Debt: The Last 30 Years

We are marginally less constipated than before. Ideologically speaking. Thanks in large part to Jeremy Corbyn British politics has begun to move on from the mendacious obsession with public debt being the cause of the last financial crisis (and the harbinger of future ones).

Political conservation has started to appreciate the seriousness of enormous levels of private debt, which was always the elephant in the room. The Bank of England has warned of a ‘spiral of complacency’ about growing household debt, while the IMF has cautioned that the ‘rapid growth in household debt – especially mortgages – can be dangerous’. Anthropologist David Graeber says ‘the household sector is a rolling catastrophe’. Around 17 million Britons have less than £100 in savings.  And with the BoE making noises about raising interest rates from rock bottom levels, there are worries that some mortgage-holders could default, precipitating a US-style sub-prime crisis.

The problem is that all attention is directed at one kind of private debt – personal debt. And while its seriousness should not be minimised there are other sorts of private debt that merit just as much, if not more, concern:

Personal debt is not the most extreme form of private debt

Private debt can be divided into three types – financial sector debt (i.e. banks & insurance companies), corporate debt and personal or household debt. All three have grown exponentially since the start of the 1990s. According to economist Michael Roberts, what he terms ‘global liquidity’, a combination of banks loans, securitized debt and derivatives, mushroomed from 150% of world GDP in 1990 to 350% in 2011. And while in some countries, colossal financial sector debt has declined to a degree following the financial crisis, and household debt levels fell before rising once more, corporate debt, nourished by near zero interest rates, has just snowballed over the last nine years.

According to figures released by management consultants McKinsey in 2015, all forms of private debt have grown since 2007 but corporate debt has increased by double the rate of both household and financial debt, which nonetheless rose but in a more subdued manner than before the crisis (see the graphic in this article). Government debt has also exploded as financial debt was transferred to state coffers. “Nonfinancial corporate debt remains the largest component of overall in the advanced capitalist economies at 113% of GDP,” says Roberts, “compared to 104% for government debt and 90% for household debt.”

The forms that corporate debt takes vary but one of the most common is for companies to use debt to buy back their own shares. This practice, which was illegal in the United States before 1982, increases the firm’s share price in a totally artificial manner, giving the appearance of financial health and success in the marketplace. Frequently, it also personally benefits the corporate executives who authorise it as they are paid partly in stock options. In fact the corporate sector has been the main buyer of US equities since the market meltdown of 2008, engaging in what has been described as ‘the greatest debt-funded buyback spree in history’. It was estimated that in 2017 the largest US companies would spend a record $780 billion on share buy backs, though, in reality, the forecast bonanza has apparently hit a snag.

Or possibly corporate debt takes the form of shareholder loans, the practice by which one company deliberately loads another company that they own (they are the main shareholders) with huge amounts of debt which the captive company is then obliged to pay back at high rates of interest; 15 or 20% for example. The Financial Times recently highlighted the case of Arqiva which owns 9/10ths of the UK’s terrestrial TV transmission networks and, in the three years to June 2016, paid around £750 million in interest to its controlling shareholders, payments financed by borrowing.  It is now £3 billion in debt. And that’s just one company.

Household debt did not cause the 2007-8 Global Financial Crisis

What household debt did was light the touch-paper. The nationwide implosion of the housing market in America after interest rates were raised signalled the demise of all those mortgage backed securities and collateralized debt obligations but the reason it proved so devastating for the US economy and spread the crisis around the world was because of the fatal combination of household debt with gargantuan financial sector and corporate debt. The Global Financial Crisis was sparked in August 2007 (‘the day the world changed’) when French bank BNP Paribas froze its funds because of its exposure to the mortgage backed securities of the US sub-prime market. The problem wasn’t defaulting French mortgage-holders but the effects were being felt by a French bank. BNP was one of three major French banks who were collectively overleveraged to the tune of 237% of French GDP. That level of indebtedness caused the crisis to spread to Europe as hugely indebted, and now effectively insolvent, European banks called in the loans they had made to southern European governments.

Nobody can say with any assurance what the trigger will be for the next financial crisis. It might be heavily indebted US college graduates or UK credit card borrowers or Australian consumers or Dutch mortgage holders (a country which has the most indebted households in the euro area).

