The Debt Fallacy

Because this blog has a strong political theme, it might surprise you to learn that I don’t watch Question Time very often. Partly this is because I’m usually in bed by the time it comes on, but if it were called “Answer Time” and the politicians were forced to give proper answers to the questions I would probably be compelled to stay up late once per week and watch it. Instead it is generally an hour of politicians indulging in their favourite pastime of evading, misrepresenting and misleading and to be honest, I get enough of that already.

Still, I did watch some of it a few weeks ago and noticed that in pretty much every answer the Conservative or Lib Dem gave they managed to blame having to take lots of “difficult decisions”, such as cutting benefits for poor people and cutting taxes for rich people, on…

The mess we inherited from the Labour government

The government seems to believe that this is some kind of carte blanche to do whatever they want without any accountability; a Get Out of Jail Free card that they never have to give back. It isn’t though. It’s the political equivalent of saying, “OH MY GOD, WHAT’S THAT BEHIND YOU?” then running away when you turn around. That particular favourite phrase is not what I am going to spend time talking about because no one believes it anyway. Despite the government’s best efforts, no one is actually dumb enough to agree that they don’t need to be accountable for their policies.

They did come up with another favourite line, however, that narks me even more than this one because a lot of people do actually believe it. When someone mentioned government spending they said something like this:

It was the irresponsible spending of the last government that got us into this mess in the first place…

And the thing that annoyed me more than them wheeling out this spin-doctor nonsense for the thousandth time was that no one else on the panel directly challenged it. If I’d been on the panel, (I was on holiday so they had to go with Steve Coogan as the non-politician), I would have directly challenged it. I would have directly challenged it because it isn’t true. It is a lie and when politicians say it they are lying. This, ladies and gentlemen is The Debt Fallacy, the widely-held belief that UK government debt caused the financial crisis.

Before we delve into what actually did cause the “mess”, let’s see why this is a fallacy by looking at UK government debt between 1997 when Labour took office and 2007 when the financial crisis started. (Source IMF)

National Debt of G7 Countries as % of GDP

National Debt of G7 Countries as % of GDP

Yes, not only was borrowing significantly lower in every single year than everyone else in the G7, it was actually lower in 2007 than when Labour took office ten years earlier. Staunch Conservatives will no doubt be hugely disappointing that there is no marked increase in UK government debt in that graph. Don’t worry, just for you I’ve done another one for just the UK with the previous five years under John Major added in. Now you can see a government who did oversee a marked increase in the national debt. I’m nice like that. Don’t mention it.

UK National Debt as % of GDP

UK National Debt as % of GDP

So you can see why the government’s claim about a debt-fuelled spending binge is a lie. This level of public debt clearly didn’t cause the financial crisis. So what did?

The cause is actually fairly simple. Banks make profits by borrowing money and then investing it. Their profit comes by getting a higher return on their investments than they have to pay on to the people from whom they borrowed the money. For example if I put £100 in a bank account the bank might pay me 1% interest and then invest that £100 in in a scheme that makes them 5%. Simple enough.

Banks though, like any other businesses, want to compete against one another – they want to make the biggest profits for their shareholders and show everyone that they are the best bank. This is what caused the crisis.

Over time, banks became increasingly competitive and concerned themselves more with trying to make the biggest profit and less with the risks associated with what they were doing. With the £100 I put in my bank account they could invest it in something safe and make 5% or they could invest it in something risky and make 10% or 15% or 25%! The more risky the investment the more return it could yield. No bank was going to invest in something risky if its likely return was less than a safer alternative and so risk equalled reward. Competition between banks, all vying for the biggest profits, led to riskier and riskier investments and nowhere was this more prevalent than housing. It became possible for people to borrow crazy amounts of money to buy a house, even if they had poor credit worthiness. This irresponsible lending fuelled housing bubbles all over the world. Here’s how Florida house prices changed in the four years prior to the financial crisis.

Florida House Prices (Q4 2002 = 100)

Florida House Prices (Q4 2002 = 100)

In just four years they increased by almost 80% and people’s wages were definitely not increasing at anything like that rate. In short it was unsustainable. There is a useful principle in economics called Stein’s Law after the late American economist Herbert Stein and I wish more people had paid attention to it in the pre-crisis years. It says simply this:

If something can’t go on forever, it will stop.

