Niall Ferguson: The Crisis and How to Deal with It





This is the end of the age of leverage, which began, I guess, in the late 1970s, and saw an explosive rise in the ratio of debt to gross domestic product, not only in this country, but in many, many other countries. Once you end up with public and private debts in excess of three and a half times the size of your annual output, you are Argentina. You know, it's funny that people refer all the time back to the collapse of Lehman last September. Let's remember that this crisis actually began in June 2007. It fully became clear in August of 2007 that major financial institutions were almost certainly on the brink of insolvency to anybody who bothered to think about the impact of subprime mortgage defaults on their balance sheets.

But we were in denial. And we stayed in denial until September, more than a year later, of last year. Then we had the breakdown. Notice how psychological terms are very helpful when economics fails as a discipline. After the breakdown, we came out of denial and we realized that probably more than one major bank was insolvent. Then in September and October the world went into shock. It was deeply traumatic.

Now we're in the therapy phase. And what therapy are we using? Well, it's very interesting because we're using two quite contradictory courses of therapy. One is the prescription of Dr. Friedman—Milton Friedman, that is —which is being administered by the Federal Reserve: massive injections of liquidity to avert the kind of banking crisis that caused the Great Depression of the early 1930s. I'm fine with that. That's the right thing to do. But there is another course of therapy that is simultaneously being administered, which is the therapy prescribed by Dr. Keynes—John Maynard Keynes—and that therapy involves the running of massive fiscal deficits in excess of 12 percent of gross domestic product this year, and the issuance therefore of vast quantities of freshly minted bonds.

There is a clear contradiction between these two policies, and we're trying to have it both ways. You can't be a monetarist and a Keynesian simultaneously—at least I can't see how you can, because if the aim of the monetarist policy is to keep interest rates down, to keep liquidity high, the effect of the Keynesian policy must be to drive interest rates up.

After all, $1.75 trillion is an awful lot of freshly minted treasuries to land on the bond market at a time of recession, and I still don't quite know who is going to buy them. It's certainly not going to be the Chinese. That worked fine in the good times, but what I call "Chimerica," the marriage between China and America, is coming to an end. Maybe it's going to end in a messy divorce.

No, the problem is that only the Fed can buy these freshly minted treasuries, and there is going to be, I predict, in the weeks and months ahead, a very painful tug-of-war between our monetary policy and our fiscal policy as the markets realize just what a vast quantity of bonds are going to have to be absorbed by the financial system this year. That will tend to drive the price of the bonds down, and drive up interest rates, which will also have an effect on mortgage rates—the precise opposite of what Ben Bernanke is trying to achieve at the Fed.

One final thought: Let's not think of this as a purely American phenomenon. This is a crisis of the global economy. I'd go so far as to say it's a crisis of globalization itself. The US economy is not going to contract the most this year, even if the worst projections at the International Monetary Fund turn out to be right; a 2.6 percent contraction is far, far less than the shock already being inflicted on Japan, on South Korea, on Taiwan, to say nothing of the shock being inflicted on Europe. Germany is contracting at something close to 5 or 6 percent. So we are faced not just with a problem to be dealt with by American policy, we are faced with a crisis of global proportions, and it's far from clear to me that the prescriptions of Dr. Friedman and Dr. Keynes together can solve that massive global crisis.



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