Jerry Jones explains why he was predicting the financial crisis five years before it hit.
The credit crunch was utterly predictable. I forecast it five years ago in this paper. We have been here before. This time it is going to be worse. The problem, as always, arises from the fact that, left to their own devices, banks are bound to expand credit as far as they dare or rules allow because that is how they make their profit.
As always, politicians ignored history. They were lulled into complacency over the extent to which this process benefits the economy. The economic growth that Britain enjoyed since new Labor came to power until last year depended almost entirely on the easy availability of credit.
It was mainly directed towards property, regarded as the most secure form of collateral for bank lending. Loans secured on property feed back into the rest of the economy because, whether they are spent on housing or other things, they expand overall economic demand. This stimulates investment and employment to meet that demand.
More investment and more jobs further expand economic demand, leading to more investment and so on. The easy availability of credit also pushed up property prices, because bank lending was growing much faster than the supply of housing.
This boost in the value of properties made bank lending and borrowing even more attractive, because it increased the value of collateral that people could put up against loans. This pushed property prices – or, more precisely, the land element of property – higher still, encouraging greater bank lending.
But lending on such a scale cannot be sustainable. A time must come when more and more people and businesses become so involved in repaying their debts plus interest that it is at the expense of spending on other things, causing economic demand to decline. Firms then start to cut back. People start losing their jobs, which further reduces demand, leading to more firms cutting back or being forced out of business. This leads to more people losing their jobs and so on.
Tax receipts are also affected. Governments have less to spend or have to borrow more at the expense of capital being used in other ways. This adds a further twist to the spiral of economic decline. Banks start running out of people with sufficient collateral to put up against loans. This also puts a cap on lending and its positive effect on economic growth.
In recent years, banks have been so desperate to find people to lend to in order to stay ahead of their competitors that they have extended loans to people with little or no collateral and who almost inevitably would have problems repaying such loans. Many people were enticed into borrowing that they could ill afford out of sheer desperation to acquire a home – not least because of the complete collapse of investment in public housing provision which could have provided homes at affordable rents. These are the people who will suffer the most during the coming recession.
Banks were encouraged in their reckless lending by the invention of a whole range of complex financial devices that they believed insured them against defaults. This might have worked for the banks if only a few had been involved. The trouble was that all banks around the world, as well as other financial institutions, were involved. This meant ultimately that they depended on one another to cover defaults. Once they realized this, it was everyone for themselves and they refused to lend to each other. This is what brought the credit crunch to a head.
The inventors of those financial devices and the mathematical wizards who created the computer programs to operate them have long since run off with their vast bonuses, leaving the rest of us to pick up the pieces. The total bonuses received by the top people at the now bankrupt Lehman Brothers amounted to some $8.7 billion in 2006, $2.1 billion more than the losses run up by the bank that rendered it bankrupt.
The history of reckless bank lending is well illustrated by the chart above. The solid line depicts average house price indices since 1952 after discounting inflation. This is a proxy measure for the ebb and flow of bank lending and its impact on the economy. The bigger the peak during the expansionary phase, the further is the fall when bank lending dries up. The current peak is huge compared to the rest.
The dotted line, which extends the graph to 2018, suggests that average house prices might have to fall by some 60 per cent in real terms before they will start to recover, although somewhat less in money terms if there is inflation. The chart also implies that we might have to wait as long as 10 years before the economy starts to grow again, unless governments at last begin to realize the folly of their ways and end their flirtation with the neoliberal policies that led us into this mess.
A further feature of the graph is that there were no peaks or troughs before 1970. This can be explained by the fact that bank lending until then was highly controlled, in accordance with Keynesian-type policies. This was undermined by the mushrooming of offshore tax havens, which allowed banks to bypass credit controls. Instead of reining in these tax havens, governments, under pressure from banks, decided to loosen their controls on bank lending. That is what produced the first peak.
Each of the subsequent peaks followed a further relaxation of credit controls. For instance, the peak in 1989 was the result of new rules that allowed banks to enter the mortgage market and building societies to act like or become banks. The huge peak of 2007 was the result of the belief among banks, which were free almost to decide their own rules, that they could lend with impunity.
The great lesson now is that bank lending must be controlled if it is to sustain steady economic growth and not end in disaster. This applies to any economic system. Finally, it will be observed from the chart that the troughs follow an upward trend as indicated by the broken line. This line represents rising land values due to economic growth, discounting the effects of uncontrolled bank lending.
Rising land values benefit landowners, including those owning the land on which their properties stand. But this is at the expense of the rest of society, because it is society as a whole that generates the economic growth that raises land values, not the landowners. As explained in my pamphlet Land Value – For Public Benefit, a system of land value tax, partially replacing other taxes, would address this inequity. It would also benefit society in other ways.
In particular, it would reduce the cost of acquiring land and property, releasing more money for investment in the economy. In short, the control of bank lending, together with a land value tax, would have prevented those property price bubbles and the havoc that they cause when they collapse.
But now there is the question of what to do about the current mess.