual error, but as a betrayal of the main duty of the economist and a grave
menace to our civilisation.…
It is alarming to see that after we have once gone through the process of developing a
systematic account of those forces which in the long run determine prices and production, we are
now called upon to scrap it, in order to replace it by the short-sighted philosophy of the business
man raised to the dignity of a science. Are we not told that, "since in the long run we are all
dead," policy should be guided entirely by short-run considerations? I fear that these believers in
the principle of après nous le déluge may get what they have bargained for sooner than they
wish.[1]
Then, as now, a spending orgy is not what we need. What is needed is a considered response that addresses
the structural problems ailing the economy. The key issue, in essence, is that the economy's financial engine
has broken down, and this engine needs to be repaired before the economy can properly recover.
Resolving the Financial Crisis
So how do we fix the financial engine? The answer is that we need to restructure the balance sheets of the
main financial institutions. And, as we all know, these balance sheets are best understood using the medium
of — poetry:
A balance sheet has two sides.
A right-hand side and a left-hand side.
On the right, nothing is left.
And on the left, nothing is right.
Believe it or not, this little poem gives us the key to resolving the financial crisis. So let's have a look at a
balance sheet:

The right-hand side shows the bank's assets, which move up and down in value depending on whether the
bank makes profits or losses. The left-hand side shows the claims on those assets, the liabilities. These
liabilities consist of the bank's deposits and its share capital. This share capital is also a buffer that protects
the value of the deposits and reassures depositors that their money is safe. So, for example, if the bank takes
a loss, the loss is usually borne by the shareholders, but if the buffer is big enough, then the bank can absorb
any reasonable loss and still have enough share capital left to be safe. This situation is illustrated in the next
slide:

The bank makes a small loss, but can absorb it and still be safe.
However, if the bank takes a very big loss, we get the following situation:

The bank's loss is now so high that the value of the bank's assets is not enough to pay off the depositors in
full. In this case, the shareholders are wiped out completely, and depositors take a loss too. The bank is now
insolvent — it can't meet its debts.
The problem now is how to get the bank back on its feet and operating again on a solvent, going-concern
basis.
The answer is to rebuild the banks' balance sheets. There are good and bad ways of doing this.
The authorities chose the bad way. They panicked — what else could we have expected? And in their panic
they injected massive amounts of taxpayer money into the banks, and in so doing threw our money into a
virtually bottomless hole.
A much better way, by contrast, is to rebuild the banks' balance sheets following the precedents of traditional
bankruptcy law. The bank would go into some form of temporary receivership, and three things would
happen:
1. Its assets would be marked down in value to reflect the losses.
2. The liabilities would be marked down by the same amount.
3. The liabilities would be reorganized so that the bank would have a decent capital base again. This new
share capital would come from the depositors, some of whose deposits would be converted into shares.
We might also wish to ring fence the smaller depositors to protect them — this would make the package
easier to sell politically, but this is a detail.
The restructuring is shown in the next slide:

The bank's balance sheet is now much smaller, but the new capital base is large enough to make the bank
safe again. The bank can then return to normal business but on a smaller scale.
There would be no taxpayer bailout, no propping up weak institutions, no too-big-to-fail, no humoring of the
banks and their bonus culture, no prolonged period of crippling uncertainty, no fiscal profligacy, no loose
money. Instead, we should have a quick, emergency-room operation on the economy's financial engine
followed by a rapid return to normal market conditions. This is rather different from what actually happened.
Of course, I am not suggesting that the operation would be easy. In particular, it is very difficult to work out
what the "true" value of the banks' assets should be — no one really knows what a toxic asset is worth. But
fortunately, it is not necessary for the write-downs to be "realistic" or accurate. In fact, it is best if the write-
downs are harsh and the valuations biased on the conservative side, and these could be based on formulas
reflecting worst-case estimates of what different types of asset might be worth (i.e., zero in some cases). And
if those valuations later turn out to be too low, it doesn't really matter: the banks' assets can be marked up
again later.
The trick in all this is speed. We could close down the banks or limit their operations for a weekend or a few
days, but not for months. A prolonged disruption of bank activities would cripple the payments system and
the supply of credit to the broader economy, and this would be catastrophic. It is therefore essential that the
operation be carried out quickly to minimize the disruption to bank activities — and not for the sake of the
banks, but for the sake of everyone else.
Looking forward, we should be looking at a reform package with a number of key elements:
"We should abolish the limited-liability statutes and give the bankers the strongest possible incentives to look
after our money properly."
First, we should consider reforms of bankruptcy and insolvency laws to get the ER treatment "right" in the
future: should any bank ever need emergency surgery again, this should be a straightforward, by-the-book
process anticipated and thought through in advance, not some battlefield-surgery hatchet job.
Second, the financial-services industry needs serious reform. Hard to believe as it might be, there was once a
time when the industry was conservative and respected, when it focused on providing straightforward
financial "products" to its customers and did so well. We have got to get back to that. No more financial
hydrogen bombs blowing up the financial system.
The key to this is corporate-governance reform. I am talking, not about tinkering with the number of
nonexecutive directors or a new Sarbanes-Oxley, but radical reform to make the banks accountable and to
rein in the moral hazards that have run rampant. And the key to good corporate governance is to remove
limited liability: we should abolish the limited-liability statutes and give the bankers the strongest possible
incentives to look after our money properly.
And, of course, there is our old enemy, the state. If I had my way, the state would be rolled back right: no
deposit insurance, no capital adequacy rules, no financial regulation, no central bank, no monetary policy —
in short, the restoration of a sound monetary standard.
Short- and Medium-Term Economic Prospects
I could easily spend the rest of my talk drooling over these wish-lists. But rather than do that, I would like to
spend the rest of my time looking at our economic prospects. And our prospects are not too good. To save
time, I will focus on the US, but much of what I say applies to some extent to other countries too.
Let's start with inflation.
If we look over the period 2006–2008, we see inflation of between 2% and 4% on a year-on-year basis, and
the broader monetary aggregates expanding quite rapidly and growing at double-digit rates by the end of
2008. We also see an extraordinary growth in the narrowest aggregate, the monetary base, which grew 100%
over 2008, a consequence of the highly dangerous and irresponsible policy of "quantitative easing."
From early this year, admittedly, we see monetary growth halting and prices falling a little. However, I
wouldn't put too much emphasis in such a short downturn in the monetary growth rates, especially in a
period where the demand for money is clearly falling due to the impact of the recession. Instead, we need to
look over the broad period and consider the likely impact of the large amount of excess money that is already
in the system. So, overall, combined with still-low interest rates, these figures indicate a loose monetary
policy and the prospect of resurgent inflation once economic activity returns to normal.
Interest rates are low, due in part to "soft" monetary policy, but also due to a flood of hot money pouring into
the allegedly safe US Treasury bond market. Low interest rates mean high bond prices, and there are signs
that the T-bill market is undergoing a fair-sized speculative bubble. This bubble would seem to be very
vulnerable — even a small rise in inflation could easily trigger a loss of confidence and a massive exit from
the market. If that happens, market interest rates could rise sharply. And of course, we shouldn't forget that
the prospect of massive federal deficits for years to come will also put upward pressure on interest rates. So
interest rates are set to rise.
"For those of you who want any investment advice, my advice boils down to a choice between two positions:
a cash position and a fetal one."
At the same time, the Fed faces a difficult dilemma: If it continues with its current monetary policy, then
inflation will return, and probably with a vengeance. The worst thing that the Fed can then do is to put its foot
down even harder on the monetary accelerator. This would push interest rates back down temporarily but
lead to higher inflation and higher interest rates down the road — and, in all likelihood, to the return of
stagflation and yet another massive boom–bust cycle.
But on the other hand, the best thing that the Fed can do is also the hardest thing for it to do: bite the bullet
and put its foot on the monetary brakes. Such a policy would encounter massive political resistance — and
risk pricking the bond-market bubble and stalling the nascent economic recovery.
In effect, the Fed now risks being hoist by its own petard, a consequence of its own past profligacy.
So the near-term outlook is not too good: the prospect of renewed inflation, even hyperinflation; higher
interests rates; a bond-market crash; an uncertain and possibly stalled economic recovery; and the danger of
a dollar crisis.
And for those of you who want any investment advice, my advice boils down to a choice between two
positions: a cash position and a fetal one.
Long-Term Prospects: Deficits + Entitlements
But all these shorter-term worries pale compared to the long-term outlook.
Federal deficits will be more than 10% of GDP for years to come — these are extremely high.
But this is only the tip of the iceberg. We also have to take account of the unfunded entitlements to which the