But it’s equally possible that the fuse will be lit from another sector of the economy entirely – massively overleveraged corporations being unable to repay their creditors when interest rates rise, for instance. In that case, households will simply be spectators to the unfolding events.

All the focus is on personal debt because it represents a morality play

In Debt: The First 5,000 Years David Graeber points out that in Sanskrit, Aramaic and Hebrew ‘debt’, ‘guilt’ and ‘sin’ are all the same word. In modern German, the word for ‘debt’ – schuld – also means guilt. “If history shows anything,” Graeber writes, “it is that there’s no better way to justify relations founded on violence, to make such relations seem moral, than by reframing them in the language of debt – above all because it immediately makes it seem that it’s the victim who’s doing something wrong.”

The existence of enormous level of personal debt in advanced capitalist countries is a sure sign that the individual freedom these societies claim to uphold is skin deep. In reality, they are founded relations of coercion and control. To be in debt is to have someone’s boot on your neck. In the UK, high rates of personal debt are intimately related to the fact that real wages are 10 per cent lower than a decade ago. Rising personal debt is also strongly correlated to mental health problems like depression and anxiety.

From another perspective, personal debt is the symbol of our fatal addiction to consumerism, the consequence of an all-embracing need to maintain a modern lifestyle, decorated with the latest products, no matter what the cost to ourselves or the environment. Either way, personal debt unmistakably says something about the current state of society – what drives it and who is in control.

Corporate and financial sector debt, by contrast, is not only opaque, it is frightening neutral. Debt has simply become the way of doing business over the last 30 years. Debtors are frequently also creditors and companies may simultaneously indebt themselves and hoard cash. Indeed, increasing ‘leverage’ (to use the technical term) or loading debt onto captive companies (as in the Arqiva case) is often the primary means by which profits are made. No sense of shame or ‘doing something wrong’ attaches to it.

The question that should arise is why the corporate sector – financial and otherwise – has become so addicted to debt? Why is old-fashioned investment in new products or new technologies comparatively shunned?

It is possible to reduce personal debt but corporate debt is far more of an intractable problem

Theoretically it is possible to cut personal debt to more manageable and less dangerous levels.  Ending austerity, strengthening trade unions, instituting rent controls and directing efforts to raising the level of real wages should see the rates of payday loan and credit card debt diminish. I say theoretically because, interestingly, some of the highest quantities of personal debt, as a proportion of GDP, are in Scandinavian countries – nations that have impressive rates of trade union membership, collective bargaining and high personal incomes. However, those in debt in Nordic countries tend to be higher earners. In the US and UK, by contrast, personal debt often afflicts people much lower down the income scale – people who are much more likely to default given a slight change in the economic winds.

Corporate debt is a different matter entirely. The massive government bail outs of 2008 only succeeded in transferring debt from the financial sector to the state and, even then, only denting marginally the indebtedness of the banks. Corporations, whose debt had risen markedly over the previous twenty years, merely took advantage of the lower interest rate environment, to become even more indebted.

The writer and broadcaster Paul Mason says governments have to do something ‘clear and progressive about debts’. He advocates a policy of ‘financial repression’ – that is stimulating inflation and holding interest rates below the rate of inflation for 10 or 15 years as a way of writing off debt. But we can see the problems that a mild rise in the rate of inflation to the historically low level of 3% is currently causing people in the UK, with wages unable to catch up. Deliberately stoking inflation for a decade or more would surely precipitate the household debt defaults that so many people are warning about – inflation would erode the total amount of people’s debt but interest payments would still need to be met as real incomes plummeted. And if interest rates are below inflation – as they are now – the incentive for corporations to take on more debt is still there.

It is difficult to imagine how this system can gradually and progressively resolve its problems without provoking the economic collapse that everyone is so desperate to avoid.

Addendum

It's probably worth re-emphasising that when I speak about corporate debt, I'm not referring to the borrowing a company naturally needs to do to keep going and expand its operations. See - https://www.touchfinancial.co.uk/knowledge-centre/blog/4-reasons-why-successful-businesses-borrow-money

What's happening now is massive borrowing to either appear successful (share buy backs) or invest in debt to make more money. They're nothing to do with how capitalism is meant to function in the textbooks.


 

Financial crisis: Why and what's the reason for?

