Storm, The (22 page)
At the time of writing, the fire seemed to be abating. But there is still plenty of combustible material around that could
ignite, fuelling the blaze. The house-price collapse has led to falls of 20 to 30 per cent in the USA. But UK house prices
still have some way to fall to a point where price-to-income ratios are at a sustainable long-term level. Moreover, markets
usually overshoot. These
further falls, should they occur, would add to negative equity and to the losses of banks.
Then there are commercial property, credit cards and car loans, which could bring a new round of defaults. The crisis has
spread to leading corporates – the car industry, steel, construction, airlines, retail chains – and there have been numerous
and high-profile bankruptcies, dragging down suppliers and adding further to the bad debts of the banking system. With recovery,
these problems are easing, but the full extent of the damage has yet to be assimilated. The fire is also spreading internationally
to sovereign debt, with the most vulnerable countries already requiring emergency balance of payments support. Doubts about
government borrowing have spread from extreme cases like Iceland to over-borrowed European countries such as Ireland, Greece
and Spain, and are now beginning to affect the UK. It is the long-term creditworthiness of countries like the UK, and even
the USA, which have borrowed massively through the recession, that could cause a new flare-up.
Firemen fighting a big blaze need to pour on lots of water. The first line of defence, and the orthodox, monetarist response
to a contraction of credit, is monetary expansion through deep cuts in interest rates. Milton Friedman, no less than Keynes,
would have argued for aggressive use of monetary policy. Only the austere ‘Austrians’ believe the opposite: that interest
rates should rise to purge past bad investment. Monetary expansion has been pursued in the USA, the UK, the eurozone, Japan,
Sweden and elsewhere. The aim was to spur spending by reducing the cost of borrowing for firms and households. As inflation
turned into deflation – with signs of falling prices and pay cuts – interest rates needed to fall towards zero. In the summer
of 2009, even as there was talk of recovery, the USA, Japan, the euro area and China all recorded consumer price deflation,
and the Governor of the Bank of England considered it a greater threat than inflation.
The world of deflation is something that has not been experienced in our lifetime, except, to a limited extent, in Japan.
It is like a world of zero gravity in which all our assumptions about movement are turned upside down. Debts become more onerous,
even if interest rates are very low. Conversely, cash savings become more valuable. Because prices are expected to fall, buyers
defer spending until prices have fallen even further. Lack of spending adds to depression and further downward pressure on
prices, while workers take pay cuts to save their jobs. Active monetary policy through interest rate cuts is necessary rather
than sufficient, however. It cannot work any more once rates have fallen to zero, or if the public is so frightened that it
hoards cash even when interest rates make it unattractive to save.
But even before we have reached that world, the active use of interest rates has proved a blunt instrument, because banks
have been reluctant to pass on interest rate cuts to their borrowers. Banks are having to borrow at significantly higher rates
than the central bank rate because the normal mechanisms of money transmission have broken down. Despite government money
pumped into banks, and despite government guarantees on the money banks lend to each other, investors have been wary of putting
their money into banks except at a premium, which raises borrowing costs.
There are other ways of stimulating the economy using monetary policy. The central bank controls the supply of money and can
pump more money into the economy to encourage spending. It can do this by expanding the reserves of the banks, for the purpose
of lending on to business or consumers. But in the current climate, banks are reluctant to use these reserves. They are also
being pressed by other agencies – the financial regulators – to hold greater cash reserves, not less, and that reinforces
the banks’ new-found conservatism, avoiding risk wherever possible and reducing their loan exposure. Governments can bypass
the banks altogether by lending directly to big firms (by buying up firms’ short-term debt, as is happening in the USA), though
this raises
practical problems of the government acting as a lending agency and can really only work for very large firms. Alternatively,
money can simply be printed and handed out to people to spend. I shall return later to the emotive issue of ‘printing money’
and the inflationary risks involved. But the practical problem in this context is that it may do little good if the money
does not circulate but is hoarded because banks, firms and families are scared to spend their cash. Nor does it deal with
issues of insolvency in financial institutions, which are paralysed as a result.
Where monetary policy does not work, or work well, governments have to use fiscal policy: that is, government deficit financing,
putting money into peoples’ pockets via tax cuts or public spending, or both. That was the particular insight of Keynes. His
magnum opus, the
General Theory of Employment, Interest and Money
, was in fact a specific theory designed to address the unusual circumstances in which monetary policy is not effective because
interest rates cannot be cut below zero (though monetary hoarders can be penalized, as Sweden is doing with its banks), or
because these is inexhaustible demand for liquidity. His view, which has now become accepted wisdom almost everywhere, is
that in these circumstances it is necessary to depart from the orthodox view that governments should aim to balance their
budgets. Governments should borrow and spend in order to maintain the level of activity of the economy. In a modern economy,
there is broad acceptance that deficits should be allowed to widen in a period of slowdown (because tax receipts fall and
welfare costs rise), offset by surpluses in a cyc lical upswing. But in a slump, Keynesian remedies go further than that and
involve a calculated additional injection of purchasing power through deficit-financed tax cuts or spending, or both. That
is what is needed – and is happening – now.
