Author Archives: Alex Harrowell

About Alex Harrowell

Alex Harrowell is a research analyst for a really large consulting firm on AI and semiconductors. His age is immaterial, especially as he can't be bothered to update this bio regularly. He's from Yorkshire, now an economic migrant in London. His specialist subjects are military history, Germany, the telecommunications industry, and networks of all kinds. He would like to point out that it's nothing personal. Writes the Yorkshire Ranter.

Occupy the space to the left of the European Council. There’s a lot of it

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This morning’s Irish Times reports that German opposition leader, former environment minister, and Social Democrat Sigmar Gabriel was in town. And what did he say? Every damn thing.

THE AUSTERITY measures being imposed on Greece are “mad”, and indicate that Europe learned no lesson from the rise of the Nazi Party, Germany’s main opposition leader said yesterday. Sigmar Gabriel, the chairman of the Social Democratic Party and potential future chancellor, said the measures were “mad” and amounted to an “evil circle”….At a seminar organised by the Institute of International and European Affairs in Dublin yesterday, Mr Gabriel cited the example of Weimar Republic chancellor Heinrich Brüning, who cut successive budgets during the Great Depression. Germany ended up with six million people unemployed. Brüning’s cutbacks contributed to a rise in support for the Nazi Party, which grabbed power in 1933.

He went there. Wham.

Mr Gabriel said it would be “impossible” for Greece to solve its problems without a policy for growth and unemployment. He accused the European Council of leading the country into a “dead-end street”.

Mr Gabriel said countries such as Greece and Italy should have taken advantage of lower interest rates when they joined the euro zone to develop their economies and infrastructure and become more competitive. Instead, they used it for current spending.

That, at least, isn’t controversial. But this is:

He also criticised his own country, which had accumulated about €1 trillion in savings that could have been invested in the real economy, but instead went into high-risk investments and real estate.

Well, yes. As I said back in May, 2010:

Every Sparbuch is the flipside of a tax break for a mobbed-up developer setting fire to a Greek hillside. Obviously, it would be silly to hold individual German savers responsible – but the Great Banks of Frankfurt, the institutions through which the German trade surplus is recycled?

However virtuous all those savers in Exportland were (if you go with Angela Merkel) or however successful German internal devaluation was (if you go with Kantoos) or however ruthless German politicians and executives were in demanding wage cuts in Germany and a massive trade surplus with the rest of Europe (if you go with me), it seems pretty clear that the European financial sector failed to allocate the capital it collected up north into productive uses. Instead, well, we got golf courses in the semi-desert of Andalusia and ships flagged-out to Liberia.

You might not be surprised to find that Gabriel’s remarks were part of a coordinated push. Here’s the piece the German, Swedish, and UK opposition leaders pushed out later in the day. The key points are that austerity everywhere isn’t helping, that something needs to be done about banks, that the politicians have lost legitimacy and authority, and that we need the surplus states to reflate and enjoy some sunshine, already.

It’s high time there’s an opposition program in Europe. This could be better, but it’s a start.

Meanwhile, of all people, Marine Le Pen is going to Occupy Wall Street. That’s what narrative power sounds like.

Is there a credit channel?

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An important argument at the moment is whether or not the so-called credit channel exists. When central banks carry out quantitative easing, and even more so in the case of a “credit easing” policy like the one George Osborne announced recently, a major reason for it is that they are trying to reduce the price (i.e. the real-terms interest rate) and increase the supply of loans to businesses. This being their effective cost of capital, this should encourage them to invest, and thus to increase aggregate demand. This is the New Keynesian account; the monetarist one is that creating an expectation of future inflation creates a disincentive to hold onto cash.

But there is a criticism of the credit channel that works like this: as banks actually create credit, they are only loosely constrained by its supply. Instead, they supply just as much as their customers demand. If the customers are businesses, they are more likely to worry whether their new venture is a good one or not. If it’s a winner, whether it’s a winner with a carrying cost of 4% or 6% isn’t a primary consideration. If it’s a loser, it’s a loser no matter what the interest rate. The bank operates in one of two states – essentially, risk-loving or risk-averse. In the risk-loving state, it expands its balance sheet as fast as its customers demand credit. In the risk-averse state, it digs in and hoards cash. Therefore, there is no credit channel, and the transition between the two states is something like the Minsky model of financial crisis.

