The coming first world debt crisis

Ann Pettifor
31 August 2003

Jubilee Research at the New Economics Foundation (NEF), the team that spearheaded global awareness of a third world debt crisis released provocative new research in September 2003 which argues that the “first world” is approaching a major debt crisis. These findings appear in the first of NEF’s annual reports on the global economy, Real World Economic Outlook – which shadows the IMF’s annual World Economic Outlook.

The report predicts that a giant credit bubble, created by central bankers and finance ministers (the engineers of decades of “easy money”) has now reached a “tipping point”. This point – at which the “bubble” of financial assets exceeds GDP by nine times – has triggered financial crisis elsewhere. Another “tipping point” would be a rise in interest rates – not unlikely for economies like the US and UK which have massive foreign deficits.

The financial system: unbalanced, unfair, unsustainable

On a global level, there is $100 trillion of debt outstanding, but only $33 trillion of income with which to repay those debts. Even the drastic recent stock market falls have barely dented the credit superstructure. When this credit bubble bursts in the United States and Britain, it will be middle-class consumers that will first bear the brunt of the financial crash.

That will be unjust and unfair, because American and British consumers have been actively encouraged in their borrowing by the financial deregulation policies of both central bankers and governments. Moreover, politicians and bankers have watched as dutiful and compliant consumers have propped up these two big economies – helping to keep the global economy afloat. They will be rewarded for their heroic efforts by bankruptcy, losses, liabilities, and personal anguish – which will extend some time into the future. The impact of a collapsing credit bubble will reverberate around the world, and hurt the poorest most.

The crisis will be exacerbated for individual consumers, because the end of the credit boom will take place in a deflationary environment. Deflation is in part a consequence of the policies of central bankers and finance ministers for opening up markets, and clamping down on wages and prices. Deflation is good for lenders, but bad for debtors. This is because the value of debts rises in real terms in a deflationary environment. This is in contrast to inflation, which ultimately erodes the value of debt.

A financial crisis under debt-deflationary conditions will be catastrophic for many debtors. It will also be grossly unjust and unfair, because while central bankers and finance ministers have clamped down on prices and wages – they have used the credit bubble (borrowing) to inflate asset values (stocks, bonds, and property) to extraordinary heights.

On the whole, it is the poor and the middle classes that rely on wages and salaries – while the rich derive their incomes from wealth. However, while the rich have been getting richer, they have not become indebted. Nor are they using these assets to spend and boost the economy. Instead, on the whole, they are standing by while their assets rise in value. The poor, by contrast, have watched as their wages and salaries declined as a share of GDP, and have had to borrow to compensate for these losses. By doing so, they are providing a service to the rest of the economy, and helping asset prices stay high.

Winston Churchill’s storm warning

The team producing Real World Economic Outlook warns that the coming “first world” debt crisis will resemble the debt crisis of the 1920s – when bankers and politicians embarked on a similar experiment of “globalising” and deregulating capital. Then, as now, their liberalisation of capital markets and reckless inflation of credit encouraged massive borrowing. Then as now, the burden of resulting debts fell most heavily on the middle classes and poor.

Winston Churchill, in his book about that period, The Gathering Storm, described it well:

“The year 1929 reached almost the end of its third quarter under the promise and appearance of increasing prosperity, particularly in the United States. Extraordinary optimism sustained an orgy of speculation. Books were written to prove that economic crisis was a phase, which expanding business organisation and science had at last mastered. “We are apparently finished and done with economic cycles as we have known them” said the President of the New York Stock Exchange in September. But in October a sudden and violent tempest swept over Wall Street…

The whole wealth so swiftly gathered in the paper values of previous years vanished. The prosperity of millions of American homes had grown up a gigantic structure of inflated credit, now suddenly proved phantom. Apart from the nation-wide speculation in shares which even the most famous banks had encouraged by easy loans, a vast system of purchase by instalment of houses, furniture, cars and numberless kinds of household conveniences and indulgences had grown up. All now fell together. But yesterday, there had been the urgent question of parking the motor-cars in which thousands of artisans and craftsmen were beginning to travel to their daily work. Today the grievous pangs of falling wages and rising unemployment afflicted the whole community, engaged till this moment in the most active creation of all kinds of desirable articles…”

If we substitute “the urgent question of parking motor-cars” with the “urgent question of parking SUVs”, Winston Churchill could be writing in 2003.

