Since financial calamity first hit in 2007, the economic debate has merrily oscillated between those who reach for Keynes and those who reach for the neo-classical, Treasury view school of economics. It is a fascinating theoretical debate – and at that level I tend to side with the Keynesians. But what if neither outlook can get us out of this mess in practical terms?
This last week of bond, stock, and commodity market turbulence mixed with political death matches and poorly coordinated responses has changed the environment decisively. If there was a Keynesian route out, it is now off the table in all probability. In a sense, while not conceding an inch on the theory, even Paul Krugman has admitted defeat. In his recent Keynes’s General Theory at 75 lecture, he laments:
“But watching the failure of policy over the past three years, I find myself believing, more and more, that this failure has deep roots – that we were in some sense doomed to go through this.”
And this is the problem, the right Keynesian response – debt-financed demand expansion – has hit three simultaneous buffers. The first is intellectual. The neo-classical response has been robust and what’s more it is more politically powerful. That leads to the second limit – political. It is mightily difficult to either get politicians, the media or voters to be relaxed about budget deficits of 10% of GDP or more for any prolonged period of time. Keynes never had a mobilisation strategy and his modern day disciples still don’t. Even more critically, is the third buffer – financial. This is the buffer that Keynesians are now hitting. It’s difficult to find people to fund deficits and debt on the scale that’s required.
Credit rating agencies are easy targets in all this. There is no doubting their incompetence given that they merrily AAA-rated sewage for many years. Equally, there is no doubting their corruption. They are paid by the people they rate. Moreover, they are intimately linked to a broader super-structure of power and influence. Just take Standard & Poors. They are owned by McGraw-Hill. The chairman, president and CEO of McGraw-Hill, to quote his full name for comedic effect, Harold Whittlesey “Terry” McGraw III, is rumoured to be a supporter of Mitt Romney. Go figure.
Nonetheless, who can really argue with the S&P downgrade given what we’ve seen over the last few weeks? A credit rating is reflective, amongst other things, of a possibility of default. The Tea Party in Congress sailed the federal government mighty close to a default, so is it any wonder that the downgrade followed?
So the downgrade is reflective of a political reality. The Keynesian response is then to demand leadership. Sure, the contrast with the G20 Summit in 2009 is stark. And let us never tire of mentioning the formidable role played by Gordon Brown in preventing the world economy from entering the abyss. But what is the leadership that the bond markets are demanding? It’s not another round of reflation. They are insisting on further fiscal consolidation. In other words, markets are demanding precisely the opposite form of leadership than that demanded by Keynesians.
The situation we are in leaves three further options for recovery: austerity, default, or inflation. The sovereign debt markets want austerity and growth. So does George Osborne. The problem is that is very unlikely that we will see austerity and growth. In fact, the results from George Osborne’s early austerity package indicate that austerity undermines growth. And worse is to come. The bond markets are just as irrational as the British government: they have growth and austerity objectives that, as things stand, are mutually exclusive and make little sense. The medicine they prescribe prevents the patient returning to health so they then plan to administer a fatal injection instead.
As Cormac Hollingsworth has outlined, the government’s austerity programme may actually result in the UK borrowing more than the previous government would have done under the Darling plan. The Office of Budget Reponsibility, which has had a disastrous first year by any measure, continues to downgrade growth every time it appears in public. Hollingsworth calculates that if growth comes in around the 1% mark this year then the deficit reduction plans are out the window. The IMF sees growth as much less than the OBR is predicting and also forecasts Osborne hitting his fiscal targets a year later than he is forecasting – 2016 instead of 2015 – and then only by the skin of his teeth.
Osborne has made the wrong call and it’s too late to reverse – the UK would be punished but the incompetence belongs to the chancellor. The problem is that by going down the austerity road, even a moderate plan such as the Darling plan may have been taken off the table given the irrationality of bond markets. They’ve tasted austerity blood and like it. We’re in an Osborne-flavoured pickle. We haven’t even talked about the social and economic costs of his strategy which are immense. More austerity vicar?