Now, I responded to Daniel Davies (who made exactly this argument on the blog he is still keeping private – surely it is time for an Occupy Dsquared movement) on the grounds that if a big, price-insensitive buyer like a central bank can cause a dramatic turnaround in the market for Swiss francs, it could by the same logic flip the bank from state 2 back to state 1 if it went in hard enough.

Here is a data point: the refusal rate for British SMB loans tripled from 2007 to 2010. This could be used in either sense – the credit channel side would argue that this shows that, yes, the supply of credit to the business sector has been choked off, the demand first side would argue that SMB lending is a terrible business to be in at the moment because there’s no demand for their products. The problem is, however, to what extent agency is with the sell- or the buy-side.

On the other hand, the UK business sector excluding finance and real estate was a net saver through the boom years; surely that’s got to be a problem.

The ECB is still very much in the game

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It was widely reported last week that the Bundestag had “ruled out” or set a “red line” against any further ECB intervention in the market for government bonds. This is nonsense, and based on the common practice of not reading German. The vote, which for a start was a vote taken after debating a statement from Angela Merkel and not anything more concrete, expressed the Bundestag’s agreement with a text containing three statements. The first of these is under the heading “Sachverhalt” (Factual Background) and summarises the current state of play with regard to the EFSF.

The second is headed “Vor diesem Hintergrund stellt der Deutschen Bundestag fest:” (In the light of these facts, the Bundestag understands/recognises/realises) and contains the statements that the Bundestag (I’ll use the abbreviation, Bt. from here on) knows that the EFSF must be used more efficiently, and that it is aware that leveraging it carries a risk, that the existing instruments will be used and that the EFSF shall only be used under the terms of the treaty creating it, and finally, that “with the entry into force of the EFSF, the continuation of the ECB Secondary Market Program is no longer necessary”.

Note that, well, the opinion of the Bt. is a jolly one to have. It explicitly doesn’t say that “The ECB SMP shall not be continued”, and of course the ECB is banned by its charter from accepting any instructions from politicians. Also, this clause – which is the one that was doing the work – is in the first section of the resolution, which merely takes note of its content as facts.

The second section begins very differently: “Der Deutsche Bundestag fordert die Bundesregierung auf:” (The Bt. calls on the Federal Government to…). You will note that we have moved from merely taking note of the facts and expressing an opinion, to a demand from the legislature, which is the supreme power in the German constitution, that the executive do something. There is no reference to the SMP in this section of the document. The only reference to the ECB in it refers to the fact that it is forbidden to buy government bonds direct from government, rather than buying them in the open market or accepting them as collateral on the discount window. This neither rules out continued ECB intervention, nor does it even rule out the EFSF buying bonds from governments and then selling them to the ECB (or, if it gets its bank licence, posting them for rediscount).

On Friday, of course, the rate on Italian paper hit 6% and, as has repeatedly happened before, the ECB presses rolled into action. In fact, it seems that the ECB is operating an implicit decision-rule that it will buy whenever the rate on Italian debt hits 6%. There’s a nice discussion here of the semantics of Merkel’s use of the words “firewall” and “Schutzwall” – the most common meaning of the first is something which selectively permits access to a network, and the second manages to combine both Nazi and East German connotations in one sweeping infelicity.

But it seems to me that the ECB is operating something more like an electric fence. Cows will try to push through the electric fence a few times, unwisely prodding it with their sensitive noses and getting zapped. But then they will leave well alone. The question is how often you need to zap a bond trader before they get the point.

UK shadow chancellor, Ed Balls, for one, got the point faster than either the cows or the bond trader:

I think the most important thing in the markets today is that the European Central Bank has actually intervened and bought Spanish and Italian debt and that shows that the ECB is doing its job. But fundamentally will there be the scale of financial backing for sovereign countries like Italy? We don’t know. What will the actual details of this plan be? We don’t really know. What is going to be the bank recapitalisation? We don’t know. Will the European economy grow next year? That’s really in doubt…I don’t think it’s sensible for Britain to make bilateral contributions to a euro bailout fund. The ECB should be doing this job.

Meanwhile, perhaps we should all worry more about the fact that the European Council communiqué promised “very specific measures” to boost competitiveness and growth, without naming any very specific measures. It’s reminiscent of the famous company launched during the South Sea Bubble to “carry on an enterprise of great advantage, but no-one to know what it is”. But this is the opposite – the South Sea Anti-Bubble, even if the original South Sea Company was in fact a device to inflate away government debt.