There’s an old Bob Dylan song called ‘Who killed Davey Moore?’ It’s the tale of a boxer killed by a fatal punch and the song recounts the protests of those involved – the referee, the crowd, the gambler, his manager and his opponent – that they weren’t the ones really responsible for his death. “It wasn’t me that made him fall,” they all cry. “No, you can’t blame me at all.”

That song springs to mind whenever anyone apportions blame for the 2008 financial crisis. There are no shortage of culprits. And given that the world may experience similar economic tremors in the near future, the question of who is to blame is extremely relevant.

Who really did make the system fall?

Culprit # 1 Senior Bankers

Bankers are, unsurprisingly, the most likely suspects. Adjectives like reckless and greedy have clung to banks like leeches since 2008 (which may be an apt analogy). But according to Dutch author Joris Luyendijk, the fatal flaw was not so much greed as wilful incompetence. The recently released movie The Big Short exemplifies, he says, the atmosphere in run-up to 2008. Days in which extremely clever finance geeks took advantage of the fact that senior managers in most banks had no idea what was really going on in their organisations. The impenetrable financial products they devised combined to make them vast fortunes and lay the seeds for financial meltdown.

Luyendijk quotes former UK Chancellor Alastair Darling who laments the fact that top managers in US and UK banks “failed to understand – or even ask – what was making them so much profit and what were the risks.”

He attributes this failure to lack of personal liability. In the days before the Big Bang, financial firms were organised as partnerships, rather than publicly floated corporations which any person, or hedge fund or other company could buy shares in. Partnerships ensured managers kept an unblinking eye on their organisation’s activities, says Luyendijk, because if things went awry they were personally liable for the cost of mistakes. But when partnerships were taken over by publicly floated banks or the investment divisions of major banks began marketing their own financial products, this discipline was lost.

I believe that while deliberate blindness on the part of senior managers was a factor in the financial crisis, it is far from a complete explanation. Firstly, bank executives were not as unaware as Luyendijk or The Big Short suggest. From pooled mortgages, to Libor and Forex fraud, the idea that senior executives were utterly oblivious to the machinations going on beneath them is not credible. When apologies become necessary, incompetence is always preferred to culpability.

In 2004, it was agreed that banks needed to have capital or deposits worth a mere 8% of the risky loans they had on their books. That agreement, known as Basel II, was “largely written by the banks themselves” says Mark Blyth in his book, Austerity: The History of a Dangerous Idea. Banks became massively indebted in the early 21^st century (they still are) and that was a conscious decision on the part of senior managers; a way of securing more profit by increasing the amount of money they loaned out. European banks, especially, became chronically ‘over-leveraged’ and may yet have to be recapitalised ‘on a scale yet unimagined’. To blame all this on unruly traders is way too convenient.

Second, the financial crisis was not just about the risk-laden products, the famous mortgage backed securities, collaterized debt obligations and credit default swaps, that boomeranged on the institutions that devised them. It spread across the world with such devastating effect because other institutions – other banks, companies, governments and NGOs – bought those toxic assets. And they bought them because they seem to embody the irresistible combination of low risk and high yield.

Lastly, risk-taking by banks was not merely an internal transgression. They were subject to pressure, possibly decisive pressure, from outside …

Culprit # 2 Shareholders

“In the run-up to the financial crisis, shareholders failed to control risk-taking in banks,” concluded the UK Parliamentary Commission on Banking Standards, “and indeed were criticising some [directors] for excessive conservatism. Some bank leaderships resisted this pressure, but others did not.”

So it wasn’t just that senior executives in banks failed to control super-intelligent and ambitious underlings who could reel off all the prime numbers up to 100 in 2.5 seconds. As directors of publicly floated companies, they were also under constant pressure to deliver greater and greater profits for the owners, the shareholders. And aware that if they didn’t succeed, they needed to look elsewhere for regular remuneration. In the words of Citigroup chief exec Charles O Prince in 2007, (in an article written by Luyendijk) “as long as the music is playing, you’ve got to get up and dance.”

To whose tune were the senior bank managers dancing? Other banks, primarily. Financial behemoths like Barclays, JP Morgan and Deutsche Bank top a list of 147 multinationals who literally own each other through interlocking shareholding. Other major shareholders include hedge funds, fantastically wealthy individuals and pension funds.

