If this is part 2 of the Great Recession, what were the 10 recent policy errors that got us here?

When it was all academic, I enjoyed reading about the causes of the Wall Street Crash, the Great Depression and the German hyper-inflation.  Policy errors abounded. The UK going back on to the Gold Standard in the middle of the crisis and sending the economy down in to a deflationary spiral.  Andrew Mellon, US Treasury Secretary, saying “liquidate labor, liquidate stocks, liquidate farmers, liquidate real estate…it will purge the rottenness out of the system” (and letting the banks go bust).  France demanding punitive war reparations from a desperately weak Germany, causing money printing and social unrest.

So if what we’re seeing right now is the start of a second wave of the Great Recession, what will historians think were the big policy mistakes in the couple of years since the first down-wave ended in 2009?  Here are a few ideas – the 10 recent policy errors that have sent us back to the brink:

1. The ECB hiking interest rates twice this year in response to a commodity led inflation overshoot.  Whilst I guess this gets reversed next month (or even sooner?) and the ECB cuts, the damage this did to confidence and to European funding costs was significant, not least because it caused the Euro to remain relatively strong.  There was no evidence of second round inflationary effects, and the hikes came at a terrible time in the recovery.

2. The Tea Party and the idiots on both sides of politics in the US not coming up with even small compromises that would have given S&P an excuse not to downgrade the US from AAA.

3. The continuing Osborne UK austerity programme.  As economic growth deteriorated, as youth unemployment rocketed and as confidence collapsed, he announced there was no Plan B.  “Liquidate, liquidate, liquidate”, as Mr Mellon might have said, applauding.

4. Not banning shorting via sovereign CDS.  We like CDS, we use CDS.  But if they didn’t exist, the ECB could have aggressively bought peripheral European bonds and driven their yields down.  Nowadays, whilst they were doing this in the physical bond market, the market was signalling its disbelief via wider CDS spreads.  This visible secondary market doesn’t allow anyone to suspend disbelief.  The price action in sovereign CDS dominates sentiment – just take a look on Twitter.

5. Over-regulation of the banking sector.  I’m not sure about this one, because the banks are evil, right?  But the backdrop of Dodd-Frank in the US, the global solvency regulations and Basel 3, the ring fencing of retail/investment banking etc. doesn’t provide an environment in which bank lending will aggressively recover.  That’s if you think more bank lending/leverage in the system is a solution to this mess.

6. Not bailing out Greece/not letting Greece go bust quickly.  It kind of didn’t matter which, but one of them could have saved the Eurozone.  Greece started to wobble at the end of 2009, so we’ve had nearly 2 years of sovereign debt uncertainty now.  Incidentally, could you compare the clamour for austerity for the Greeks now, to the French demands for implausible payments from Germany after the first world war?

7. Doing the wrong kind of Quantitative Easing. Operation Twist? The Fed needed to inject printed money directly into a broken housing market and underwater mortgages, boosting labour mobility and getting cash to those with a high marginal propensity to consume, rather than giving the printed money to investors in assets who didn’t do anything with it.  QE needed to look a little more fiscal than monetary.

8. China’s pegging of the RMB to the US dollar, and the consequence of many other countries having a semi peg to the US dollar in order to remain competitive versus China.  Currency wars.  The RMB is the wrong price – it’s artificially too weak and therefore developed countries’ currencies are artificially too strong.  This led to a race to the bottom to weaken relative to other economies, and that didn’t help anyone.

9. There was a brief moment in the quiet year or so that we had, when UK defined benefit pension funds were pretty much fully funded for the first time in years.  They could have de-risked and locked in benefits for their members.  Now that equity markets are nearly 20% lower, and bond yields have fallen by 1.5% (meaning assets have fallen, and liabilities risen) that’s no longer the case.  Pension funds didn’t de-risk in the good times, and left millions of workers and pensioners in peril for the future.

10. Not enough shock and awe.  Policy was always too incremental.  The world economy needed huge injections of monetary stimulus and fiscal stimulus.  The policy announcements were never enough, and confidence in policy making itself faded away as time went on.  Obama would like to extend a tax cut, the Fed will do something to do with the shape of the yield curve, the ECB will buy a few Portuguese bonds, the Bank of England might print £50 billion more.  The policy action was too tentative – and there wasn’t enough collaboration between policy-makers across the world.