Update: Mooo!

If you’re not scared, you’ve not been properly briefed

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So, if Neal Stephenson, J.G. Ballard, Charlie Stross, and Mervyn Peake had collaborated on a movie about the near future of the global economy, perhaps we’d have something about Chinese property developers trying to create the perfectly blank fascimile of a mid-century European suburb in the outskirts of Shanghai, not too far from Ballard’s old concentration camp at the Lunghua airfield, when a massive financial crisis erupts across the Internet. After the Party shuts off access to the major banks, the developers turn to high yield paper traded in Hong Kong, until rates spike and even Hong Kong brokers won’t touch it no more. But plungers plunge, it’s what they do. Shark gotta swim. The music’s playing and while it’s playing, we’re dancing, as someone said.

That’s when they notice the people from Wenzhou, who have a deeply dodgy but robust store-credit network going back to the days when any private business at all was illegal and who knows, maybe even further, back to the chaos of the Civil Wars. They’re in all kinds of business so long as it’s shady and they look out for each other, and they lend money. You wouldn’t be that far wrong if you thought you’d seen them in the movies before, just not as Chinese. More pasta, less mantou. So they roll over the loans.

But this is all can-kicking; the ballroom days are over. Nothing goes quite like a bubble. And pretty soon the Wenzhou guys are in trouble themselves. Colourful identities in shoe-biz are hopping out of tall buildings and pizza-ing the sidewalk. And here’s the kicker. You kick loans out the front door, you gotta turn them over out the back. The deal is the same for Citigroup and dodgy bookies. So they set up “trusts” with big names and float them in Hong Kong…and the Royal Bank of Scotland is a big investor.

No. No. That’s not the kicker. The kicker is this – the big deal, the hacienda if it hadn’t been a nightclub, the daddy, is a whole suburb designed by one Albert Speer.

I’m making none of this up. It’s not old man Speer, of course – it’s his son, also an architect like his grandad and his great-grandad, who was commissioned to build a German town in Shanghai’s globo-shed airport’n’datacentre belt. Trouble, he took that mean they wanted a town like a real German town, all post-war and either Christian or Social Democratic and square and energy efficient. They wanted Rothenburg ob der Tauber, or at least a lot of flickwerk fachwerk. Old Speer would have wanted something different – waiting for the end, he imagined he’d rebuild Germany in aluminium prefabs built by the idled Junkers aircraft industry, very Bucky Fuller, and even tapped up some of his staff to join him in his new practice.

About the Chinese property bubble and the increasing role of the mob, here’s Pat Chovanec. You’ll observe he’s getting a wee taste of the wumaodang in comments.

On Wenzhou and the property bubble, and spiking rates for speculation on margin like in ’29, JamesP at Jamie Kenny’s place. Some more general dread.

Here’s China Daily on sweatshop shoemaker-loansharks dropping out of skyscrapers. Wenzhou sounds like a mashup of Sicily and Leicester. With Chinese people. (Here, take one of these tabs, it’ll make sense.)

Here’s Bloomberg – hey, Bloomberg, even AFOE readers take that seriously – with great detail on Chinese shadow banks and RBS. More RBS, from the FT.

Finally, all that stuff about weird buildings and Albert Speer? I wasn’t kidding. Der Spiegel, auf deutsch. You bet.

That’s how it worked out for Sweden

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At Crooked Timber, they’re discussing a Tobin tax. Andrew F. asks:

How well did this work out for Sweden?

In the ruins of the city once known as Stockholm, ragged survivors barter rotting fish for scraps of used toilet paper outside the scorched hulk of the former Riksbank, that was once the oldest central bank in the world. Many have hacked out their own eyes with shards of plastic rather than see the desolation and depravity they brought upon themselves. “Would we hadn’t done it! The Tax that Dare Not Speak Its Name has reduced us to things lower than beasts!”

Elsewhere, corpses litter what were the chic alleys of hipster Södermalm, marking out the last desperate and insane brawls over crispbread and Cheap Monday products, clearly fought to the knife or rather to anything that would take an edge, in that grim night without darkness.