What these owners have in common is a need to maximise yield. According to Paul Mason, economics editor of Channel 4 News, big institutional investors such as pension funds, in their pressing need for higher returns on their investments, have become “crucial drivers of instability”. The signature products of the 2008 crisis, mortgage backed securities and collaterized debt obligations, seemed, before they exploded, low risk. So major shareholders were happy to buy them and to breezily criticise banks for ‘excessive conservatism’.

What lies at the root of this predilection for risk-taking among shareholders is the same weakness that Luyendijk criticises bank executives for – that if things go drastically wrong, they know they won’t be accountable. Just as bank executives are cushioned by a lack of personal liability, so shareholders enjoy the protection of limited liability.

Limited liability means that shareholders can lose only their investment in a company; they are never on the hook for the entirety of its bad debts. It is a right granted by the state. Limited liability first originated in Britain in the 1850s and was opposed in an earlier time by the father of market economics, Adam Smith, because of the dangers he saw in separating ownership and management.

The situation is complicated by the fact that, while shareholders seem very adept at pressurising the managers of the corporations they own to maximise profit without heed to public welfare, they are positively impotent when it comes to reining in harmful behaviour. Senior managers seem able to set their own pay which has mushroomed to 180 times that of the average worker in Britain. When shareholders do revolt over excessive executive pay – as they did at Shell in 2009 - they find that their opinion is merely advisory. In many ways, the senior management of large, shareholder-owned corporations are a law unto themselves.

So some have concluded that protecting the public from the selfishness of corporations requires removing both the limited liability of shareholders and the personal liability of company directors. “The most effective way of curbing predatory practices is to withdraw limited liability and hold the shareholders and directors of these enterprises personally liable,” argues Essex University’s Professor of Accounting, Prem Sikka.

Sikka wants alternatives to the corporate model – mutuals, cooperatives, not for profit and worker owned enterprises – to thrive and be promoted by government. “All are subjected to community pressures and control by employees, savers and consumers,” he says. “They see something beyond making a fast buck.”

The trouble is, during the crisis of 2008/9, the eyesight of these supposedly alternative enterprises seemed as myopic as anyone else’s.

Culprit # 3 the global market

The list of mutuals in Britain felled by the financial crisis is embarrassingly long. The Dunfermline Building Society, the Scarborough Building Society, the Chesham Building Society, the Derbyshire Building Society and the Cheshire Building Society all either collapsed or had to be bought by other financial institutions. In the case of the Dunfermline, the Bank of England bailed it out and ran it for a time.

Building societies don’t have shareholders. They are owned by, and in theory accountable to, their members – people who have mortgages or savings with them. But, though they didn’t create the banks’ financial ‘weapons of mass destruction’, they were just as reckless with the way they lent money.

In May last year, regulator Andrew Bailey, the chief executive of the Prudential Regulation Authority, warned building societies that they must not return to the ‘fatal’, high risk lending that helped trigger the financial crisis. He cited evidence that building societies were resuming the pre-crisis practice of making loans many times larger than their customers’ income and property.

These failings are not limited to Britain. In 2009 two of Germany’s famous state-owned Landesbanken, were forced to merge after they had borrowed too much capital and invested it in toxic US sub-prime mortgage assets. Four others had to be bailed out by state governments in Germany to the tune of millions of euros.

In Spain, savings banks, known as cajas de ahorros, are owned by non-profit foundations and dedicated to charitable activities as well as savings and mortgages. But they were at the heart of the implosion of Spain’s housing bubble. Of 45 cajas in existence at the start of the crisis in 2007, only two survived. The rest collapsed and had to be taken over by banks or the government. The effects have been catastrophic. Hundreds of Spaniards have been evicted every single day and the unemployment rate has reached a staggering 25%.

The financial crisis may have been hatched in corporate-land but it unfolded like a virus throughout the world because of markets. And allegedly alternative enterprises were as starry-eyed about these markets as anybody else.

Why then did alternative enterprises, which presented themselves as different to soulless, money-grubbing corporations, turn out to be not so different after all? Partly, because of a lack of real accountability. Though they were accountable in theory, they weren’t in practice. German Landesbanken had advisory boards that were meant to keep senior management in check but merely rubber-stamped their activities. In Britain, the Cooperative Bank’s woes can be attributed to the fact that its elected board didn’t have the knowledge or confidence to challenge the ‘incredibly optimistic’ assumptions of the management team. In this sense, the corporate and mutual sectors suffer from a similar affliction – out of control senior executives.

