The international credit crisis which began in 2007 did not come out of a clear blue sky, without warning. As long ago as 1999, British economist Peter Warburton had warned in his book Debt and Delusion that the ultimate consequence of the build-up that was occurring in personal, corporate and government debt would be financial collapse. In April 2001, he reiterated his concerns in his essay, The Debasement of World Currency.
“What we see at present,” he wrote in this paper, “is a battle between the Central Banks and the collapse of the financial system fought on two fronts. On one front, the Central Banks preside over the creation of additional liquidity for the financial system in order to hold back the tide of debt defaults that would otherwise occur. On the other, they incite investment banks and other willing parties to bet against a rise in the prices of gold, oil, base metals, soft commodities, or anything else that might be deemed an indicator of inherent value. Their objective is to deprive the independent observer of any reliable benchmark against which to measure the eroding value, not only of the U.S. dollar, but of all fiat currencies.”
For a time in 2002, following the collapse of the Dot.Com bubble, it appeared that his worst fears of a major financial collapse might be realised. But then international stock markets began to recover, and the world economy continued to grow. Warburton was widely dismissed as a Cassandra.
But he was by no means alone in his concerns. Taking a wider international perspective in 2005, Richard Duncan predicted an impending global catastrophe in his incisive book, The Dollar Crisis: Causes, Consequences, Cures. In this book, he predicted that the policy response to the collapse of the Dot.Com bubble had actually made the threat of a major financial crisis worse. The sharp increase in the American Federal Government deficit and US money supply had resulted in a growing American trade deficit that had destabilised the global economy by creating a worldwide credit bubble. This, he said, “was the outcome – and indeed the goal – of the policy response to the slump that followed the implosion of the technology bubble.” The consequence of this credit bubble was inflation in asset prices, driven by bank loans. When the asset price bubble burst, as inevitably it would, it would lead to widespread bank failure. “Global economic stability will only be restored,” he wrote at the end of the seventh chapter of his book, “when policymakers implement measures that eliminate the disequilibrium in the international balance of payments that caused these crises.”
At a more modest level, I was also becoming increasingly concerned about the unsustainability of the Millennium Boom. At that time, I was Managing Director and majority shareholder in Caledonian Economics, a firm I had founded ten years earlier. In November 2006, at one of the regular conferences we hosted for our clients, I reviewed current market developments and drew on the analysis of a Swedish economist, Knut Wicksell, who had examined the apparent paradox of what economists term an “inverted yield curve” more than a century before. In normal times, savers require higher interest rates to persuade them to deposit their money for longer periods of time. They are giving up the flexibility of having ready cash available, and in return seek a higher rate of interest on their savings. So usually, interest rates will be higher, the longer the period that savers have to wait to get their money back. The yield curve which traces the relationship between the rate of interest and the length of time to repayment therefore slopes upwards. This is a normal yield curve.
But in November 2006, the yield curve for British Government bonds was not tracing this normal upward-sloping pattern. Rather, it was sloping downwards. Investors were being offered – and were prepared to accept – a lower yield, the longer the bond had to run to maturity.
The question arises: why would investors be prepared to lend money to the government at lower rates of interest for longer periods than for shorter periods? This seems irrational, taking account of the additional risks involved in lending for a longer time…
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