In the darkened concrete bunkers of what used to be one of the world’s largest Internet exchange points, Netnod, we found the rotting bodies of sysadmins still surrounding a router that appeared to have exploded, as if some sort of wave of pure evil had exploded across the wires from the hearts of a million bloggers the moment the first transaction tax was assessed.

And they tell me it’s worse in Skane. That’s how it worked out for Sweden.

(Although, the Greek source quoted here seems to be thinking along the same lines:

“If we default, it’s not just the domino effect. It will make Argentina look like small game. This place will become worse off than Bangladesh. People will be killed for a sandwich as they cross the road. It will be that bad.”

)

Sunshine club members’ newsletter…

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From William Keegan’s column in the sadly reduced business section of the Observer, a newspaper that used to be worth buying just for its business section, it looks like the sunshine club has got another member, ex-MPC man Christopher Smallwood of Lombard Street Research:

In Lombard Street Research’s Monthly Review for September, the economist Christopher Smallwood reminds us that “a currency system with Germany at its core necessarily displays a strong deflationary bias. For a monetary union to work well, it needs to be operated on the basis of ‘symmetrical obligations’ among the members. But if the strong surplus country is perpetually unwilling to take expansionary action, all necessary adjustments within the system have to be made by deficit countries taking deflationary action.”

Smallwood points out that Greece, Portugal, Spain and Italy have suffered a rise in costs relative to Germany and some of the northern economies of up to 30%….

Meanwhile, the BANKERS! remind us that something like 15% of German GDP is accounted for its intra-eurozone trade surplus. Also, note that Jürgen Trittin and the Greens are calling for a Northern European fiscal reflation, according to the transcript of the EFSF debate.

Speaking of the Observer and bankers, Heather Stewart quotes the IMF:

“The large number of ‘underwater’ mortgages poses a risk for a downward spiral of falling house prices and distress sales that further undermines consumption and labour mobility,” it warned, calling for courts to be allowed to write off a proportion of mortgages where borrowers have got themselves in trouble; for the taxpayer-backed mortgage guarantors Fannie Mae and Freddie Mac to encourage writedowns; and for an extension of state-level programmes to support troubled homeowners.”

The IMF is now arguing for unilateral cramdown by the GSEs.

Review: Tinker, Tailor, Soldier, Spy

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What would it be like if a Swede made a classic British spy movie? Well, we found out.

One of the things I liked most about this version of Tinker, Tailor… was that it was a visually convincing portrayal of Britain. The cinema is always in the business of constructing a mythic past or present, and in the UK, there are basically four historical eras in the eyes of the movies. One is Will Shakespeare and before, the age when everything was brown except the crown jewels and the sword blades. Another runs from the deer parks of the 18th century to the 1930s and basically celebrates everything posh. It’s the world of Mary Poppins and a million takes on Jane Eyre. Then there’s Blitz Grim, which runs from the outbreak of war through to the miners’ strike or thereabouts as if the bombs had never stopped falling. And then there’s Shiny World, which picks up in the late Thatcher era and runs through to now.

The problem with this is that the UK is the only European country where the post-war consensus is depicted as looking like shit. I suspect that class is behind this; the people who weren’t rolling in prosperity and unrivalled possibility in those years were exactly the old-fashioned upper middle class that gave us someone like Control as played by John Hurt, a pseudo-academic spook in a studiedly tatty silk near-kimono. He doesn’t dress like that because he’s poor, after all, but because he can. Smiley and his colleagues are much the same, marinating in cod-Oxbridge shabby-library kitsch in chilly flats in Hampstead, plunging into Highgate Ponds, dressing in expensive-but-fashionless tailoring.

But Tomas Alfredson shows early 1970s London as a city with tatty look-and-feel but fleets of brand-new cars (hey! it was the golden era of the British sports car! nobody feels existentially crushed by decline and runs out to buy a MGB roadster!), ruled by a government with uncared-for buildings but a more than generous budget for the technology of spookery and bureaucracy. This suggests he may have read a book or two before starting out. In fact, the intelligence world’s budget is nothing as to Alfredson’s budget for sets – the enormous, hugely detailed archives and secure conference centre are amazingly impressive, and permit him to put the audience in the point of view of a highly classified file making its way through the system.

