Leverage, Liquidity, And The Economy

It seems to me…

The Great Depression, like most other periods of severe unemployment, was produced by government mismanagement rather than by any inherent instability of the private economy.”  ~ Milton Friedman.

I am not an economist but it is obvious that a variety of factors led to the 2009 financial collapse; one of these was excessive leveraging[i].  Leverage basically is the increase in debt relative to assets or income.  Substantial increases in leverage eventually lead to economic instability and, if not corrected, to financial and economic collapse.

Collapse of the housing market resulted in increased borrowing restriction not only making it more difficult to borrow but also forcing debtors to “pay down” existing debts.  Creditors encouraged debt increases in an expanding economy as it came with little risk: home values increase, prices of stock bought on margin went up, business sales expanded.  Homebuyers that purchased their home with no money down and an interest-only mortgage were highly leveraged as was a business having a high percentage of its cash flow going to debt payment.  Both had increased difficulty during the financial downturn and when a sufficient number of debtors attempted to de-leverage by liquidating assets at the same time, it lead to a self-reinforcing downward spiral of debt deflation – decreased purchasing and corresponding reductions in production and employment.

Following the economic collapse, those low expenditures by consumers, businesses, governments, etc. were the primary cause of unemployment and low economic output.  Home construction and consumer product sales decreased substantially.  State and local government revenue decreases resulted in correspondingly reduced expenditures.  Business investment likewise decreased due to reduced sales.  Insufficient spending results in increased unemployment since businesses will not produce what cannot be sold and will not hire workers not needed for production[ii].  The U.S. economy currently still has a residual problem of inadequate demand.

U.S. growth rates following each of recent economic declines have progressively slowed, recoveries have been jobless, and median wages have declined[iii] for more than a decade.  The information revolution and globalization have negatively impacted high-wage countries such as the United States.  These new forces are accelerating, and without a strategy to revive growth, all of our problems get worse, especially long-term debt.  While the focus has been on taxes and deficit reduction, it should be on reforming and investing.

The best method of reviving growth is a combination of structural reforms, to increase economic competitiveness, and investments in human and physical capital, to ensure next generation growth.  Government austerity while the economy remains caught in a liquidity trap is counterproductive as any fiscal savings will be at the expense of reduced output and higher unemployment.  Fiscal savings are likely to be small and maybe even nonexistent: lower output and employment reduces revenues, and may inflict long-run economic damage that actually worsens the long-run fiscal position.

Rather than having negative impacts on growth, rising government debt while in a liquidity trap can be beneficial if used appropriately.  Spending cuts when an economy is in a liquidity trap, regardless of whether those reductions are in the public or private sector, increase unemployment whereas spending cuts in an economy not at that zero bound do not.

Inadequate liquidity, regardless of the cause, can result in recession but frequently can be resolved by an increase in the money supply.  This is only productive up to some point – exclusively expansionary monetary policies are counterproductive.

Federal monetary expansion while in a liquidity trap never can cause inflation as long as liquidity remains a problem since even if interest rates are set at 0 percent, they still are unlikely to restore full employment.

That’s what I think, what about you?

[i] The collapse and its primary cause was predicted by Hyman Minsky based on his “financial instability hypothesis”.  He was said to have predicted nine of the past three financial crisis.

[ii] Krugman, Paul.  End This Depression Now!, W.W. Norton & Company, Inc., New York, 2012, pp24-25.

[iii] Zakaria, Fareed.  What’s Missing From The Cliff Debate: Growth, http://fareedzakaria.com/2013/01/03/whats-missing-from-the-cliff-debate-growth/, 3 January 2013.


About lewbornmann

Lewis J. Bornmann has his doctorate in Computer Science. He became a volunteer for the American Red Cross following his retirement from teaching Computer Science, Mathematics, and Information Systems, at Mesa State College in Grand Junction, CO. He previously was on the staff at the University of Wisconsin-Madison campus, Stanford University, and several other universities. Dr. Bornmann has provided emergency assistance in areas devastated by hurricanes, floods, and wildfires. He has responded to emergencies on local Disaster Action Teams (DAT), assisted with Services to Armed Forces (SAF), and taught Disaster Services classes and Health & Safety classes. He and his wife, Barb, are certified operators of the American Red Cross Emergency Communications Response Vehicle (ECRV), a self-contained unit capable of providing satellite-based communications and technology-related assistance at disaster sites. He served on the governing board of a large international professional organization (ACM), was chair of a committee overseeing several hundred worldwide volunteer chapters, helped organize large international conferences, served on numerous technical committees, and presented technical papers at numerous symposiums and conferences. He has numerous Who’s Who citations for his technical and professional contributions and many years of management experience with major corporations including General Electric, Boeing, and as an independent contractor. He was a principal contributor on numerous large technology-related development projects, including having written the Systems Concepts for NASA’s largest supercomputing system at the Ames Research Center in Silicon Valley. With over 40 years of experience in scientific and commercial computer systems management and development, he worked on a wide variety of computer-related systems from small single embedded microprocessor based applications to some of the largest distributed heterogeneous supercomputing systems ever planned.
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6 Responses to Leverage, Liquidity, And The Economy