A cycle of illusions

How did we get into this mess? Real World Economic Outlook challenges standard explanations for the launch of the “globalisation” experiment. We contest the view that deregulation of capital flows – the very core of the globalisation project – was brought about by a form of “spontaneous combustion” caused by new technology. Nor do we share the view of many activists that globalisation is “corporate-driven”.

Instead, we argue, globalisation was triggered by elected politicians, and central bankers, in both the US and the UK. In the post-Vietnam war era, led by Richard Nixon and later Ronald Reagan, these politicians sought ways to avoid making the “structural adjustments” necessary to the American economy if debts incurred by foreign wars were to be repaid by US taxpayers. Rather, these politicians preferred to disband the existing system of paying off debts by exchanging gold, and opening up capital markets, so that the US could borrow to pay off its debts.

This new arrangement also allowed them to print the money in which they paid off those debts (unlike poor countries which have to repay debts in foreign currencies like dollars or sterling). British politicians and central bankers were only too happy to act as US intermediaries in the capital markets. Together they constructed a new financial architecture that effectively obliges central banks of both rich and poor countries to lend to the US – by buying US treasury bills (debt).

It is US treasury bills that have now effectively become the world’s reserve currency – where once that reserve currency was neutral (gold). It is this international financial system that makes the US administration so arrogant in its refusal to “adjust” its economy by cutting spending and pay its way – as poor, indebted nations are required to do by the International Monetary Fund (IMF). (The IMF’s double standards in its dealings with poor countries on the one hand, and the US on the other, are breathtaking).

It is this financial system which makes US financiers so confident that the rest of the world will continue to finance their nation’s extravagant spending binge. In the words of David Goldman, head of debt research at Banc of America Securities: “America is at little risk for the foreseeable future, simply because the world’s capital has nowhere else to go”(Wall Street Journal, 13 August 2003).

The day of reckoning

The Real World Economic Outlook challenges that view. There is now a growing consensus that the vast build-up of household, corporate, state and foreign debts of the US is not sustainable. Some central banks are already switching out of US dollars and into euros. When capital flows shift away from the US, and there are recent signs of this happening, Alan Greenspan may have to raise interest rates to attract capital back into the US to fund the growing federal, state and foreign deficits. Indeed, the bond markets seem to be signalling that they expect this to happen quite soon.

When interest rates begin to rise again, when debt costs soar both for corporates and households, when defaults and bankruptcies increase more rapidly than now – then the “tipping point” will be reached.

The latest official US government statistics show that mortgage debt rose in the previous year by a staggering $700 billion, to $6,219 trillion, in the first quarter of 2003. That is double the increase in the 1990s. At the same time, personal bankruptcies in the US rose in the last quarter by 9.0% more than in the same period in 2002; business bankruptcies in two successive quarters rose by 5.9%. Samuel J. Gerdano, executive director of the American Bankruptcy Institute said as far back as May 2003: “Today’s new bankruptcy record is continued evidence that U.S. households continue to struggle with the burden resulting from consumer debts incurred in the 1990s”.

Avoiding the next great crash

For some, therefore, the day of reckoning has already arrived. When it arrives for the millions more that are dutifully and heroically borrowing and spending, and thereby propping up the economy, great pain and anguish will be inflicted on individuals, businesses, their workers, families and communities. The consequences for the rest of us, and particularly for those in the poorest countries, are frightening.

Real World Economic Outlook calls on governments and central banks to take three measures to take responsibility for their reckless deregulation of finance.

First, we call on them to re-regulate international capital, by bringing back exchange controls. (It has been done before, and can be again. Capital was re-regulated in 1944, at Bretton Woods, after the “globalisation” experiment of the 1920s that created a giant credit bubble, which led to the crash of the 1920s and 1930s).

Second, we call on them to rein in the “easy money” of reckless lending and borrowing; to return the economy to scale.

Third, we call on governments and central banks to compensate those consumers now dutifully propping up the US and the UK economies. But we argue that this should not be done by taxing the middle classes, but by obliging the rich to share some of the incredible gains that economic and political leaders have allowed them to make over the last two decades.

Our world has been turned upside down. It is time to put it right again.

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