The three-phase crisis cycle

We’re in the third phase of the financial crisis that peaked in 2008. The events of 2007-2009, which are generally called “The Crisis”, were only phase two. The three phases are:

  • Phase One: The bubble. Creation of false assets by financial capital, mostly banks and smaller players in the property market. These assets have a nominal value way in excess of their real earnings potential, and that gap in value is hidden.
  • Phase Two: The stall. Transfer of the deficit of those assets to state balance sheets under emergency conditions. Private insolvency becomes state liability, while the gap between nominal and real wealth remains outstanding and is now visible.
  • Phase Three: The payback. Closing of the gap by a transfer of funds from the public to states. This may be achieved by means such as austerity, taxation, write-off, default, or inflation. These different options hurt or benefit different groups.

We’re in phase three, and the reason we have austerity in most of the west is that austerity is the method capital wants to see used to resolve the gap. Using austerity in the payback phase serves to consolidate the gains that capital made in phase one, such that the whole cycle is a transfer of real funds from the general public to capital. Austerity is the “hard money” way to close the cycle. It’s the only way to close it that refuses to accept nominal losses.

Using inflation (by printing money), taxation of capital gains, debt write-off, or controlled default would allow the valuation gap to close by eroding rather than consolidating the nominal gains made in the bubble phase. These options wouldn’t be clean but they would be fairer and less destructive of the real economy. These options are very unfriendly to capital, so they’re absent from politics. The US Fed is using a small amount of inflation, presumably to reduce damage to the real economy, while the fabulously independent European Central Bank insists on a hard Euro and austerity. The ECB is working as intended, since the whole point of an independent central bank is to avoid taxation of capital in situations like this. On the whole, present monetary policy is strongly in favor of wealth and capital and against social cohesion or development.

The whole crisis cycle lasts many years. This one started in the late ’90s and will probably go on to the late ’10s. Furthermore the economy is always in such a crisis cycle. We had similar cycles immediately before, although they were smaller, and we’ll probably have another one starting in the ’20s unless there is deep reform or other major change. The economy is not in a state of normal development broken by sudden, unpredictable, short crises. Rather, the economy is constantly in a dysfunctional state of financial crisis in three phases. The period when everything is supposedly going well is the bubble phase, where false assets are created. The so-called crisis that seems to take everyone by surprise is the short stall phase. The bitter time when people are made to pay and the economy is weak is the payback phase of the same cycle.

Although the events of the stall can be quite spectacular, and the economic dislocation that it involves does some damage to the real economy, that phase is not especially destructive. It’s a transfer of nominal debt and other liabilities from banks to states – vast but not directly consequential – marked by unease because the insolvency of various assets is visible. The real destruction to the economy and society happens in the payback phase, now, if austerity and hard money policies are pursued. Further, the massive transfer of wealth from the many to the very rich that the whole cycle effects is itself greatly destructive to the prosperity of society. That is because a very top-heavy distribution of wealth results in wasteful consumption (a billionaire’s dollar buys less happiness than a low income dollar), direct harm through social exclusion, and a prioritisation of further speculation over more productive activities.

This three-phase cycle that happens to transfer vast wealth from the public to the very rich isn’t accidental or unknown to those who benefit. It’s the result of vested interest. Phase one of the cycle, if it were to keep going, would be an ever-growing bubble. Much is in fact good about this phase: Capital flows liberally, confidence is high, productivity is good, and the real economy expands. One may question whether capital is well allocated, for example in real estate as opposed to technology, but that is a minor point. The real economy in the bubble is both healthy and sustainable. What is unsustainable about it is that it generates vast nominal claims, as financial assets whose apparent value grows much faster and far beyond their fundamentals. At some point the gap between the nominal and the real value of assets becomes too great and some assert holder, deserving or otherwise, is revealed as bankrupt. The fair and natural way to clear this problem would be to realise large nominal losses, with little harm to the real economy. The brilliant innovation of our financial system is to use the stall and payback phases to make a complete, repeatable cycle of wealth concentration.

The money that fuels the bubble doesn’t come from nowhere or from “stupid people”. It comes from banks. We have a folk notion of banks as places that store money and connect savers with investors, while money creation is sparingly done by the state. Both of these are myths. Since the 1070s, quietly and as a result of elite negotiations, the job of creating money has been given to the banks in every advanced economy. Not the central bank, private banks. Banks today are primarily money-issuing institutions, and that is almost entirely what they do. Money is banks. You “have” a dollar or a euro or a pound because a bank somewhere has it in its books that you do (except for the few coins and notes in your pocket that the state makes). Banks arbitrarily create money and give it to people as loans. In exchange, they take claims on assets such as houses or other collateral.

