© Robert Ayres
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I think it is accurate to say that none of the countries, which really suffered from a financial collapse, have seen their debt reduced even by austerity. In fact, the debts normally just get worse, because unemployment reduces government revenues and we see this everywhere. Paul Krugman, who is a Nobel Prize winning economist, and also a columnist for the New York Times, commented recently on this. He has been looking for any example of a country, which has prospered as a result of austerity. It appears that there is none, not even Estonia. Obviously, if austerity does not work, then the only possibility is the opposite: mainly, incentives to the economy, either by encouraging consumer spending or investment. What we see now is that central banks basically just cut interest rates. The idea behind that is that it will increase both spending and investment, and thus trigger renewed economic growth. If spending increases there will be more employment, which leads to more tax revenues and a chance of reducing the debt. However, I do not think that any country has succeeded in reducing its debt in recent years. However there are some past examples: after the Second World War the U.S. federal debt was 100% of GDP but 25 years later the US federal debt was down to only 25% of GDP. That is one case where rapid growth did reduce the debt.
The other part of the question concerns current alternatives. In brief, I argue that spending incentives need to be targeted toward energy efficiency and renewables. That would address problems that need to be addressed in the coming decades anyway—thanks to climate change and "peak oil". Before you ask, I must say that the recent excitement about shale gas (and oil) is greatly over-blown. That is one of those things I talk about in my book.
You also claim that "the financial system is inherently unstable". With all the misregulations, blowing asset bubbles, and short-sighted policies, will the global financial system be able to withstand the tumults coming from different parts of the world? Or is it on the edge of collapse, and thus the creation of a new more advanced and sophisticated system?
I think the observation that the financial system is unstable is not very new. It goes back at least to Joseph Schumpeter, the Austrian economist, who spoke about it in late 1920s even before the Great Crash of 1929. The instability arises from the lack of an effective automatic mechanism for matching money supply with credit demand. In recent years banks have discovered that they can create demand by increasing credit exogenously – sort of "supply creates its own demand" – but the demand for cheap credit turns out to be for risky financial gambles. After the "Dot-com" bubble of 1998-2000 the U.S. Federal Reserve cut interest rates from over 6% to around 2%. This greatly increased demand for home mortgages, and set off the housing bubble. As house prices went up, speculators borrowed money in expectation of buying a house and then selling it later at a profit. It was the large amount of cheap money made available by the banks that created the bubble. Of course, like in any bubble, sooner or later it burst, leading to financial collapse. Thus, the fact that the money is not like goods seems to make a big difference and I think historical evidence agrees that the financial market is not inherently stable.
You ask: Is there a way of surviving against all of the turmoil and problems that are arising from different directions? Since the financial system is not inherently stable, and it does not necessarily fix its own problems. It needs to be managed and regulated. The metaphor I would use to explain this is that the manager (i.e. the Minister of Finance or the Head of the Central Bank) is a bit like a bicycle rider. He has to lean one way or another, to make a turn; and if he stops, he is likely to fall. It is a situation where the motion is necessary to keep in control. However, let's suppose the bicycle rider is riding down the mountain and the turns are very frequent and the wind is blowing in different directions. Thus, it is very difficult to control that bicycle without crashing. That is what we are seeing in the financial system. It needs to be managed very actively by people who have lots of tools, information, and regulatory power to compensate for external forces – including market forces. So far we do not see enough of that. We see that the bankers themselves are still trying too hard to prevent effective regulation.
I do not think the financial system has to be radically new. I may be wrong, but I believe that the current system can be fixed. However, there is not a single simple solution; it is a very complicated adjustment with a number of different changes or "tweaks" that need to be made. One part of the fix is in the national – or European -- regulatory system itself. For instance, the so-called "Volker rule" about banks trading for themselves needs to be enforced. Conflict of interest needs to be prosecuted and punished much more rigorously. The rating agencies need to be completely dis-connected from the banks. They were working for banks. In fact, it would be better if the buyers of bonds paid for the ratings than the sellers (i.e. the investment banks). I think that in the future the rating agencies have to be independent. They cannot be owned by other businesses as they are now. In the case of Europe, I think that the European Parliament has already tried to start some process to create an independent agency, and I think that needs to happen, but of course banks will resist. Another problem is the risk-evaluation system created by the Bank for International Settlements (BIS) in Basel. The BIS s aims at determining by fiat which assets are more or less risky and which can be used by banks for the base capital, which is what determines the amount of lending (i.e. credit creation) they can do. At one time sovereign bonds were regarded by the BIS as risk free, but that is no longer the case. Now they say that bonds of government sponsored organisations are ipso facto more risky than sovereign bonds, but less risky than loans to businesses.
The economic problem today is slow recovery. This is primarily due to the fact that banks are not making loans to small businesses. They are much more willing to make loans to hedge funds or private equity firms that are basically gambling. What those funds are doing is buying and selling companies after a cosmetic "financial engineering" that is more likely to cost jobs than to create jobs. Another problem is the "mark-to-market" rule of evaluating bank assets. If there is no market or no liquidity in the market for an unfamiliar security, such as a CDO or a package of derivatives - once the default rate starts to rise - it is not possible to attach a real value to those CDOs or packages of derivatives. Therefore, with the mark-to-market rule in place, those assets cannot be counted as part of the banks' primary capital. I think bankers must be allowed a little more discretion in how such assets are evaluated, when there is no active market.
In short, I think that the financial system is repairable, but it can take quite a lot of new and open minded thinking.