Unit 4 Macro: Money, Debt and the New World Order

“All money these days is really a form of debt from somewhere else. We know now in 2012 that our debts cannot be repaid in full.”

Philip Coggan from the Economist was on fine form at the LSE last week when he spoke to a packed audience in the new academic building on the subject of his latest book. When trust in the monetary system breaks down we are in a very difficult place and, in a wonderfully broad historical sweep Philip Coggan offered some revealing insights into what a reformed global monetary system might look like in the years ahead.

I will focus on what Philip Coggan said about the last forty years - namely the period since 1971 with the end of the Bretton Woods system in which the world economy has effectively operated without a true monetary anchor.

We have seen the rise to prominence of independent central banks who have aimed to keep inflation in check with a range of targets and instruments. We have moved from money supply targets to currency targets and latterly to inflation targets. By and large, currency controls have been taken away and most advanced countries have favoured floating exchange rates, capital mobility and the autonomy to operate their own monetary policy.

During the Great Moderation from the early 1990s onwards inflation remained low, interest rates trended downwards and there was a huge rise in lending and leverage much of which was ratcheted higher by financial innovation. While most debt did not go bad, the system could cope and new ways of lending brought huge profits and a massive increase in relative wages for thousands working in the financial system. But the trouble with asset fuelled booms is that is makes everyone think they are a genius - traders, homeowners, central bankers and politicians.

Debts used to buy assets and debts taken out to sustain rising consumption in an age when real median wages were stagnant or often falling were fundamental to the financial crisis that engulfed much but not all of the world from 2007 onwards. Central banks tended to cut interest rates when markets wobbled; the financial sector became a powerful and influential rent-seeking industry that has imposed huge costs on millions of ordinary people and businesses.

The debt dilemma

The global debt crisis infects nearly every discussion about macroeconomics - where are we heading?

Debt is an expression of confidence - namely the confidence that borrowers will repay the capital as well as some interest.

In a growing economy when wages and asset prices are rising, meeting debt repayments is relatively easy. But for most countries this is a long way from the reality. Powerful deflationary forces and the inevitability of sustained high rates of unemployment both seriously threaten the chances of individuals, businesses and governments to repay some or all of their debts.

There are three main ways of dealing with the debt crisis:

1/ Stagnate - along the lines of Japan whose debt to GDP ratio exceeds 200% (although most of this debt is owed to themselves)

2/ Inflate - allow higher rates of inflation to cut the real value of debt - but the capital markets will see this coming and immediately raise yields on new debt issues

3/ Default - default becomes increasingly favoured and inevitable in a world where democratic resistance to a decade or more of real income cuts and fiscal austerity is fierce.Millions are being asked to swallow austerity and it little surprise that Greece and Italy now have appointed / unelected Prime Ministers.

The prediction is that many countries will default

i) Individual default rates on mortgages and other loans will rise (defaults tend to lag the economic cycle) even when official policy interest rates are low

ii) Politicians will default on their election promises - for example long-held promises to maintain public sector pensions. They have run out of fiscal bullets and the fiscal “shock and awe” response to the last recession seems to have had little long term impact

iii) Individual countries will default on their loans, it will not be confined to Greece but she is a good example of a country that simply cannot finance their debt from the markets.

In the long run, after financial crises, creditors tend to win and they set the rules for a reformed financial system. China prefers relatively fixed exchange rates and control over international capital controls. They and other creditor nations hold the key now because the balance of power in the world economy has shifted decisively.

A Brief History of Money