Stop it did and we all know the rest. In hindsight it’s easy to look back at this and say that the banks were lending irresponsibly but much harder to say why they didn’t they realise it at the time. The only explanation I can offer is that they were too concerned with out-performing one another and not concerned enough about the risks involved until it was too late. Like a gambling addict who’s had a good night but doesn’t know when to quit, the banks didn’t want to think about Stein’s Law.

Essentially the positions they took on the housing market assumed that:

  • House prices always go up
  • Mortgage defaults are pretty rare

On the first point the banks thought, “Even if this individual doesn’t repay their 120% mortgage, the house will be worth more than that in a couple of years, so where’s the risk?”

On the second point they seem to have committed a really basic error in their probability calculations. Imagine I have lent to 5 risky individuals. The chances of any one of them defaulting on their mortgage is 5%. Therefore the risk of all of them defaulting on their mortgages is:

5% x 5% x 5% x 5% x 5% = 0.00003125%

But those of you who remember your GCSE maths will recall that you can only multiply probabilities together like this when they are independent. For example if the probability of a person having a beard is 20% and the probability of someone being female is 50% the probability of a lady having a beard is not 10%. (Unless of course you work in a circus.)

Similarly, the chances of individuals defaulting on their mortgages are not independent. When an economic downturn occurs, unemployment rises, incomes drop and lots of people all suddenly can’t repay their mortgages at the same time.

Banks, in their bid to out-profit each other, took huge positions on the housing market. They were betting that economies would grow and house prices would go up. It had been so long since the economy had been through a really serious downturn that they had forgotten the lessons of the past. The resulting crisis shows that so confident were they in endless economic prosperity, that none of them had a Plan B in the event of a downturn. The global economy isn’t like that though and if economic history has taught us anything it is that bad things have always eventually found a way to happen and by the time the banks spotted the bubble was about to pop it was too late.

Banks weren’t just lending irresponsibly on mortgages though. People took cheap loans and were able to borrow more than ever before on their credit cards. Banks were so desperate to lend that they offered amazing deals to secure our credit card debts. Fee-free transfers, interest-free balances for 12 months etc etc and the same thing happened – all of a sudden lots of people were unable to make repayments at the same time and the banks had no fallback.

This had a short term effect of making the banks insolvent and governments world-wide were forced to bail them out. While this solved the short-term problem there was another problem that almost six years later remains unsolved.

When economies around the world turned bad, people were left with mortgage debt, loan repayments and credit card bills that were ridiculously high. Those lucky enough to keep their jobs switched overnight from not worrying about their personal debt to worrying only about their personal debt. The thousand pounds they had on their credit cards was no longer something they could kick into the long grass and assume they would just pay it off later. Seeing their friends and co-workers losing their jobs made the risk of redundancy a reality.

This shock led to a very sudden and very dramatic change of behaviour. People moved almost overnight from spending to reducing their debt. Even those who had avoided running up debt became very worried about how little they had tucked away for the hard times and moved from spending to saving.

In the economy your spending is my income and my spending is your income. When everyone stops spending at the same time the consequences can be catastrophic. I say “can be” because a responsible government could plug the gap by increasing public spending but in most cases they didn’t, hence it was catastrophic, hence the depression. (I like saying “hence”. I think it makes me sound all knowledgable.)

So that’s how it happened and that’s the real reason we are in a depression and it had nothing to do with UK government debt at all.

There is a good argument that the previous Labour government should have spotted what the banks were up to and should have done something to address it. Although the banks caused the crisis, the previous government was asleep on the job while this was going on. If the current government were pushing that argument they would have a valid criticism but they aren’t because although it is the truth, it doesn’t pin all of the blame on the previous government.

Politics aside, the years before and since the crisis really are a shameful and embarrassing period in economic history. A first year economics student taking their first macroeconomics module will learn that government spending increases economic growth and that it works best of all when the economy is suffering from a lack of demand. They will learn that my spending is your income and your spending is my income. They will learn that if your spending disappears my income does too. They will learn about economic cycles – the economy will go down as well as up, so plan for it.

Sadly these are lessons that the current government has either not learned or has simply chosen to ignore. Simple enough as those lessons are, it’s sadly far more convenient for them to just propagate The Debt Fallacy.