Of course, London is always like that. There is a long history of new arrivals writing about the noise! and the smog! and the prices! and how do they live like that! and then, in their next letter home, declaring that all their friends had better hurry up as it might not last. These days, Smiley might have moved his skunk-works mole hunt into a Regus serviced-office block in Shoreditch rather than a rotten railway hotel around the old Broad Street station. The paranoia would have to float through the air conditioning in the spirit of J.G. Ballard rather than give the walls uncanny life in that of M.R. James. But it wouldn’t be all that different.

Neither would the politics, in some ways. One reading of the plot is that the loyal British spies and the pro-Soviet moles are in a sort of unconscious conspiracy. The original scheme is to get information from a Hungarian defector that will induce the Americans to share more intelligence with the British. But the moles, who are deliberately providing the British with information to get them to keep the defector case running, also hope that the Americans will be impressed enough to share, so they can get their hands on whatever they do share. After all, the British are deliberately passing information back to the Hungarians to protect the agent’s cover. In what way, then, are their aims actually opposed? The distinction between loyalty and betrayal is a question of the terms-of-trade.

Interestingly, we now know that while John Le Carré/David Cornwell was writing the book, the whole issue had blown up and the Americans had cut off signals intelligence sharing with the UK over prime minister Edward Heath’s refusal to let SR71 reconnaissance flights over the battles of the Yom Kippur war land at the British base in Cyprus. Specifically, Heath and his foreign minister Alec Douglas-Home were concerned that the Americans would pass the information to the Israelis, forcing the UK to take sides in the conflict. The Americans refused to give this assurance and the landing rights were refused, and the US flew the missions anyway using dozens of air-to-air refuelling tankers. As it happened, the Israelis weren’t being entirely honest with the Americans in exchange for the use of the photos, and the Americans were severely embarrassed, leading them to patch up the row with the UK quickly once it was all over.

So the British and the Russians (including the Hungarians) are willing to go to any lengths in order to influence the Americans. The other big target is of course the British Government, specifically the Treasury and SIS’s parent ministry, the Foreign Office. Ironically, the moles are as keen as the loyal to fight the good bureaucratic fight, and both sides want to do so by scoring off the Americans. If anything they mistrust the mainline civil service even more than they do Karla. There is a brilliant moment when the suspected mole, Alleline, spits at a senior civil servant that “None of your civil servants lost their lives!” – in Britain, the intelligence and diplomatic services are technically “crown servants”, without the independent professional status or final access to the highest peaks of power reserved for the civil service proper.

There are other things that haven’t changed much. Gary Oldman’s diction was so perfectly establishmentarian that I missed the first reference to what sounded like “Pseare” but was of course SERE, the survival, evasion, resistance to interrogation, and escape training course that Donald Rumsfeld’s agents re-purposed to create a wholesale torture capability after 2001.

Some other points…who didn’t love the government minister, very much the motorway-building go-ahead bulldozer of the Heathite Tory imagination, who plays a vigorous bout of squash in his Fred Perrys and immediately afterwards sparks up a gasper? It was also hard to avoid thinking that it was the Cold War that made Britain European, a time of civil service linguists and the BBC World Service. And finally, this is a slow movie, as slow as paranoia, well likened to the Godfather. Time stacks up, thickens, intensifies.

Revisiting the Eurodebate

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This post of P O’Neill’s made me think of something. That is, the British debate on joining the Euro, and on Europe more generally. I was strongly pro-Euro, something which now looks as bad a decision as joining the Liberal Democrats was. It’s hard to avoid the conclusion that had the UK had Eurozone interest rates in the 2000s, we would have had an even huger housing bubble and even more gigantic bank balance sheets, and we would have had to resolve them without being able to use the central bank as lender of last resort, and we would have been unable to devalue the currency as a stimulus mechanism.

Any counter-argument requires that the influence of the Bank of England in ECB policy would have been both powerful and right. The first is debatable, but we have to accept that the Bank didn’t restrain the housing bubble and also failed to respond to the crisis in the real economy in 2008, sitting on its hands and mumbling about inflation while the labour market cliff-dived and the bank regulators across the corridor frantically juggled with Halifax-Bank of Scotland, Lloyds, and Northern Rock. Also, the early 2000s situation of a bubbly periphery and a stagnant core would have been even worse with the London housing market in the Euro, and it’s hard to say how that would have panned out.

But what were we really debating in the 90s?