Keynes said many things, not all of them consistent. He has also been widely quoted in defence of positions he certainly did
not hold. In the post-war era he was widely associated with a large-scale expansion of public spending, in totally different
conditions
from the inter-war period, and with unsustainable deficit financing, which led to inflation. The experience of the post-war
era was that increases in public spending in bad times were not offset by contraction in good times, and that cumulatively
excessive government borrowing drove up (long-term) interest rates and ‘crowded out’ private investment. As a result Keynesianism
had become discredited by the 1980s. Furthermore, politically, Keynesianism was appropriated by socialists, though Keynes
was not a socialist but a Liberal (and liberal), who was concerned with saving capitalism, not replacing it. Seven decades
after he developed his ideas – in parallel with the ideas implicit in the American New Deal – circumstances have once again
returned in which those ideas are highly relevant in their original form.
What governments have to do in these circumstances is temporarily to maintain demand, in order to stop a self-fulfilling economic
slump, using the government balance sheet to borrow, while debt-laden companies and individuals recover confidence and rebuild
their own balance sheets and reduce their debt. Public borrowing is currently cheap, because investors trust governments ahead
of most private borrowers. The fiscal stimulus should do either or both of two things, putting money directly into the hands
of consumers, or investing in a once-and-for-all programme of public-infrastructure investment which can be mobilized quickly:
social house-building; rail and road projects for which the design and preparations have already been completed – what Americans
call ‘shovel-ready’ projects. The Obama package put before Congress in January 2009 meets these requirements to the tune of
around 4 per cent of GDP. The Gordon Brown stimulus package announced in November 2008 is proportionately more modest (just
under 1 per cent of GDP) and the small, temporary cut in VAT is unlikely to do a great deal for private consumption because
it is a drop in an ocean of retailer discounting.
Just as in the 1930s, the Keynesian remedy is proving controversial. British Conservatives and American Republicans have attacked
such methods, as they did in that earlier crisis.
Underlying some of this hostility is a philosophical position – the ‘Austrian’ view of economics – that recessions should
purge themselves of past ‘malinvestment’. Germans of all political stripes seem reticent about Keynesian policy, perhaps because
their folk memory is that ‘Keynesian’ economics was the fiscal stimulus of Adolf Hitler’s rearmament programme. One objection,
currently advanced mainly by the German government, is that a fiscal stimulus does little good, since households will save
more to compensate for government spending because they fear higher taxes or higher inflation later (so-called ‘Ricardian
equivalence’). There is even an argument that fiscal consolidation will raise consumption better than a fiscal stimulus, because
consumers will revise upwards their estimate of permanent disposable income and therefore spend more. Despite these theoretical
objections, the Germans embarked on a fiscal stimulus package which, ironically, was more audacious than the British. A related
concern, invoked by Anglo-Saxon fiscal conservatives, is that deficit financing will inevitably be followed by higher taxes
(or inflation) in the long term, causing economic damage, and so should not be undertaken. Keynes’s own answer to this point
was that ‘in the long run we are all dead’: failure to act could produce a deeper slump and an even bigger fiscal black hole
than if no government action were taken.
It is too easy to caricature the arguments about fiscal policy. A lot depends on the inherited fiscal position of the government,
the expected longevity and severity of the recession, and the design of the policy package. There are some legitimate criticisms
of what is called ‘toxic Keynesianism’: that the fiscal stimulus envisaged in the UK, particularly, may have the effect of
depressing consumer and private-sector confidence, because compensating tax increases or deep public spending cuts are clearly
signalled and because the public may be unconvinced that a return to long-term fiscal discipline is credible. I have taken
the view that in the current circumstances it is on balance right
to attempt a fiscal stimulus, recognizing, however, the risks. The alternative – prolonged and deepening slump – would be
worse.
Expansionary fiscal policy also has its limits and has to be treated with care. The bond markets, which the government use
to borrow money, may resist new issues, forcing up yields and the cost of capital. Some governments are already finding it
difficult to borrow, but while some highly indebted countries, such as Greece and Italy, pay a significant premium over US
bonds, other highly indebted governments, like Japan, can still borrow very cheaply because they have access to willing domestic
savers who trust government paper. Overall, there is no serious constraint at present on deficit financing through the markets,
but it may well be coming.
Supposing, however, that conventional monetary and fiscal policy fails: what then? Japan struggled for a decade with prolonged
recession brought about by a deflating property bubble and an overhang of debt. Fiscal stimuli and zero interest rates didn’t
work. One solution to this problem, were it to arise now in major economies, would be for governments directly to expand the
money supply. The euphemism ‘quantitative easing’ is increasingly being used in the USA and the UK, and was advocated by Mr
Ben Bernanke of the US Federal Reserve when Japan was mired in its crisis. Essentially, the government borrows from the central
bank rather than the markets. The government, in effect, leaves its deficit unfunded. The money created could be used either
to give money to individuals, bypassing banks and money markets, or to support and cheapen the government’s market borrowing
(by the government offering cash to buy up its own long-term bonds). Or it could be used to buy up a variety of private assets,
including bad and toxic debt, in order to encourage new lending. Carefully managed, the inflationary impact of money expansion
– which is popularly described as printing money though it does not directly involve printing presses – would simply offset
the forces of deflation. The problem is, however, that governments might not know when to stop. They might be tempted to create
inflation to revive the economy by rescuing debtors (at the expense of savers). Fears
that governments might be headed down the road to Mugabe’s Zimbabwe or the Weimar Republic could frighten currency markets
and, of course, voters. Such fears are, however, far-fetched and the major experiments so far have been carefully conducted.
The authorities will have to take care to ensure that there is no excess money created, or that it is mopped up quickly (which
could require government borrowing by the issuing of bonds). And there is the longer-term threat to central bank independence,
since once the immediate crisis is over there will be a temptation for governments to ‘burn off’ accumulated government debt
through inflation, and inflation targeting will come under strain.
