Comment: The hole we’re in is a bottomless pit
IN ECONOMICS, as in life, we become only slowly wise. But five years on from the week that the great financial crisis first erupted, are we any the wiser?
Far from gaining wisdom, the past five years look to have made fools of us. There was the early failure to recognise the scale and severity of the threat to the western financial system. Central banks assumed it would quickly blow over. Then came a manifest and continuing under-estimation of the economic impact. Indeed, early prognoses in the US argued that there was no risk of recession and that demand and output would quickly recover.
There was also a persistent, false confidence that this was a conventional, albeit severe, economic downturn and that conventional fiscal and monetary policies would secure recovery. By mid-2009 there was a widespread view that the worst was over and that the economies of Europe and America would, within two years, be firmly on a sustained uphill path.
Well, here we are, five years on, deep in the wreckage of these shattered wisdoms.
The belief still persists that the decade that preceded the financial crisis was a “normal” state to which we should aspire to return; that if only governments spent and borrowed more, western economies would snap back and recover; and that central banks can and should embark on massive monetary stimulus without fear of inflationary consequence.
Across the Eurozone the delusion has persisted that governments and politicians can defy the doubts of markets and manufacture confidence by fiat and decree.
Historians looking at what we have done over these past five years might reasonably come to the conclusion that, far from becoming wiser, we have grown dumber.
In America and Europe government finances have barely recovered from the financial shock – indeed, across much of the Eurozone they have grown worse. Banks, in the grip of a huge political and regulatory backlash, are still faced with massive bad-debt write-downs and provisions. Lending to business – partly due to new regulatory constraints – is well below levels that would promote recovery. And confidence – household and business – remains deeply depressed.
Our previous assumptions and beliefs have failed us. That is the truth of our situation. Here in the UK we have relapsed into a double-dip recession. And in the wake of the Bank of England Governor’s assessment last week, we now seem headed for a triple-dip by year end.
How has the conventional wisdom failed us – that helped by rock bottom interest rates and massive monetary easing – we would by now be well into a sustained recovery?
A quick glance at any central bank chart in recent years showing the explosion in public and private debt would very quickly tell us how and why we went off the rails.
The Bank’s Sir Mervyn King has been wont to call the decade up to 2007 “the great moderation”. Here he was referring to the downward pressure on inflation caused by the great China boom and its impact on the prices of manufactured goods. In this he was right. The fall in the prices of manufactured goods – electronic products in particular – eased inflationary pressures and enabled central banks to lower interest rates.
But the pre-2007 period also came to represent the very opposite of a great moderation – instead, there was a debt and borrowing explosion without precedent. For four decades after the end of the Second World War, debt as a percentage of GDP in the US moved in a narrow band between 140 per cent and 170 per cent. From the mid-1980s it began a ferocious acceleration, climbing to almost 360 per cent.
This phenomenon – repeated across other western economies – was the equivalent of our “roaring 20s”, the period running up to the 1929 Great Crash. And this was a debt boom that fuelled an explosion in personal, household and government consumption.
We could have it all. And we did. In fact, consumption and economic growth became a function of cheap credit and easy borrowing. We slid from a state of pleasant euphoria into dependence into addiction. We became debt junkies. Looking in retrospect at what happened to commercial property lending, to the financing of hedge funds and private equity, to the boom in residential house prices through the buy-to-let craze, debt addled our brains.
Over the past five years we have struggled with various solutions to this addiction that would avoid highly unpleasant “cold turkey” – whether for governments in the form of harsh reductions in public spending, or businesses and households through credit withdrawal, failure and bankruptcy. The “solution” we have broadly followed is the approach of slow “tapering off”.
However, as we are now finding, there has been little tapering in government debt to GDP ratios. And there has been strident advocacy of an increase in spending and debt to enable economies and tax revenues to recover.
The experience of the US in the 1930s is cited as the “slam dunk” argument for government intervention and the slow-taper approach. Did not the New Deal programmes of the 1930s produce recovery? These programmes helped to mitigate what was an appalling economic collapse with soaring unemployment and misery.
But there is another interpretation: that New Deal interventions extended and prolonged the downturn by slowing down the process of debt and borrowing correction and clearance. America’s unemployment rate did not fall into the range of single digits until the US declared war on Japan in 1941. And US GDP in real terms did not return to is 1929 level until Dwight Eisenhower was midway through his first term in office.
As economists Charles Rowley and Nathanael Smith argued in a paper published jointly by the Locke Institute and the Institute of Economic Affairs, economic growth only returned to its pre-1929 robustness when, contra Keynes and Cambridge, the US government had cut its war-related expenditures sharply, lowered personal corporate income tax rates and reduced its wartime budget deficits. This flies in the face of arguments by Paul Krugman and others that the New Deal failed because it was not bold enough.
These are not at all comfortable conclusions for the “big government” school. But here we are, five years on and faced with some very searching questions about our understanding, our analysis and our approach to the aftermath of the financial crisis.
This is no ordinary conventional downturn but the ending of a credit super cycle, and once we grasp this, the notion that there are quick, painless turnaround solutions by resort to more spending, borrowing and debt looks at best questionable. That the economies of Europe and America have not responded in the expected manner surely requires a wisdom greater than digging deeper into the hole we’re in.
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Weather for Edinburgh
Sunday 19 May 2013
Temperature: 10 C to 16 C
Wind Speed: 8 mph
Wind direction: North
Temperature: 9 C to 20 C
Wind Speed: 7 mph
Wind direction: West