federal government has committed itself: Medicare and Medicaid entitlements; and pay-as-you-go funding of
Social Security, that is, state pensions paid for through current tax revenue, not funded in advance.
These are set to grow massively due to there being more retirees relative to workers, retirees being set to live
longer, and old-age entitlements growing higher.
Let's look at some figures:
The cost of unfunded Social Security and Medicaid is over $100 trillion — and rising. This is about ten times
bigger than the total existing debt of the United States, and it is about $330,000 per man, woman and child in
the United States — or about $1.3m for a family of four. And rising.
So your average US family of four is facing a government-imposed bill of $1.3m on top of existing taxes!
Change the sign around and they'd all be millionaires! Welcome to the age of the negative millionaire.
It is not surprising, then, that leading experts are now openly asking if the United States is bankrupt, and they
are anticipating possible futures in which young, educated Americans flee the country in large numbers to
escape crippling taxes — and, of course, in so doing, leave their fellow citizens with even greater per capita
burdens to bear. A real case of "last one to leave please switch off the lights."
To quote one leading authority, the president of the Federal Reserve Bank of Dallas:
 I see a frightful storm brewing in the form of untethered government debt.… Unless we take
steps to deal with it, the long-term fiscal situation of the federal government will be
unimaginably more devastating to our economic prosperity than the subprime debacle and the
recent debauching of credit markets. (Richard W. Fisher, 2008)[2]
For those of you who are young, the implications are personal. You have your college debts to pay off. It's
hard to get a job, let alone a well-paying one. You can't get on the housing ladder because property is too
expensive. Taxes are likely to be high and rising throughout your working life.
You won't have much left to pay for your own personal pension. And yet current projections suggest that you
are likely to live well into your 90s or later, and there will be little left in the kitty for your state pension when
you retire — assuming that you can retire at all. Pension experts are now talking about the end of retirement,
and retirement ages are already starting to rise.
Historically speaking, a good retirement will be seen in the future as a 20th-century luxury, something that
people before or since usually didn't get. And you came too late: whereas earlier generations had it easy, you
can look forward to busting your gut all your life and working till you drop.
If you are not thoroughly depressed by now, then I am obviously not getting my message across.
You might object that this nightmare scenario is an unfair rip-off, and you would be quite right. Indeed, it
might remind some of you of a Ponzi (or pyramid) scheme. A Ponzi scheme is essentially a scam. Someone
sets up an investment scheme and gets other people to put their money into it. These people draw in others,
and they in turn draw in more people, and so on. Each new intake imagines that their money is being
invested on their behalf, but in reality the money is being creamed off by those already in the system.
"The pensions/social security system is an intergenerational Ponzi scheme, the biggest scam ever invented."
The process continues for as long as enough new suckers come in, but at some point it becomes clear that
the scheme cannot pay out. The supply of suckers then dries up and the scheme collapses. And collapse is
inevitable. Those who come in early do well, those who come later do badly — and those who come in last
lose everything.
I would suggest that the pensions/social security system — the system of intergenerational transfers in which
the young get signed up by their elders, often before they are born — not only resembles but actually is an
intergenerational Ponzi scheme, the biggest scam ever invented. And to you young people here, I am sorry to
say, if you want to see who the suckers of this Ponzi scheme are, just look in the mirror.
So the system must inevitably collapse. The younger you are, the more you stand to lose. And the longer the
scam goes on, the more it will cost you.
To you youngsters, I say: it's your choice how long you choose to put up with this. I say it's your choice
because — with a bit of luck — those of us who are older will have departed the scene when these particular
chickens come home to roost.
It's your choice.
You can play by the rules your elders would impose on you. You can expect to pay higher and higher taxes,
work harder and harder to stand still, and get less and less back in return for yourselves — a life little
different from slavery — and then the system will collapse anyway.
Or, alternatively, you can fight back. There is no law of nature that says you have to honor checks that other
people write at your expense. You are not slaves — you are slaves only if you choose to submit to slavery. You
can repudiate those checks.
I am very aware that we are in unchartered territory here, and the implications of what I am saying are
revolutionary and certainly dangerous.
Let's be blunt about what I am suggesting. I am suggesting that if default is inevitable, and if default is more
damaging the longer it is delayed, then it would be a good idea to consider embracing it. We should lance the
boil, as it were, and kill off the scam — sooner rather than later.
Do you want a life of toil and slavery, followed by ultimate destitution, or do you want to stand up for
yourselves and fight for the chance of a decent life? It's your choice.
Who was it that once told the workers of the world that they had nothing to lose but their chains?
I would like to end as I started, with the man of the moment, the prophet of the short-term, John Maynard
Keynes. In 1930, Keynes wrote a delightful essay, "Economic Possibilities for Our Grandchildren," in which he
peered into his crystal ball and mused about how economic life would be a hundred years hence, in 2030,
now only a couple of decades away.[3]
Keynes anticipated the benefits of technological progress taking us gradually toward a state of economic bliss
in which the problem of economic necessity would in essence be solved. He anticipated three-hour shifts and
fifteen-hour working weeks, worked not so much out of need, but more for the sake of having something to
do, and he worried about how people would mentally adjust to having so much spare time on their hands. We
would be like the Biblical lilies of the field, who neither toil nor spin.

And, at long last, after millennia of struggle, real life would finally catch up with the traditional charwoman's
epitaph. After a lifetime of unrelenting hard work, she went to her grave looking forward above all else to a
very, very long rest:
Don't mourn for me, friends, don't weep for me never,
For I'm going to do nothing for ever and ever.
At least Keynes was right about one thing: all that spare leisure time is overrated. Thank you all.

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