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Keynes
can't help us now

Governments
cling to the delusion that a crisis of excess debt can be solved by creating
more debt.

Niall Ferguson

February 6, 2009

It began as a subprime surprise, became a credit
crunch and then a global financial crisis. At last week's World Economic Forum
in Davos, Switzerland, Russia and China blamed America,
everyone blamed the bankers, and the bankers blamed you and me. From where I
sat, the majority of the attendees were stuck in the Great Repression: deeply
anxious but fundamentally in denial about the nature and magnitude of the
problem.

Some foretold the bottom of the recession by the middle of this year. Others
claimed that India and China would be the engines of recovery. But mostly the
wise and powerful had decided to trust that John Maynard Keynes would save us
all.

I heard almost no criticism of the $819-billion stimulus package making its way
through Congress. The general assumption seemed to be that practically any kind
of government expenditure would be beneficial -- and the bigger the resulting
deficit the better.

There is something desperate about the way economists are clinging to their dogeared copies of Keynes' "General Theory."
Uneasily aware that their discipline almost entirely failed to anticipate the
current crisis, they seem to be regressing to macroeconomic childhood,
clutching the Keynesian "multiplier effect" -- which holds that a
dollar spent by the government begets more than a dollar's worth of additional
economic output -- like an old teddy bear.

They need to grow up and face the harsh reality: The Western world is suffering
a crisis of excessive indebtedness. Governments, corporations and households
are groaning under unprecedented debt burdens. Average household debt has
reached 141% of disposable income in the United States and 177% in Britain.
Worst of all are the banks. Some of the best-known names in American and
European finance have liabilities 40, 60 or even 100 times the amount of their
capital.

The delusion that a crisis of excess debt can be solved by creating more debt
is at the heart of the Great Repression. Yet that is precisely what most
governments propose to do.

The United States could end up running a deficit of more than 10% of GDP this
year (adding the cost of the stimulus package to the Congressional Budget
Office's optimistic 8.3% forecast). Nor is that all.
Last year, the Bush administration committed $7.8 trillion to bailout schemes,
in the form of loans, investments and guarantees.

Now the talk is of a new "bad bank" to buy the toxic assets that the
Troubled Asset Relief Program couldn't cure. No one seems to have noticed that
there already is a "bad bank." It is called the Federal Reserve
System, and its balance sheet has grown from just over $900 billion to more
than $2 trillion since this crisis began, partly as a result of purchases of undisclosed
assets from banks.

Just how much more toxic waste is out there? New York
University economistNouriel Roubini
puts U.S. banks' projected losses from bad loans and securities at $1.8
trillion. Even if that estimate is 40% too high, the banks' capital will still
be wiped out. And all this is before any account is taken of the unfunded
liabilities of the Medicare and Social Security systems. With the economy
contracting at a fast clip, we are on the eve of a public-debt explosion. And
similar measures are being taken around the world.

The born-again Keynesians seem to have forgotten that their prescription stood
the best chance of working in a more or less closed economy. But this is a
globalized world, where uncoordinated profligacy by national governments is
more likely to generate bond-market and currency-market volatility than a
return to growth.

There is a better way to go: in the opposite direction. The aim must be not to
increase debt but to reduce it.

This used to happen in one of two ways. If, say, Argentina had an excessively
large domestic debt, denominated in Argentine currency, it could be inflated
away -- Argentina just printed more money. If it were an external debt, the
government defaulted and forced the creditors to accept less.

Today, America is Argentina. Europe is Argentina. Former investment banks and
ordinary households are Argentina. But it will not be so easy for us to inflate
away our debts. The deflationary pressures unleashed by the financial crisis
are too strong -- consumer prices in the U.S. have been falling for three
consecutive months. Nor is default quite the same for banks
and households as it is for governments. Understandably, monetary
authorities are anxious to avoid mass bankruptcies of banks and households, not
least because of the downward spiral caused by distress sales.

So what can we do? First, banks that are de facto insolvent need to be
restructured, not nationalized.(The last thing the
U.S. needs is to have all of its banks run like Amtrak or, worse, the IRS.) Bank
shareholders will have to face that they have lost their money. Too bad; they
should have kept a more vigilant eye on the people running their banks.
Government will take control in return for a substantial recapitalization, but
only after losses have been meaningfully written down. Those who hold the
banks' debt, the bondholders, may have to accept a debt-for-equity swap or a
20% "haircut" -- a disappointment, but nothing compared with the
losses suffered when Lehman Bros. went under.

State life-support for dinosaur banks should not and must not impede the
formation of new banks by the private sector. It is vital that state control
does not give the old, moribund banks an unfair advantage. So recapitalization
must be a once-only event, with no enduring government guarantees or subsidies.
And there should be a clear timetable for "re-privatization" --
within, say, 10 years.

The second step we must take is a generalized conversion of American mortgages
to lower interest rates and longer maturities. About 2.3 million U.S.
households face foreclosure. That number is certain to rise as more
adjustable-rate mortgages reset, driving perhaps 8 million more households into
foreclosure and causing home prices to drop further. Few of those affected have
any realistic prospect of refinancing at more affordable rates. So, once again,
what is needed is state intervention.

Purists say this would violate the sanctity of the contract. But there are
times when the public interest requires us to honor the rule of law in the
breach. Repeatedly in the course of the 19th century, governments changed the
terms of bonds that they issued through a process known as
"conversion." A bond with a 5% return was simply exchanged for one
with a 3% return, to take account of falling market rates and prices. Such
procedures were seldom stigmatized as default.

Another objection to such a procedure is that it would reward the imprudent.
But moral hazard only really matters if bad behavior is likely to be repeated,
and risky adjustable-rate mortgages aren't coming back soon.

The issue, then, becomes one of fairness: Why help the imprudent when the
prudent are struggling too?

One solution would be for the government-controlled mortgage lenders and
guarantors, Fannie Mae and Freddie Mac, to offer all borrowers -- including
those with fixed rates -- the same deal. Permanently lower monthly payments for
a majority of U.S. households almost certainly would do more to stimulate
consumer confidence than all the provisions of the stimulus package, including
tax cuts.

No doubt those who lost by such measures would not suffer in silence. But the
benefits would surely outweigh the costs to bank shareholders, bank bondholders
and the owners of mortgage-backed securities.

Americans, Winston Churchill once remarked, will always do the right thing --
after they have exhausted all other alternatives. If we are still waiting for
Keynes to save us when Davos comes around next year,
it may well be too late. Only a Great Restructuring can end the Great
Repression. It needs to happen soon.

======================================

Niall Ferguson is a professor at Harvard University and Harvard Business
School, a Fellow of Jesus College, Oxford, and a senior fellow of the Hoover
Institution. His latest book is "The Ascent of Money: A Financial History
of the World."