From independence, freedom and truth


Reform is not enough: we must reboot the system

Fernando del Pino Calvo Sotelo

December 29, 2011

The economic and financial crisis that the western world and, in particular, Spainare now suffering is the Great Debt crisis. Although each country has its own particular features, the common factor is excessive borrowing, first in the private sector, now in the public sector as well. How did we get into this situation? For the sake of simplicity, let me put forward three main causes. First, the central banks decided to keep interest rates too low for too long. Indeed, in a recent working paper the Bank for International Settlements, known as the “central banks’ central bank”, adopted as a working hypothesis that “monetary policy contributed significantly to the financial crisis.” Secondly, commercial banks followed central banking action by greatly increasing their lending and easing the repayment terms and required collateral. Thirdly, the recurring and very human projection ad infinitum of boom conditions rationalised what was on any sensible grounds wholly irrational. All this led to households, companies and banks to abandon their customary qualms about taking on debt. As a result, the greater part of the Western world indulged in an orgy of credit. Obviously, both supply and demand were equally to blame for this, both the party offering the caramel and the party that freely gobbled it down.

This orgy of credit fuelled price bubbles across all asset classes. Particularly dangerous was the real estate bubble, due to the lack of liquidity of this asset, its sheer size with respect to the overall economy, and the social acceptability of borrowing to acquire bricks and mortar, to a degree that would not have been tolerated in the case of other asset classes.

When the housing bubble burst, the inflated price of all real estate collapsed whereas, on the other side of the balance sheet, the principal of the debt stood firm and unshakable. It was a problem for the borrower and a nightmare for the lender. Faced with the task of coping with a snowball of mammoth proportions that they themselves had set rolling, central banks invented the zero interest rate, abandoning the traditional concept of risk-free return and replacing it with its exact opposite, return-free risk, a concept which, logically, benefits the debtor to the detriment of the creditor. Now, trying to solve a problem created by low interest rates and too much debt with even lower interest rates and double portion of debt seems weird. When you buy time in the hope of someone rescuing you and that someone refuses to appear, you have not been buying time: you have been wasting time. If borrowers are unable to return 100, fat chance of them returning 200. In adopting this policy we have created a system addicted to debt and high asset valuations, born out of artificially low interest rates. When an annual interest rate of 6 or 7 per cent, considered run-of-the-mill in times past, is now regarded as the bankruptcy threshold, what further proof do we need? Curing an addiction requires battling with the withdrawal symptoms. It is the only option available. As a matter of course, increasing the dosage merely strengthens the addiction and defers the cure.

Let us look at the root of the problem. Politicians and central bankers (is there any difference?) have lowered the pain threshold of society at large by trying to prevent at all costs any suffering, discomfort or pain (and disgruntled voters. A swarm of newborn “rights” have appeared out of the blue. Concepts such as duty, effort and sacrifice have been put to sleep. Amid loud popular applause we have created a society of teenagers and steadfastly denied the acceptance of responsibility for being both right AND wrong, for both winning AND losing. In search of this artificial inoculation against pain, each time economic growth threatened to slow, the State, “Big Daddy”, adopted expansive policies designed to prevent the market from correcting its excesses and errors in the time-honoured way.  The State genuinely believed that it could rejig the inevitable consequences of the exercise of freedom by fallible hands: that is, economic cycles, as old and wise as they are, as stubborn and inevitable as ever. After all, crises are not new to us: lean cows and fat cows; famine and plenty; the grasshopper and the ant…remember? What the State did was toss away huge quantities of resources that would otherwise have served to meet one of the prime duties of a civilised society, that is, protect the growing minority of people that cannot, temporarily or permanently, fend for themselves. These plausible popular but pernicious intentions overrode the pedagogical role of error and pain, otherwise called learning from our own mistakes. Theses “good intentions” destroyed the principle of individual responsibility and fuelled belief in a radically unfair system of gain: tails I win, heads I lose not. Finally, they encouraged irresponsible behaviour fraught with risk that served only to inflate the bubble to bursting point. And now, they threaten to leave unprotected those most in need of such protection.

The present crisis is not the typical recession. It is a long lasting process of deleveraging, of shrinkage of excess debt piled up during many decades. But that is not the worst of it. Politicians must wake up to the fact that we now might face three structural changes of the first order of magnitude, changes that could wreck primary Western assumptions. First, that the developed countries are entitled to carry as much debt as they choose. Second, that a group of half a dozen adults, called central bankers or government, sitting round a table, have a crystal ball by means of which they can foresee the future and control our destiny (another example of the illusion of control and arrogance of the so-called, self-called elite, with the disastrous consequences we have seen in the last few years). Embarrassingly, the gathering storm went unnoticed to them all. Third: the belief that a fractional reserve financial system, dependent on leverage, confidence and the apparent absence of extreme volatility, is sufficiently robust to withstand any onslaught of the storm.

In addition to the structural changes common to all Western countries, inSpainwe see growing evidence of a radical collapse of the political and economic model. For this reason the incoming conservative government should dismiss any ideas it may have of dealing with this crisis in the same way it did when it was last voted into office. Today’s crisis is far more serious than its immediate predecessor. We are now much more heavily indebted; we have no control over our own monetary policy; our present currency, the euro, may well disappear; and our domestic banking system is extremely fragile. To make matters worse, the German camouflage that allowed us to enjoy lower interest rates than our track record warranted no longer fools anyone. Furthermore, and this is the key, it appears most unlikely that the new government will be able to surf an expansive world economic cycle of the kind that arose in the second half of the 1990s (or, for that matter, bask amid the resulting applause). Consequently, the economic and political reforms required are far more radical than any adopted in the last fifty years (since 1959, to be exact). They must go to the root of our underlying deficiencies. If we tackle the problem with half-way measures, we may meet the demands imposed by our creditors and European partners in terms of well-meaning reforms and an arbitrary cap on the deficit, albeit it more by obligation than conviction. But that in itself will not take us far. If we want to do the job properly, we must go back to the drawing board and start from scratch. We must reboot the system. Today we have the opportunity to do this. Let’s do it, for goodness’ sake.


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