RedEaredRabbit

A Letter To America

From checking the stats on this blog I see that after the UK, the second highest readership is in the United States. In fact, I get more hits from the US than from positions 3 – 12 in the list combined. (Australia, Canada, India, Ireland, Spain, France, Germany, The Netherlands, Sweden and New Zealand, if you’re interested.)

Tomorrow, my second highest contingent of readers will be going to their voting booths to decide whether Obama or Romney is their next president. So, American readers, this post is for you.

The Romney campaign has focused primarily on the terrible job Obama has done with the economy. The Republican plan is benefit cuts for poor people, tax cuts for rich people and generally cutting public spending wherever possible. Might this work? Well we have a good test case in the UK. In contrast to Obama we have done all of these things in the pursuit of economic growth. I’ll be frank, it hasn’t gone well. While Obama has presided over 13 consecutive quarters of economic growth, the UK is currently celebrating one consecutive quarter of economic growth. While the US economy is bigger than it has even been before, the UK economy is smaller than it was five years ago. On the economy, Obama wins.

Of course, it doesn’t stop there.

Romney on abortion, when asked whether he’d support a bill to ban all abortions:

I’d be delighted to sign that bill.

Romney on equality for gay couples:

I’m going to want to see a marriage limited to a man and a woman. I don’t want to see civil union either.

Romney on Obama voters:

There are 47 percent who are with him, who are dependent upon government, who believe that they are victims, who believe the government has a responsibility to care for them, who believe that they are entitled to health care, to food, to housing, to you-name-it — that that’s an entitlement. And the government should give it to them. And they will vote for this president no matter what. These are people who pay no income tax. My job is not to worry about those people.

Romney on Obama’s ethnicity:

My dad, as you probably know, was the governor of Michigan and was the head of a car company. But he was born in Mexico and had he been born of Mexican parents, I’d have a better shot at winning this. But he was unfortunately born to Americans living in Mexico. He lived there for a number of years. I mean, I say that jokingly, but it would be helpful to be Latino.

No one has ever asked to see my birth certificate. They know that this is the place that we were born and raised.

Romney on why public health care is bad:

I like being able to fire people who provide services to me.

Romney on climate change:

My view is that we don’t know what’s causing climate change on this planet. And the idea of spending trillions and trillions of dollars to try to reduce CO2 emissions is not the right course for us.

Tomorrow, America you have an opportunity to vote for someone who has not only, for the first time brought in health care for the poor in the wealthiest country in the world, he has also massively outperformed Europe in economic growth. He hasn’t done enough on climate change but at least he doesn’t deny its existence.

Tomorrow, America you also have the other option of voting for the climate-change denying, economy-destroying, tax-cuts-for the-wealthy-pursuing, health-care for-the-poor-withdrawing, gay-rights-denying, Mr. Mitt Romney.

It’s up to you but we’re all watching.

America, it’s your call.

RedEaredRabbit

Obama vs Cameron

Last night’s question time had a bit of a US election theme and Conservative MP, Kwasi Kwarteng couldn’t resist taking a stab at Obama for not pursuing a policy of austerity. Because Obama hadn’t gone for austerity like we had in the UK, the US economy was now in a mess etc. etc.

It’s an all too familiar noise from the government but is it actually true?

Here’s a graph showing how the US and UK economies have grown over the past four years:

US vs UK GDP (2008Q3 = 100)

US vs UK GDP (2008Q3 = 100)

(The green diamond is when Obama came to power and the purple diamond is when Cameron came to power.)

It’s fairly clear from that graph that the US economy has far out-performed the UK economy in the last few years. If you compare just the time since David Cameron came to power things look even worse:

US vs UK GDP (2010Q3 = 100)

US vs UK GDP (2010Q3 = 100)

If the performance of the US economy is a failure then I would love some of their failure over here.

It makes me wonder why politicians say things like this. Why, as an austerity pursuing government, would you even bother bringing up this subject when talking about the United States? Of course they still have problems but it’s an economy who didn’t pursue full out austerity and who massively out-performed our own who did.

One possibility is that when politicians say things like this they just hope none of us will check the actual facts and find out they’re telling lies. Worrying as that possibility is, I think the reality is even more scary:

This government is so far down the road of austerity that the truth just isn’t important any more.

RedEaredRabbit