The arguments in favour, at least the economic ones, were that we might benefit from being fully integrated in a bigger trading bloc, that we would benefit from currency stability, that lower interest rates would be nice to have, and that the Eurozone restrictions would be a force that would require industry to be more competitive (or did they just mean lower wages?). The arguments against, at least the economic ones, were that the Stability & Growth Pact would be an anti-Keynesian force for deflation and that the option of devaluation would be removed.

Then there was a whole lot of other stuff. A lot of the “for” side thought it would make us more European and meant by this that it would make us more social-democratic (or Christian-Democratic, or even Free Democratic), although I don’t think any of them could have articulated a mechanism by which this would happen. I suspect that for a lot of us it was a bit like the Estonian MP who told Tim Garton Ash that “Europa ist…nicht Rußland!”, or in our case, Europe was not-America.

A lot of the “against” side seemed to agree with the idea that joining the Euro meant the triumph of social democracy, because they at least claimed to think that the European Union was an inherently socialist institution. Some of them still think this now, when it has imposed structural adjustment on three European countries in order to avoid the nightmare of fiscal expansion in Germany. Others took the Friedmanite line that currency adjustment was a form of free market competition and therefore desirable. This was at least defensible. And others thought that it was a scheme to redraw the UK’s internal borders or replace the flag or something.

The interesting contradiction here was that the same people who worried that we would be unable to devalue the currency were also fervent austerians who didn’t believe in demand management of any kind. It was as if they believed in hardcore new classicism up to the point where it affected their re-election. How could it happen?

Obviously, whether you felt the SAGP would be useful discipline or an anti-Keynesian straitjacket simply depended on whether you expected the economic problem of the 2000s to be inflation or deflation. But the economic argument that was very rarely discussed was the one that is now fascinating everybody – exactly how the Eurosystem, rather than the Euro, would function in a financial crisis. Apparently this was discussed in specialist circles, but it didn’t make even the best of the national press.

To sum up, I agree that the yes side was wrong about fixing the currency. To be honest, when asked, I always said I was in favour of joining if we could join at a significantly lower exchange rate. The benefits of which Jaguar-Land Rover just demonstrated. But this is a cop-out on my part. On the other hand, I think the Eurosceptics and some of the conservative Europhiles should accept that they were wrong about the SAGP – yes, Virginia, inflation was a phantom menace, and the ghosts of 1929 were not finished with us. And we can all agree that we were all wrong about the banking and financial aspects of the Eurosystem, in that we didn’t even bother to argue about them.

I promised to blame somebody in the last post. Here it comes: the key European politicians, especially the French and the Germans and the European Commission officials, who designed the Euro and the Eurosystem. They created a system that had a structural deflationary bias in an era of deflation, one that delivered rock-bottom interest rates to countries in the grip of land fever, and one that couldn’t cope with a banking crisis although it included the biggest banking system in the world. And then they kept putting up interest rates. What’s worse is that they now have the gall to give lectures about virtuous savers – even when they are the same individuals, like Wolfgang Schäuble, who were in power in the 1990s.

Yes, the banks are to blame

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Daniel Davies’s effort to become the most popular man in Britain has, apparently, not developed to his advantage, to quote the Emperor Hirohito. It struck me that there are two opposed explanations for the unusual toxicity of the comments thread that ensued, and they tell us quite a lot about the Great Bubble and the Great Recession that followed.

The first would be Daniel’s explanation. Look at them! It took only six comments for someone to analogise him to a soldier whose commander pays him in whiskey and delta 8 vapes to cut the ears off prisoners, and sixty-five for someone to compare him to one of the anonymous organisers of the Holocaust. We got to Josef Stalin by comment 115 and to Megan McArdle by 108. Surely, this is evidence that there is an unreasoning and unproductive rage around at anything that smacks of banks, bankers, or banking.

The second would be mine. Fans of Daniel Davies’s work since the distant era of Adequacy.org will appreciate that he is a practised and expert troll, and distinguished among the guild of ancient Norwegian bridge-guardians by the fact he can turn it on and off as desired. Knowing that bankers are unpopular (were they ever popular?), and that Crooked Timber is a website full of left-wing people, he crafted a post that would cause them all to freak out amusingly.

You will of course notice that the basic distinction here is that one explanation is demand-driven and one supply-driven. The first assigns agency to the buyer, the second to the seller. The distinction is important in economics – one of the most standard assumptions is that consumer sovereignty holds and that firms are generally price-takers. Another key assumption is that industry fundamentally responds to demand. Electrical engineers would say that it is load-following, like a power plant whose output can be throttled up or down to respond to the needs of the grid.