We don’t live in democratic societies. People don’t have the knowledge, time or inclination to hold the powerful to account. Without a conscious change in that level of knowledge and intention, mechanisms of accountability will remain empty shells.

But perhaps the problem is deeper still. The Marxist economist Andrew Kliman argues it is foolhardy, in a capitalist economy, to expect nationalised or worker controlled banks to behave differently to their corporate equivalents. “In order to survive, a state-run (or worker-run) bank must pursue the goal of profit maximisation, just like every other bank,” he says. “As long as there is capital, what are actually in control are the economic laws of capitalism.”

Those economic laws of capitalism mandated that building societies and other mutuals compete with major banks for market share and profitability. And doubtless many members, at the time, agreed with these aims. Governments in Britain have since the 1980s relied on rising house prices to ensure re-election. When that measure goes into reverse, as it did for the Conservatives in the early ‘90s, they watch as erstwhile supporters desert them in droves. Pensions funds are a ‘crucial driver of instability’, yet many millions rely on them to deliver high investment returns to fund their pensions.

This is not to descend into the ethical void and assume that everyone is equally guilty. Some people are infinitely more culpable than others. A tiny elite get to set their own pay. A tiny elite have been bailed-out by government and their wealth rescued by state action. A tiny elite get to make – and rig – the rules of the game. But, as in Dylan’s Davey Moore parable, it is the rules of the game that need altering. The blame game confers only an ephemeral pleasure. A bit like shopping.

So this is a private debt crisis after all

 The return of the Greek crisis and its revelations

They want you to believe it’s all about public debt. Reckless spending by governments has caused a ballooning of debt, which can only be addressed, painful though it is, by years of austerity, and the drive to be more ‘competitive’. So the mainstream debate is confined to arguing whether national debt and deficits are being shrunk sufficiently. And if it turns out they aren’t, the logical conclusion is that austerity is not being applied with enough vigour. The condensed version of this argument is ‘this doesn’t work, so let’s have more of it’.

But the return of the Greek debt crisis has punctured a giant hole in this masochistic ideological construct. Because, contrary to the official narrative, Greece wasn’t bailed out at all; its creditors were.  Analysis reveals that around 89% of the bailout money has gone to creditors:

This is masked by the fact that, as a result of the 2012 restructure, Greek debt was transferred from the private sector to the EU/IMF/ECB Troika. So the debt crisis can now be presented as a generous bail-out by prudent, efficient Northern European countries to profligate, lazy Southern Europeans. This picture, eagerly lapped up by the mainstream media, such as the BBC, conspicuously omits the most important players.

So, in the interests of accuracy, they should be reinstated. Europe has followed the path trodden by the US, in that the private debt of highly leveraged (in plain language indebted), financial institutions has been transformed into the public debt of states. With the caveat that the indebtedness of European banks - and that includes the UK - is actually much higher. According to Mark Blyth, author of Austerity: The History of a Dangerous Idea, in 2008 the combined assets of the top six US banks came to 61% of US GDP. That’s about 10% of GDP per bank. When they fail you have a huge problem.

But in Europe, the situation was way more extreme. “In the same year,” he writes, “the top three French banks had a combined asset footprint of 316% of French GDP. “The top two German banks had assets equal to 114% of German GDP. In 2011, these figures were 245% and 117% respectively. Deutsche Bank alone had an asset footprint of over 80% of German GDP and runs an operational leverage of around 40 to 1. This means a mere 3% turn against its assets impairs its whole balance sheet and potentially imperils the German sovereign. One Dutch bank, ING, has an asset footprint that is 211% of its sovereign’s GDP … The top four UK banks have a combined asset footprint of 394% of UK GDP”.

If you’re seeking an example of profligacy and rash borrowing, here it is. And it’s not Greek coloured.

What happened, in a nutshell, was that these supposedly more conservative European banks borrowed like crazy to profit from the government debt of countries such as Greece, Spain and Portugal. Chronically overleveraged, when their investments in US mortgage-backed securities turned ugly in 2008, they swiftly became insolvent. In the words of Stephanie Kretz, private banking investment strategist with Swiss bank Lombard Odier, in 2012, “Germany, by lending money to the peripheral countries, is trying to prevent its fragile and leveraged banks from getting hit, effectively orchestrating a back-door recapitalisation of its own banking system.”

