A pivotal article by John Kay appeared in the January 6^th edition of the Financial Times. The word “pivotal” is used on purpose, because the piece breaks new ground.

Mr. Kay is the first commentator (to our limited knowledge at least) to connect the last three major crises (the 1997 Asian bust, the dotcom crash and the current Great Recession) to a common denominator. In addition he squarely points to the current globalized financial system as the common cause of these three events.

He also points out that each downturn has been more severe than the preceding one, indicating an escalation in size and intensity. The current recession has “maxed out” the capacity of central banks and governments to deal with the situation. The next one will be worse and possibly beyond anyone’s control.

We regret that the author did not, in our opinion, define more clearly the underlying causes of this sequence of booms and busts. These, as we see, are as follows:

The first cause is the creation, through unrestrained trade and budget deficits, of a large unanchored monetary mass beyond the control of any government or international institution. Because the U.S. is the primary provider, this mass consists mostly of dollars exported from America to finance U.S. private consumption and government spending.

The second cause lies in the globalization of finance and the removal of nearly all previously existing controls on currency and capital flows. This allows the large monetary mass mentioned above to move relatively freely around the globe in pursuit of the best returns, concentrating wherever such opportunity arises.

These capital flows are now so large that they overwhelm the ability of even the richest states to react and bring about the necessary corrections. As long as financial globalization remains an article of faith, neither governments nor international organizations will be able to prevent another financial tsunami.

As Mr. Kay points out, governments barely contained the devastation caused by the latest wave. However, they have done so not by starving and weakening the “financial beast”, but by feeding it additional mountains of money through bail-outs and deficit spending, all under the cover of financing a “recovery”.

Such a recovery is posited by Keynesian theory, according to which government spending replaces private outlays during an economic downturn. This has, in the past, worked to a degree. But we are not living in the past. The present is different.

Keynesian theory was created during the Great Depression, when the bulk of national economic activity took place within national borders. In addition, capital flows and exchange rates were controlled by regulation, and trade was limited by tariffs. Under such constraints government spending would remain concentrated within the national economy.

This is no longer the case. Current government outlays are funneled through a transnational system, within which money flows wherever the returns are highest and speculative activities most profitable.  In addition, the expansion of the welfare state guarantees that a large portion of government spending goes to cash transfers, which, while maintaining a subsistence level of economic activity, result in no productive investment.

The amount of stimulus spending needed to generate a “recovery” is therefore far greater than what would have been considered adequate during the 1930’s, which have provided the model for current policies. In the meantime a large portion of the money leaks out and increases the loose global monetary mass, guaranteeing that the next boom-and bust cycle will be more intense than the last one.

This is a situation for which there is no historical precedent, because such conditions have never existed until today. As Mr. Kay writes, we have created a “monster”. In fantasy stories, monsters are feared and eventually destroyed. We are feeding ours instead, making it bigger and stronger.

Our current policies thus lead directly to another crisis, worse than the current one.

The remaining ray of hope is that the “recovery” will prove so weak and unstable (which is likely) that political pressure will require to abandon present policies in favor of more effective measures. The upcoming U.S. congressional elections may turn out to be a test case in this area.

This entry was posted on Friday, January 8th, 2010 at 2:15 pm and is filed under Our Money, The People's Business. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.