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Preview of The Greatest Crash, by David Kauders

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All round the world, many governments are in serious financial trouble. Many of them don’t really understand why and have little idea what to do about it. Should governments try to reduce their annual deficits faster … or more slowly? (Of course, few governments can hope to reduce their national debts for several years, unless they default.) Does the UK government’s approach make more sense than the US government’s? Surely they can’t both be right?

It is perhaps too easy for armchair critics in the United Kingdom to take comfort in our decision not to join the Euro-zone. It is true that our exchange rate is not ‘fixed’ in the same way, but the British government’s essential problem is not so very different from that of the governments of Greece, Ireland and Portugal.

Adam Smith said ‘There’s a deal of ruin in a nation’, and it would be a mistake to despair. But one of the things we need now is new thinking on the fundamentals. That is what David Kauders provides in his book ‘The Greatest Crash.’ Most readers will learn a good deal from his provocative insights, even though few may agree with everything he writes. Warmly recommended.

Professor D. R. Myddelton,

Chairman of the Institute of Economic Affairs



Many human interest stories about the credit crunch have already appeared. Politicians have lined up their scapegoats, journalists have offered their opinions, economists have questioned their theories. There has been a substantial debate between those who believe austerity is now needed and those who argue for continued economic stimulus. This is the heart of the problem, since I believe both camps mean well but represent two sides of the same problem, namely a roadblock in the global financial system. Like a speed governor in a lorry engine, or a road junction that has no more traffic capacity, this system limit prevents further financial growth.

In researching this book, I found five previous books particularly useful in aiding my understanding of aspects of the change in the financial system. There are many others, but the reader who wishes to learn more should consult:

  1. Fantasy Island, by Elliott and Atkinson which exposed Britains enormous debt problem.

  2. The Black Swan, by Nassim Nicholas Taleb and Lecturing Birds on Flying, by Pablo Triana, which need to be read together. They debunk the statistical assumptions underlying derivatives trading. In doing so, they show the limits of much financial theory.

  3. Verdict on the Crash, by a panel at the Institute of Economic Affairs, which identified the responsibility of governments in precipitating the crisis by creating asset bubbles. The contributors argue that more regulation is of little relevance.

  4. Fools Gold, by Gillian Tett, which records almost the entire history of how credit derivatives developed, showing how increasingly absurd assumptions were made about what derivatives could achieve, how they worked and the risks involved. Tett describes the devastating consequences of the entire episode as “a terrible, damning indictment of how twenty-first-century West-ern society works.”

The ideas I develop in The Greatest Crash are unconventional. However, I hope to alert those willing to think broadly about the direction taken by global policy and start a debate about more useful alternatives to austerity versus stimulus. Above all, though, I hope to make the subject intelligible to everyone.

The need to challenge the status quo and develop a new conceptual framework underlies this book. To show why a new framework is needed, I ask you to consider the explanations that appear from official sources:

1. Bankers bonuses are too high, encouraging banks to take bigger and bigger risks, thus endangering the financial system. Bonuses are asymmetrical, allowing banks to declare profits and pay bonuses in the good times, but leaving society at large to pick up the pieces in the bad times.

2. Chinas trade with the West has generated imbalances.

3. The Economist published an extensive analysis of what had gone wrong in summer 2009, and argued that finance and economics professionals needed to understand one another better.

Now contrast these with my main arguments:

1. The financial system cannot be expanded indefinitely.

2. Peoples financial behaviour has changed, and the change is irreversible, since borrowing is no longer desirable.

3. Economic relationships have changed and no longer follow the textbooks (see chapter 7).

4. Under pressure for regulatory conformity, society is losing the capability to adapt and learn.

5. Divided into compartments and overwhelmed with technical detail, few can now see the broad issues.

6. Many courses of action recommended by experts bring undesirable consequences.

I hope to elucidate the contrast and, in the final chapter, set out some ideas for the future.

Although most of my detailed examples refer to Britain, the points I make apply globally. Indeed, some of the problems that I highlight are global as a result of technical co-ordination through European and international standards and accepted practices.

As always with a work such as this, many others have contributed both directly and indirectly. I should particularly like to thank Sue Merron for the extensive help she has given me with the source material, challenging my arguments then knocking my erratic writing into shape. David Myddelton gave me considerable advice and encouraged the entire project. Frank Fishwick corrected my economics, George Hall commented on accounting practice and Elaine Turtle reviewed my opinions on pensions. Any remaining errors are entirely my own.