I’m sure you’ll disagree, or have other policy errors to add.  If so, you can comment below, or tweet me @bondvigilantes.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

Discuss Article

  1. Yohay says:

    Great points! Points 1 and 6 are obvious. Your comments in point 7 are very interesting. Indeed, fiscal stimulus is needed, but the current environment in Washington won’t allow it.
    Regarding point 5, the situation is complicated: on one hand, you want the banks to behave in a more responsible way after the mess they created, but you do want them to lend and help the recovery. Perhaps a radical solution of the central banks bypassing the commercial banks and lending directly would break the vicious cycle, something along the lines of point 7. This doesn’t seem likely and we’re probably headed for a long deleveraging.
    Or WW3 if history fully repeating itself… I hope it won’t 

    Posted on: 23/09/11 | 8:49 am
  2. Richard Harper says:

    I wish I could disagree but I think that you are right across the board.  Maybe one extra point could be that the MPC should have brought in another round of QE as M4 started to decline.

    Posted on: 23/09/11 | 11:39 am
  3. Justin Pugsley says:

    I agree with most of those points, except maybe No 7. Wrong kind of QE – I have mixed feelings on this one. Just because equity mkts didn’t like operation twist it doesn’t necessarily make it wrong. The idea of driving down long term interest rates to lower the cost of mortgages is fine.
    I’m also concerned that QE has become like a drug and with every new dose its effects will just get weaker as the fundamental pblms discussed in the article are not properly addressed ie like Greece & US policy paralysis.
    Had the Fed just printed more money it would have surely driven up commodity prices, which has an impact on inflation and effectively reduces the disposable income of consumers, thereby reducing chances of economic growth.
    If you buy the argument put forward by some economists that oil at $140/bbl was the trigger for the last downturn then pushing oil prices up with more QE would be counter-productive.
    I just wonder had Brent been a more reasonable $70-80/bbl would the global recovery be melting away so quickly?
    However, if stock markets completely collapse, which they could be very close to doing, then I suspect the Fed, which watches equities because of the so called wealth effect, will turn the money spigots to full blast as probably will other central banks.
    I really think the G20 needs to do another global summit very quickly and come up with some concrete and credible plans to restart growth, because we’re rapidly spiralling into a crisis, which the authorities will not be able to control and that will make 2008-09 look like a mere dress rehearsal.   
     

    Posted on: 23/09/11 | 11:49 am
  4. ken barker says:

    The analogy with the adherence to the gold standard and the war reparations in the 20’s and 30’s seems horribly analagous to the cast iron euro.  Our leaders should all be carrying well thumbed copies of “Lords of Finance” just to remind themselves how a crisis gently evolves, it is not a one day affair followed by a long recovery.  This will be a hideous many tentacled monster that will drag some of its victims slowly into the mire.  The world needs a dragon slayer.

    Posted on: 23/09/11 | 12:06 pm
  5. Simon Evan-Cook says:

    Are you blaming the global slowdown on British austerity (of which there hasn’t been very much yet anyway)?

    Posted on: 23/09/11 | 1:27 pm
  6. Trevor Rothermere says:

    As per Justin Pugsley’s comments, QE2 (and any successor) is simply a green light to go very long commodities. I’ve little doubt that QE-fuelled commodity inflation, is the cause of many of the fundamental problems this year, ie. (i) sharply elevated crude generating a huge headwind for the global economy, and (ii) soaring commodity prices, particularly agricultural and the problems this causes in EM, causing CBs to tighten.
     
    Recent commodity mkt setbacks provide Bernanke with the leeway to embark on QE3, if he can sell the idea to the Republicans – which is not something that can be necessarily assumed.

    Posted on: 23/09/11 | 1:57 pm
  7. Clive Hale says:

    “Incidentally, could you compare the clamour for austerity for the Greeks now, to the French demands for implausible payments from Germany after the first world war?”
    Jim – did you ever read Bernard Connolly’s 1995 book – the Rotten Heart of Europe – in which he said the introduction of the euro could lead to WW3? He sounded like a complete fruitcake and lost his job at the time…. but now????

    Posted on: 25/09/11 | 11:23 am

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