Reformation Requires Deformation

Phase I: Breakdown

We are in the early stages of a downturn where the problem is an addiction to debt. We are only just beginning the hangover and we have yet to experience the drudgery of detox and rehab. When a bad system turns sour, few are radical or visionary enough to throw it out and start again. It is human nature to cling to the familiar, even when it has failed. This is why a cathartic end to a corrupted country or currency is a necessary precursor to evolution.

One of many examples of a debt crisis precipitating an uprising can be seen in eighteenth century France. Through her funding of the American War of Independence, the country had become highly indebted. The subsequent tax burden and food shortages made the effete aristocracy an easy target for the revolting peasants: a lesson that should not be forgotten today. Napoleon Bonaparte (who witnessed the Revolution first hand) summed up the dangers of debt when he studied an interest rate table and said ‘the deadly facts herein lead me to wonder that this monster interest has not devoured the whole human race. It would have done so long ago if bankruptcy and revolution had not been the counter-poisons.’

The classic response to an end-of-era crisis is to apply the same old mistaken methods, with ever-greater zeal, in a bid to recapture the good old days. The combination of yet more debt issuance coupled with rate cuts at every opportunity has left western economies addled with over-stimulation. In the new millennium banks forgot the old lessons of self-control and became the tools of their own self-destruction: stewardship was replaced by salesmanship when the public were sold an impossible dream. Negligible wage growth, coupled with inflation and a devaluation of the dollar is leading to a re-balancing of wealth from West to East, at the expense of American consumers.
Capitalism appears to have mutated and deformed, like a spring that is stretched too far and can never recover its useful purpose. Ironically, the US Federal Reserve has betrayed the basic doctrine of free enterprise in three ways: First, the act of repeated rate cuts to protect the financial system from endemic failure has only served to undermine it. Second, it has allowed money supply to surge which has fermented inflation. Third, by orchestrating private takeovers they have destroyed shareholder value. The market should determine the survival of the financially fittest through a form of natural selection and should also decide the break-up price for a failed concern. The message this intervention sends to foreign investors – who fund the US current account deficit and prop up the dollar – is highly disturbing. It says that investors’ rights will be subsumed by the national interests of the government. There can be no clearer example of protectionist behaviour; the antithesis to free trade. Given that Sovereign Wealth Funds have already been bailing out US banks, they may be more reluctant to do so in future.

Phase II: Break-up

Ben Bernanke is well-versed on the causes of the Great Depression and has paid particular attention to the downturn in Japan. Having seen the damage that deflation and stagnation has caused, he is applying a counter-remedy through inflation and stimulation. The clearest outlet of such a plan is a weaker dollar as more and more money is created to cushion the economy. The unintended consequence of this policy is that the prices of commodities such as oil and wheat are forced up to compensate for the dilution of the dollar. Like many tipping points of the past, a confluence of apparently unrelated events is converging into a crisis. As with previous periods of prosperity, corporations and even entire countries have merged into mega-structures. Economic stress will test their true strength but inevitably many such institutions will unravel, particularly those built on weak (debt-derived) foundations. Countries which followed the Anglo-Saxon model of gunning for growth are most vulnerable. Paradoxically, those which maintained the ‘old’ model of maintaining their industrial base and agriculture are now best-placed to withstand the brunt of market forces.
As the dollar devalues and commodity prices continue to surge, real power will lie in the hands of developing countries with access to raw materials. In the Great Depression, America was still the world’s largest oil producer while Britain had access to commodities via her colonies; neither of which is valid any longer. This time round, new trading and currency blocks are likely to emerge and may well be based on past political allegiances. Like the spread of iron filings over a magnet, a whole new pattern and polarity of power might develop. Needless to say, trade tariffs and protectionism will abound with an emphasis on self-sufficiency. This will be tough to achieve given that the world’s population has grown from 1.6 to 6.1 billion in the space of a century.

Phase III: Reformation

Reformation, like rehabilitation requires a rejection of the old ways and an adoption of a fresh philosophy. It is only through economic strife that we are able to force ourselves to change. We may yet realise that never-ending economic growth – artificially fuelled by borrowing – is the problem rather than the solution. Sustainable cycles require periods of lying fallow before fecundity can ensue. The credit crisis is a natural phenomenon and should not be feared; akin to a death-knell of a dark age which we foolishly thought was an era of enlightenment. In future decades, debt and interest may well be discarded with distaste and regarded as barbarous relics (Keynes’ description of gold). If western banks continue to dissolve then perhaps they can be bought at a large discount by Sovereign Wealth Funds. This would be a glorious opportunity to free future generations from the millstone of a mortgage, which entails paying back the original liability several times over. Instead of banks creating loans and receiving interest such Funds might lend capital then receive rental income and repayments. There is a subtle but significant difference here. While swapping debt for equity recycles the old surpluses, more importantly it curtails the creation of credit and hence inflation. It also halts the upward spiral of house prices for the benefit of future generations.

Such radical ideas will no doubt be roundly condemned by critics who will inevitably find fault with novel ideas but debt-free funding already exists, in the form of Islamic Finance. We must instead make the mechanics of a process follow the philosophy rather than dictate it. Perhaps we will also see a much-needed return to principles so succinctly summed up by US President Thomas Jefferson ‘… we must not let our rulers load us with perpetual debt. We must make our selection between economy and liberty, or profusion and servitude’. Freedom from inflation is only possible once we understand that greater austerity is the price we must pay. The quest for consumerism has created enormous economic imbalances which have historically led to tensions and trade wars. Any reformation that breeds symmetry and sustainability can only be welcomed. The coming downturn will not only be an auspicious escape from a misguided course of action, but may well be a blessing in disguise for ourselves, our environment and for future generations.

Toby Birch March 2008