David Kauders

(a founder member of Kauders Portfolio Management AG)

Zug, Switzerland

October 2011


1 The roadblock preventing growth

The concept of a financial system limit

This book argues that it is impossible to expand the financial system much further. The financial system depends on debt and credit, which are equal and opposite. Borrowers acquire debt, financed by savers and intermediated through banks. In order to expand the financial system and therefore the global economy, it is necessary to find more borrowers, or for existing borrowers to borrow more, or a combination of the two.

For the moment I wish to put governments on one side and consider the private sector, from where all growth comes. The private sector consists of households, businesses and voluntary bodies. For this analysis, voluntary bodies are a subset of businesses, some with business-like activities, others with social purposes.

Households can barely afford their existing debts, let alone take on more. Since households now prefer not to borrow, indeed some even choose to pay back debt, it follows that those who have already borrowed, as a group, can no longer contribute to economic expansion.

People can be divided into borrowers and savers. With existing borrowers unable to afford or unwilling to take on extra debt, can new borrowers be found instead? Those who do not need to borrow are unlikely to volunteer. Except for the young wishing to buy houses, facing the reality that house prices are beyond their pockets, where are the new borrowers?

Businesses are also under pressure. There has been an inadequate recovery from recession, business prospects are poor as house-holds cut back their spending. Lack of bank lending is a symptom rather than a cause, for if existing businesses were to be given more credit, they would probably be unlikely to find profitable growth opportunities in a world of austerity.

Will enough new businesses emerge, financed by debt, to fill the void caused by lack of personal borrowers? No doubt there will be some, but the scale of their emergence and growth is likely to be inadequate. On the other side of the equation, existing businesses are failing with unpaid debts, causing banks to face losses and thereby cutting the availability of new credit.

This is the financial system limit: lack of new borrowing plus excessive weight of debt obligations from past borrowing combine to slow economies down. This is a barrier whichever way policy makers turn. It is like the lid on a boiling kettle. Enough steam can lift it for a while but it always snaps back into place. The financial system limit is a roadblock preventing growth.

Academics have already noted the limits to debt growth, yet governments prefer to continually expand credit in the belief that it is a useful economic policy. This either causes short-term retail price inflation or asset price inflation. Any retail price inflation resulting from credit expansion is transient, fading away in a year or two. Asset price inflation lasts longer but also fades when the next crisis appears. Each economic stimulus is larger, costs more and has progressively less effect. The bill falls due, usually with each recession.

The cost of debt service eventually becomes the tail that wags the dog. As fewer people can afford to pay interest, demand for new loans falls and banks become choosier to whom they lend: supply also falls. As lending shrinks, economic activity stagnates, unem-ployment rises and the existing stock of debt becomes harder to service. Japan, Greece, Ireland and Portugal are in this trap, Britain is heading into it. I contend that the stagnation since the summer of 2007 arises directly from the impossibility of expanding the supply of credit any further.

It is likely that lost employment following this credit crunch will persist for years and therefore cause a worse rise in household arrears and repossessions (that is, defaults in the private sector) than has been known previously. Bad debts are already rising, unemployment is high, part-time work is replacing full-time work and therefore the capacity of households to service their existing debt will shrink.

Taxpayers cannot afford to reimburse unlimited losses, which constrains the extent to which governments can continue to provide bailouts. Both the Tea Party movement in the United States of America and German resistance to supporting the weaker Eurozone countries demonstrate this political limit, which I will expand on in chapter 5.

While the system limit I have identified is fundamental, systems thinking is also lacking. Systems thinking is the broad discipline of how things fit together and interrelate, as opposed to the narrow detail of measuring and controlling individual components of any activity. Systems thinking recognises that every system is part of a larger system, and therefore boundary assumptions merely serve to obscure the bigger picture. Systems thinking also recognises that classification schemes are arbitrary and serve to suppress characteristics that might give us insight into change. Such broad analysis could reduce the law of unintended consequences, which arises whenever policy makers act without understanding the interrelationships between different elements in society.

One of my themes is that it is no longer possible to have your cake and eat it while paying nothing for it. The era of the Internet has brought price comparison shopping, while the era of the discounter has brought cheap no-frills services. Airline tickets, consumer goods of all types, intangibles such as insurance, even books, have all seen price deflation as discounting has spread. In parallel, service standards have declined. Local business units have been replaced by uniform call centres. These are character-istics of a world that has lived beyond its means.

Pay-up time reverses the ‘something for nothing’ culture. As the economy stagnates, so those businesses that have cut corners to sell at marginal cost disappear. In consumer shopping, the cheapest price may be bad news, since it raises the chance of a business collapse that will deny ongoing service. This is the broad background now unfolding as the greatest crash proceeds.