  1. auntyuta says:

    I am not sure whether I do correctly understand the meaning of what Milton Friedman says. What does he mean by ‘government mismanagement?
    “Homebuyers that purchased their home with no money down and an interest-only mortgage were highly leveraged as was a business having a high percentage of its cash flow going to debt payment.” You’re right in pointing out what government should do now to stimulate the economy.
    But couldn’t this have been prevented what led to this crisis? Is perhaps government to blame that the banks weren’t regulated more? Has government the power to regulate?

    • lewbornmann says:

      Government seems incapable of making the right decisions. Instead of doing what might be best to improve the economy, politicians attempt to impose ideological solutions — for the U.S., this is elimination of welfare. John Maynard Keynes said “But to-day we have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand. The result is that our possibilities of wealth may run to waste for a time—perhaps for a long time.” (The Great Slump of 1930.

      Much could have been done to avoid the recession but it is necessary to go back and look at the history of how we got to where it was possible.

      J.P. Morgan was instrumental in preventing federal bankruptcy during the financial panic of 1907 when banks were unable to respond to meet depositor’s demands for withdrawals. Realization that a better method of advancing funds to banks if/when a panic arose let to the creation of the Federal Reserve. When this also was proven inadequate, Congress passed the Glass-Steagall Act of 1933 intended to prevent the type of stock speculation that resulted in the crash of 1929 by limiting the amount of risk banks could take. The act also created the Federal Deposit Insurance Corporation (FDIC) guaranteeing depositors against loss in the event of a bank failure.

      Prior to the 1980s, traditional banks were relatively safe – but conservative.
      The importance of regulation apparently was forgotten and financial deregulation was enacted under presidents Carter, Reagan, and Clinton. Glass-Steagall was repealed in 1999 and banks were permitted to merge previously separate commercial and investment divisions and deal in new financial products such as money market funds, asset-backed securities, collateral loan obligations, and credit default swaps in what is known as “shadow banking”.

      Deregulation of the banking industry resulted in the opposite of its original intent. While deregulation was predicted to foster economic growth, median incomes actually experienced slower growth; the top 1 percent of incomes, however, increased significantly leading to the wage disparity protested by the Occupy Wall Street movement. Deregulation allowed not only increased competition and freedom but corresponding risk. Availability of alternative sources of capital from the shadow banking system tended to erode traditional bank profit margins.

      We should have learned from the recent monetary crisis that a lack of financial institution oversight eventually results in financial mismanagement. While the Dodd-Frank reforms passed in July 2011 were intended to correct some of the problems that led to the crisis, banking interest lobbyists have succeeded in weakening most of its intended provisions. What is needed is re-enactment of the Glass-Steagall banking laws repealed in 1999. Unfortunately, banks have become both too big to manage but also too big to allow to fail.

      Yes, in answer to your question — the government not only has the power to regulate, it has the obligation. Realistically, I have little confidence in either the possibility of an additional stimulus or financial reform.

      • auntyuta says:

        “Realistically, I have little confidence in either the possibility of an additional stimulus or financial reform.”
        In a democracy, why can’t people vote for it if this is what they want?
        Is it possible that people do not want this reform that would help the economy?
        And if so, why don’t they want this change?

      • lewbornmann says:

        Voter mandated reform is difficult for a number of reasons. The most obvious is voter apathy. Only about 19 percent of eligible voters in Los Angeles turned out last Tuesday (21 June 2013) to cast ballots for a new mayor as well as other city posts. 42 percent of young people, unmarried women, and people of color who make up more than half of the U.S.’s voting population are not even registered to vote. Unfortunately, given such low turnout, special interest groups are able to disproportionately influence election results.

        Voters also respond to an issue or candidate able to solicited the most contributions rather than researching which choice would be most beneficial. The election in Wisconsin on 5 June 2012 demonstrated results of the 2010 U.S. Supreme Court ruling in Citizens United vs. Federal Election Commission that restrictions on corporate funding of independent political support organizations in candidate elections violates the rights of these entities to free speech and cannot be limited. To combat the attempted recall of Wisconsin Governor Scott Walker, record amounts of conservative-based donations in support of the governor flooded into his campaign primarily from out-of-state contributors.

        I’ll try to expand further on this issue shortly…

  2. auntyuta says:

    When widespread apathy exists democracy doesn’t really work properly, does it?

    • lewbornmann says:

      The quote “In a democracy, people get the government they deserve” is often mistakenly attributed to Alexis de Toqueville but more likely originally made by Joseph de Maistre in 1811. Though cynical, we probably can conclude that, yes, democracy does work properly — just not the way we necessarily would prefer.

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