A positive feedback loop develops between the ability of banks to create money and the nominal value of assets held by the same banks. One year the banks issue £10 billion of new money as mortgage loans to people. These people bid up houses, the money variously moves between bank accounts, and at the end of the year the banks end up with this extra £10B as a liability on their balance sheets and somewhat more than £10B in loans receivable or collateral assets. Next year the same thing happens: banks expand bank money and nominal property assets by another £10B while the real value of houses or the real economy doesn’t change much. Since banks have the perverse right to recognise something they themselves create, bank money, as an asset in their balance sheets, the bubble feeds itself. This is not surprising, it is inevitable. This state of affairs doesn’t require bankers to conspire illegally but only to meet and coordinate the steering of monetary policy in the interests of themselves and financial elites, as they openly do.

Proposed remedies to “the crisis” tend to consider only the stall. The majority, including all the “stress test” and “too big to fail” measures, simply aim to make the stall softer and more orderly at a technical level. These measures would reduce incidental damage but wouldn’t affect the big picture of the crisis cycle. They are very friendly to financial capital. A handful of center-right economists propose stricter regimes that would make banks realise some capital losses during the stall, but they largely miss the point: The capital position of banks, healthy or otherwise, is trivial compared to the monetary and property assets that they improperly manage. Finally, many respected economists on the left side of the spectrum, including Stiglitz and Krugman, attack the payback phase. They say, correctly, that we need to resolve it not by the ruinous austerity that damages the real economy but by deficit spending, inflation, debt write-offs, or other means that erode and reset the nominal claims outstanding from the bubble. Within orthodox economics that is the correct view.

In my opinion, the proper way to attack the crisis cycle is in the bubble phase, such that nominal asset values either do not get far out of line from the fundamentals or they are regularly reset by forcing the asset holders to realise large nominal losses. The ideal fix would break the banks’ ability to simultaneously issue money (what economists call M1) and then recognise the same money as an asset on their balance sheets once it makes the rounds through the economy. Advocates of the gold standard offer a crude fix to this problem that would cause long term depression if adopted. More enlightened advocates of “narrow banking” would ditch the majority of bank money (M1) and replace it with a stock-like investment whose value can go up and down, thus realising nominal losses. I think the latter approach is broadly right, although I’m as yet unsure of the details.

Update, December 2012:

Since I wrote this, almost two years ago, more evidence has come out in favor. I’ve also seen the destructive payback through austerity play out in Europe, and I’ve become somewhat optimistic, in a sense, about the future. perhaps there is also a fourth phase:

  • Phase Four: The rebound. When the payback phase reaches the limit of its yield, any outstanding losses are nominally resolved and capital once again expands and flows liberally, starting the bubble phase of the next cycle.

Policy once again determines when that happens and what it means for the payback to reach the limit of its yield. Adopting a policy of moderate inflation, debt default, or a flat rejection of the terms of austerity would bring this about sooner and force capital to wrap up outstanding nominal losses. Persisting with austerity yields decreasing distributional benefits to capital while making deep cuts in real well being. Eventually, even in complete failure of democratic polity, the marginal benefit of austerity to capital becomes so low that capital itself will decide to wrap up and begin the next expansionary cycle. Sadly I see the latter path being taken in Europe. I estimate the rebound to come in the 2015-16 time frame.


2 thoughts on “The three-phase crisis cycle

  1. I hate to subscribe to conspiracy theories but I think you are right. In Europe, every action taken by the ECB has had the undeclared but clear objective of protecting banks in the “core” euro countries (Germany, that means you) from the consequences of unwise lending. The fact that Germany insisted on the exclusion from ECB regulation of some 4000 of its banks indicates clearly that they did not wish to have the cleansing light of day fall upon their operations. In a properly functioning market, they would already have been exposed to the results of their failure to undertake proper due diligence and risk evaluation before financing property bubbles all over Europe and beyond.
    Even worse, the money created by the asset bubble has been sucked out of the “real” market, leaving no room for the day to day financing of otherwise viable businesses. The “real” economy is now being senselessly trashed by a combination of unbearable tax increases and an absence of trading finance. Tragic.

  2. Pingback: The Need to Reform Money | Thoughts on European Politics & Economics

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