Businesses choose between volume at a low margin, or quality at a higher margin; between going for growth, ignoring quality, or building a business steadily, maintaining quality. These are normal choices for businesses to make. As a business, Britain went overboard for volume and growth in the period from the mid-1990s through to the bursting of the bubble in 2007. Bankers mortgaged the future by lending money unwisely, declaring profits without consideration of the losses that would inevitably follow, all in accordance with accounting standards. Few have the financial resilience to cope with a financial crisis. Governments are in much the same state as many households and businesses. Bust.

A world riddled with contradictions

Policy contradictions also show us that the financial system has reached a roadblock. The glaring conflict between bailout and austerity is at the core. Each bailout or stimulus requires creation of more credit, leading to false financial speculation, and for a short while markets recover their poise. The threat of inflation returns. Later, bad debts rise, the markets tumble again and a new crisis emerges. Austerity, the alternative policy, cuts spending thereby cutting the immediate level of economic activity and bringing economic decline more quickly than the stimulus alternative. Whichever way they turn, the authorities are damned.

The world economy lurches from one crisis to another, driven by waves of artificial credit followed by distress as the costs of extra debt come to light. Governments are so frightened of the financial equivalent of detoxification ‒ deflation ‒ that they return every time to the rescue, never considering the longer term consequence. And as the debt burden grows so the crises come around more frequently, bringing greater destructive power with each success-ive cycle.

As the European debt crisis unfolded early in 2010, The Economist noted a contradiction. Impose austerity to balance the books and countries such as Greece would slide back into recession, yet stimulate any further and debt would become unaffordable.

The system limit explains why contradictions such as this keep appearing. The European debt crisis is but a minor part of the entire policy nettle. Ever since the credit interlude started in the aftermath of the 1987 stock market crash, short-term panaceas have been adopted producing apparent prosperity, while the underlying contradictions have been waiting to be discovered. These underlying contradictions include the inability to balance public services, taxation, borrowing and regulation; and the desire to regulate banks more, thereby restricting their lending further, shrinking the global economy and making it even harder to repay debt.

Bankers have been set up as the fall guys to cover for what I see as a gross failure of political leadership. Nobody was able to see the whole picture thanks to delegated government and a forest of detail that obscured the simple point: it all depended on constant credit creation. A veritable troupe of other actors joined the easy money party:

  • accountants adopted standards that restricted judgment, and regulators demanded conformity with those standards;

  • economists and financial academics invented elaborate models that erroneously assumed financial markets follow the normal distribution;

  • governments imposed increased overheads on the productive economy and measured the rise in overheads as economic growth;

  • the public borrowed way beyond any prudent level in the belief that debt could expand indefinitely at no cost;

  • banks pushed credit out and gambled that it would be repaid.

Speculation was encouraged even when there was no economic purpose. Consider the relationships between investment banks, private equity, derivatives, hedge funds, commodity trading and private finance. What did they all have in common? Speculation ‒ fed by debt based financial engineering. There was little economic substance to many of these investments.

The policy limit

When the world has previously hit a financial limit, new policies have emerged. The gold standard limited trade and deflated economies in the Great Depression; it was abandoned in the post-1945 Bretton Woods formula which adopted fixed exchange rates but limited the freedom of movement of capital. That, in turn, gave way to an era of floating exchange rates, which freed up capital movement.

There is an interaction between exchange rate policy, monetary policy and capital controls. If a country wants to have fixed exchange rates, then it cannot run an independent monetary policy as well as allowing free movement of capital: one of these has to be sacrificed to maintain the exchange rate. Likewise, a country that wants to run an independent monetary policy must choose between fixed exchange rates and free movement of capital, because an independent monetary policy together with free movement of capital will result in fluctuating exchange rates. For the same reason, a country that wants free movement of capital cannot have fixed exchange rates and an independent monetary policy.

Fixed exchange rates, free movement of capital and independent monetary policies are in a three-way contradiction: only two can be satisfied at any time. This contradiction has long been known and understood but the contradictions causing and resulting from the financial system limit and the roadblock are not yet under-stood. However, they are significant.

I need also to scotch some myths.

Lending more to those who cannot pay, in order to buy time, is foolish. If a country cannot afford its debts, how will adding to those debts with more loans make a country more able to pay its way? If a household cannot afford its existing debt, why should it borrow more?

Reverting to capital controls would be effective in stopping deliberate monetary expansion. However, without continued credit expansion, the austerity contradiction would take effect: repaying debt drives economies downhill.

Returning to a gold standard would shrink the supply of credit, thereby severely deflating economies, bringing widespread misery. Going back to the past this way is not possible.

Recycling past policies will be equally ineffective in removing the system limit. It is time for fundamental change.


Praise for The Greatest Crash

 "Radical thinkers might have a point."

Financial Times


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