In itself, this isn’t controversial. Industries produce what they can sell. There are lags in the supply-chain, and it’s possible to have temporary shortages or surpluses, but basically, the rate of production is both constrained and driven by demand. But the stronger form of this argument, and the one that is baked into essentially all economic models, is that not just the quantity of goods, but also their quality and kind, is demand driven. The distinction between drivers and constraints is important here. It is obvious, and trivial, to say that things nobody will buy won’t be produced for very long. But that is only half the argument.

How did we decide to try making fireguards out of chocolate, or self-certifying mortgages with negative-amortising interest rates, in the first place? Obviously, there are cases where new products do respond to an identifiable demand. At the level of the whole economy, though, this implies that every conceivable product or service already exists in latent form in the minds of customers, as if there was a statue in every block of stone waiting to get out. This is…somehow implausible and unsatisfying. Among other things, it has the curious consequence that being really true to the core assumptions of economics implies eliminating the role of the entrepreneur, at least as an inventor or product designer rather than as an operational manager.

If entrepreneurs are a thing, on the other hand, we have to accept the possibility that firms have agency in structuring the markets they sell into, that even if aggregate supply doesn’t create its own aggregate demand, it is possible for specific supply to create its own specific demand. It’s Milan fashion week, after all – an institution exquisitely dedicated to the proposition that producers can at least try to define what consumers will want.

Now, back to the mortgage market. Mortgage brokers are a fine example of a business that really is demand-driven. People come to them and say how much house they are trying to buy, and the broker tries to find someone who will lend them the money. As they were both in competition as firms, and usually rewarded on commission as individual workers, their structural incentives were to follow the housing market wherever it went. In that sense, property buyers had real agency and hence culpability. The broker/originator sector was also meant to evaluate their creditworthiness, but as it didn’t take the risk on the loans itself, it didn’t have any incentive to turn people down. It had agency, and therefore also blame.

But what about the banks? Just treating them as a normal business is illuminating. Businesses invent new products all the time – sometimes following demand, sometimes reaching ahead of it. Sometimes, what they invent is dangerous to the public and they have to be restrained. Nobody would argue, for example, that in inventing the RBMK nuclear reactor, the Soviet nuclear industry wasn’t berserkly irresponsible and directly to blame when one blew up.

And one product the banks surely did invent was outsourced mortgage-servicing. This practice may yet prove to be one of the most pernicious of the Great Bubble, not because it led to illegality as such (although there’s plenty of that), but because it is a major obstacle to recovery, and it is the more profitable the longer it stays that way. When lenders were responsible for collecting payments and dealing with borrowers themselves, they were much more likely to be reasonable with borrowers who struggled to keep up the payments. They had good economic reasons for this; typically, they would recover much more of their money in a negotiated settlement than in a foreclosure, an expensive process in itself that usually ends with the property going for auction at a fire-sale price.

But once the servicing function is outsourced, the incentives are actually reversed. Not only does the servicer, the party who has direct contact with the borrower, have no incentive to agree a modification of the original loan, they have every reason to insist on foreclosure. They get paid based on the tasks they carry out, and foreclosure generates a lot of lawyering and letters, all of them chargeable to the lender.

Now, there are three ways out of a balance-sheet recession. One is economic growth itself. As, I recall, Daniel Davies once said, if you are in debt as an individual, the best solution of all is to increase your income if it is at all possible. And the Kulmhof-Ranciere study argues that increasing real wages is the best way out of the crisis at the macro-level. Another is inflation. And the point has been made, by one Daniel Davies among others, that inflation is a rather simple mechanism to adjust all sorts of contracts that were set at nominal prices that have become unpayable, one which avoids all the complex machinery of courts and loan officers.

And a third is bankruptcy, in which we recognise by law the fact that both the lender and the borrower agreed on a contract that has become impossible to honour, and both of them share in the cost of cramming it down to a realistic level. Here is a case in which a major new product invented by the financial sector, in advance of demand, is directly blocking one of the three roads to economic recovery. To what extent the banks are responsible for the lack of progress on the other two is left as a topic for discussion.

In my next post, I’m going to look at some more people who are to blame. They are not Greek schoolteachers.