The three-phase crisis cycle

We’re in the third phase of the financial crisis that peaked in 2008. The events of 2007-2009, which are generally called “The Crisis”, were only phase two. The three phases are:

• Phase One: Creation of false assets by private speculators, mostly banks and individuals who play the property market. These assets have a nominal value way in excess of their real earnings potential, and that gap is hidden.
• Phase Two: Transfer of the deficit of those assets to state budgets under emergency conditions. Private insolvency becomes state liability, while the gap between nominal and real wealth remains open and is now visible.
• Phase Three: Closing of the gap by a transfer of real funds from the public to states. This is achieved by means such as austerity, taxation, default, or inflation. These different options hurt or benefit different groups.

We’re in phase three, and the reason we have austerity in most of the West is that austerity is the method capital wants to see used to resolve the gap. Using austerity in this phase serves to consolidate the gains that speculators made in phase one, such that the whole cycle is a net transfer of funds from the general public to the speculators. Austerity is the “hard money” way to finish the cycle.

Using inflation (by printing money), taxation of capital gains, or controlled default would allow the gap to close by eroding rather than consolidating the false gains made in phase one. These options wouldn’t be clean but they would be fairer and less destructive of the real economy. These options are very unfriendly to capital, so they’re mostly absent from politics. The US Fed is using a small amount of inflation, presumably to reduce damage to the real economy, while the fabulously independent European Central Bank insists on a hard Euro and austerity. The ECB is working as intended, since the whole point of an independent central bank is to avoid stealth taxation of capital in situations like this. On the whole, current monetary policy is strongly in favor of wealth and against social cohesion or development.

The whole crisis cycle lasts many years. This one started in the late ’90s and will probably go on to the late ’10s. Furthermore the economy is always in such a crisis cycle. We had similar cycles immediately before, although they were smaller, and we’ll probably have another one starting in the ’20s unless there is reform or other major change. The economy is not in a state of normal development broken by sudden, unpredictable, short crises. Rather, the economy is constantly in a dysfunctional state of crisis in three phases. The period when everything is supposedly going well is phase one, where false assets are created. Phase two is the so-called crisis that seems to take everyone by surprise, and phase three is the bitter time when people are made to pay and the economy is weak.

Although the events of phase two can be quite spectacular, and the economic dislocation that it involves does some damage to the real economy, that phase is not especially destructive. It’s mostly a transfer of nominal debt from banks to states – vast but not directly impactful – and a period of unease because the insolvency of various assets is visible. The real destruction to the economy and society happens in phase three, now, if austerity and hard money policies are pursued. Further, it is arguable that the massive transfer of wealth from the many to the very rich that the whole cycle effects is itself greatly destructive to the prosperity of society. That argument is based on the assumption that a very top-heavy distribution of wealth is likely to result in waste, through further speculation or excessive consumption, rather than in productive, sustainable, or equitable activities.

I think that this three-phase cycle that happens to transfer vast wealth from the public to the very rich isn’t accidental or unknown to the those who benefit. To put it bluntly, I think it’s the result of vested interest. Phase one of the cycle, if it were to keep going, would be an ever-growing bubble. We would call it an investment fraud if any one person or small group were behind it. As it is the bubble is engineered by the whole banking industry and very few bankers are likely to be guilty of something, in each case a technicality. But phase one obviously could not continue indefinitely. At some point the gap between the nominal and the real value of assets would be too great and some assert holder, deserving or otherwise, would be revealed as bankrupt. The innovation, and it is a brilliant one, is to use phases two and three to make a complete, repeatable, cycle of wealth concentration.

That doesn’t require bankers to conspire, but only to meet (openly) and coordinate the implementation of monetary policy in the interests of themselves and financial elites, as they do. The workings of the banking system are boring, but they’re not mysterious. In summary, modern banking is a privately run monetary system where multiple providers (the banks) implement a common currency. The main function of banks is not to store money and facilitate payments, nor to mediate between savers and productive investors. Their main function is to implement the monetary system. Central banks set monetary policy but commercial banks implement it. It’s been privatized, and banks get a large share of their revenue through providing that service. I think this role of banks is inappropriate. In the next article I’ll attempt to show how it brings about a systemic conflict of interest, which leads directly to the crisis. The role of banks in the monetary system is, I think, the core of the problem.

Proposed remedies to “the crisis” tend to consider only phase two. The overwhelming majority, including all the “stress test” and “too big to fail” discussions, simply aim to make phase two more orderly at a technical level. These measures would reduce incidental damage due to short-term loss of market confidence or collapse of institutions during phase two, but wouldn’t affect the big picture of the crisis cycle. They are very friendly to the status quo. A handful of economists would attack phase two more substantially. They propose various measures such as “narrow banking” or a return to the gold standard that would stop dead the cycle at phase two. I’m sympathetic, but I agree with the majority of economists who think that these approaches also prevent an effective growth-oriented monetary policy. Finally, a good fraction of mainstream economists on the left side of the spectrum, including Stiglitz and Krugman, attack the third phase. They say, in one way or another, that we need inflation or taxes and spending instead of austerity, so that the gap isn’t paid up by the poor and the cycle closes more equitably. I agree. I think they’re not making enough noise.

In my opinion, the proper way to attack the crisis cycle is at phase one, such that false assets are not created in the first place, or at least so that it’s not systemically profitable to do so. In the next article I’ll attempt to show where the fix ought to be directed, but I don’t have a fix. The problem is hard. Banks, when they work well, implement a growth-oriented monetary policy. When they go bad they use the same mechanism to create bubbles and profit from them. We need to allow the former without the possibility of the latter. As far as I know, no-one knows how.