This Could Be Worse Than The Great Depression

Washington, 21 May 2008. Simon Johnston is an Economics Professor at MIT – but he is no ivory tower economist. He was the Chief Economist at the International Monetary Fund (IMF) between 2007 – 2008 and as such he has practical experience of dealing with financial crises in emerging markets. What he has to say at the end of an excellent essay in the Atlantic, The Quiet Coup, is quite frankly chilling.[br]

Washington, 21 May 2008. Simon Johnston is an Economics Professor at MIT – but he is no ivory tower economist. He was the Chief Economist at the International Monetary Fund (IMF) between 2007 – 2008 and as such he has practical experience of dealing with financial crises in emerging markets. What he has to say at the end of an excellent essay in the Atlantic, The Quiet Coup, is quite frankly chilling.[br]

The conventional wisdom says that this is not as bad as the Great Recession, but the convetional wisdom is wrong, Simon argues. Because the world is so interconnected and the financial markets so large, this could end up being right.

According to Simon, the IMF’s job is to tell their clients (ie country’s in financial crisis) the hard truths they don’t want to hear. Although every crisis is different, they tend to share some common characteristics. The country in trouble has had some economic success, and then gone on a binge of development funded by debt. As soon as circumstances change, the debts can’t be repaid, and things quickly spiral out of control as funding disappeared.

The economic policies that need to be applied are fairly straight forward to work out. Simon says the biggest headaches rather are the politics involved. These usually feature an oligarchy of business interests – entrepreneurs, military/ business figures, bankers – who have cosy ties with the government of the day.[br]

These business interests help grow the wealth and power of the country, and contribute to political causes, and so gain increasing power. This emboldens them to take on increasing debt, in the knowledge that the government will back them if things go wrong.

However when credit tightens and things do go wrong, it can quickly become too big even for the government to handle. Russia’s oligarchs, for example, borrowed over $450 billion in the last five years. The vicious cycle that kicks is quick and severe. Enormous companies can be suddenly on their knees, local banks that lent to them collapse, and international capital flees the country. The government has to draw down on its foreign currency reserves to prop up the economy, but that doesn’t last long.

When the IMF is called in then, their key consideration is whether the prime minister or finance minister is ready to stop bailing out their businessman friends. Only then does the fund think it can really help. Therefore, Simon says that what really happened in Thailand and Indonesia during the Asian Financial Crisis in 1997 was an all-out fight to see which crony families would lose their banks. That struggle was bloodless in Thailand, but led to rioting and the ultimate fall of President Suharto in Jakarta.

The really scary bit of the Quite Coup is the fact that what is happening right now in the United States bears all the same hallmarks of the crises the IMF has seen in Thailand, Indonesia, South Korea, Russia, Argentina and so on.

According to Simon, if you showed the numbers to old IMF hands without telling them the name of the country, they would tell you pretty quickly what was needed. Nationalise the banks, clean them up, break them up so that nothing is ‘too big to fail’ and sell them. Too big to fail is too big to be.

However this, in Simon’s view, is not going to happen. Wall St wields enormous influence in Washington, with Goldman Sachs and others supplying officials to the Treasury and effectively writing policies that let banks wield greater and greater power. He does not believe that the conviction is there to make the changes needed to salvage the US financial system.

Two possible outcomes are predicted. The first involves a continuation of the current ‘stumbling along’, reacting to individual cases by doing deals, and helping banks to stagger along that might otherwise be insolvent. It a re-run of Japan’s ‘Lost Decade’, but played out on a much larger scale.

The other scenario sounds even scarier but may be better in the long run. Things get worse, Eastern European countries start to default and drag Western Europe down with them. Fears of defaults grow and credit gets even harder to come by. Asia’s exports crumble further, as do commodity suppliers in Latin America, the Middle East and Africa. The scenarios laid out in the US Banks Stress Test all suddenly look much too realistic, and a more sober view of reality is taken.

Whichever path we are about to tread, if Simon Johnston is to be believed, there is a lot more pain to come before we are out of the woods.

Vladimir Gonzalez, EconomyWatch.com