The result has been what I have described as a peculiarly one-eyed version of austerity. The penance of paying back debt is only applied to states, and states that have become indebted as a direct consequence of taking on private sector debt. Banks are not permitted to fail, or take responsibility for their bad debts. In contrast to the liquidationism of 1930s’ austerity, in which the insolvent firms were allowed to go to the wall, we have now the mirror opposite:  preservationism. None of the rottenness has been purged from the system, as early 1930s US Treasury secretary Andrew Mellon, advocated. Instead, it has become someone else’s problem. Namely, ours.

The official attitude towards state and private debt diverges wildly. The EU’s newly minted fiscal compact requires that the government’s deficit not exceed 3% of GDP.  Basel III, meanwhile, the rules governing banks’ capital reserve requirements, rewritten after the financial crisis because Basel II was retrospectively considered too lax, insists on a leverage ratio of 33:1. Lehman Brothers, whose collapse triggered the financial crisis, had a leverage ratio of 31:1. One law for public debt, quite another if it happens to be private.

It has fallen to faint and isolated voices to point out the real story of what happened; how the nationalisation of private debt led to huge problems for public finances. “A crisis of private finance, emerging in the financial system itself, was not ended but transformed into a burden for public finance,” says James Meadway, senior economist with the New Economics Foundation, “and through austerity, the immense cost of the transformation is now imposing itself on society.”

But the underlying problem is not solved by pointing out the evasiveness of the official account. However well-camouflaged, the crisis of private finance has clearly not been ended. The transformation of austerity, in this sense, hasn’t worked. It hasn’t erased private debts. “After the 2008 financial crisis and the longest and deepest global recession since World War II, it was widely expected that the world’s economies would deleverage,” says a February 2015 report by the consultants McKinsey. “It has not happened. Instead, debt continues to grow in nearly all countries, in both absolute terms and relative to GDP.” In Britain, total debt (of which government debt is a relatively small part) was 484% of GDP at the end of 2013, down from 507% in 2011, but still way above the 310% level it stood at in 2000.

The question is, does it matter? Austerity-mongers like George Osborne obsess endlessly about the evils of public debt, even as it continually rises, whilst managing not to mention private debt at all. If you reverse that attitude, do you not become an equally warped private sector austerian? However, there are sound reasons why private debt is a genuinely pressing issue. For a start it’s much larger than public debt. Secondly, many economists believe that beyond a certain level, which we’ve certainly exceeded, private debt makes a new financial crisis all but inevitable. Thirdly, it constrains economic growth and causes stagnating or declining real wages; problems that only exacerbate the original problem. Lastly, even without the assistance of austerity, private debt causes public debt to rise.

It is said that the overhang of private debt will cause a Japanese style ‘lost decade’, in which economic growth remains low, people are starved of economic opportunities and real wages fall. But, in truth, Japan, the most privately indebted country on earth, has suffered a ‘lost two decades’, and the Japanese government’s recent return to massive Quantitative Easing in an attempt to stimulate the economy indicates that, a quarter of a century on, the so-called lost decade is still not over.

One country, famously, did let its banks take responsibility for their bad debts and collapse. In 2008, Iceland decided to let its three biggest banks, with combined assets ten times the country’s GDP, fail. It is now thriving, advocates say. But the banks in question had almost exclusively “off border” debt, and Iceland’s domestic banking largely went on uninterrupted. In the monetary union of the Eurozone, bank debt is decidedly domestic, and much larger. Moreover, it is not just financial institutions who are indebted. Non-financial corporations, which pioneered the process of ‘disintermediation’ – lending between themselves and bypassing the banks, are also hugely indebted. Consumers may have paid down some of their debts in the aftermath of the financial crisis, but they are now rising again.

Recognising that austerity is, in the words of Mark Blyth, ‘the greatest bait and switch operation in modern history’, does not change the fact that we have an economy that exists on private debt. Writing down that debt will not be a painless process. Indeed it could cause a deep depression. But not dealing with the problem is far from painless either, and the pain that results seems to have no end in sight.