So what about defaulting on debts? If the Eurozone does not become a fiscal union (a new political entity), this may be the only option available to Greece, Italy, Spain, Portugal, Ireland and Belgium. The UK is fine for now but two or three years of very low growth, barely moving deficits, and political impotence and we may be facing a very different story. The problem with a default is that it is simply austerity by another means. Your economy is starved of credit for a considerable time. You can bounce back eventually and that is why it is an option. In the short-term though, the human and economic costs can be immense.
That leaves inflation as a final option. Essentially this involves printing money – or quantitative easing – to the extent that the dam bursts and prices start to rise as cheap credit or even free money flood the economy. Very serious economists such as Professor Kenneth Rogoff argue for the inflationary approach. He argues for inflation in the 4-6% range for the US (in the UK’s case it would be more than this given where inflation already is.) The reality is that this is default by another means which is austerity by another means. It may be a better way of defaulting and austerity but do not think for a moment it is a cost free option.
The problem with inflation is that you don’t get to ‘choose’ what the inflation rate is. You can aim for 6% but end up with 15%. It corrodes the income of those who live off their savings and of the poor whose wages fail to keep up with price rises. It might also affect the flow of credit after a while as unpredictable inflation makes loan valuation difficult. In reality, this is a strategy which must be treated with extreme caution.
So there you have it: Keynesianism is right but has hit the buffers; austerity is wrong and failing but is supported by the bond markets; default has horrendous short-term costs; and inflation is a highly risky and costly strategy. So what will work? Essentially, we need a magic money machine it would seem.
All eyes immediately turn to China. But why would China expose itself further to over-leveraged, sickly western economies? The instant retort is that it needs us as a market for its goods. And that is true but only up to a point. The future of China’s economic growth is not to be found in Europe and the US. It doesn’t want us to collapse for sure. Neither is it obligated to write us blank cheques. The markets of the future are in emerging economies.
Why would China continue to increase its credit to fund unjustified western lifestyles, unaffordable welfare systems, funded by unsustainable levels of debt when it could cement its economic power in the economies of the future? Actually, emerging economies aren’t the economies of the future anymore. They are the economies of the present. In a must read article, The Economist reports this week that on a purchasing power parity measure (which takes into account real spending power), emerging economies overtook developed economies as a share of global GDP for the first time in 2008. A report by McKinsey into global capital flows shows that more than half of global IPO volumes (new first-time share issues) has been on emerging economy exchanges in 2009 and 2010. The planet has swung on its axis. We were just shopping at Westfield on bubble-asset fuelled credit while it happened.
China’s interest is to secure lines of commodity supply from Africa and the Middle East and ensure a presence in the developing markets of the future. It has options.
That leaves the miracle option. There has been a process of corporate deleveraging and non-financial companies are holding hundreds of billions in cash. They may choose to invest it. If they do then growth may resume and things will get better. This happened in the mid-1980s and again in the mid-1990s. It does rely on the expectation of future demand for the investment (back to Keynes again). This financial collapse may have shot those expectations for a considerable time. Or we might get lucky. Whatever happens, luck is not a strategy.
So what can be done? Unfortunately, the reality is very little. I’m afraid that George Osborne has taken the Darling plan off the table as far as financing the deficit is concerned. That would have been a much better strategy but that’s for the history books. The following may be about all we can manage:
i) A capital intensive stimulus package may be doable, i.e. one that creates demand in the short-term and raises the growth potential of the economy. It would have to be clearly focused on building houses (ie reducing prices and freeing up future capital for productive investment rather than mortgages), power stations, and capital allowances. The mooted planning reforms with a presumption in favour of consent are a positive step. It would certainly be worth considering ways to incentivise companies to bring forward investment plans – how about a greater that 100% capital allowance on new investment? Perhaps part of this is seeking a new relationship and open access for China, India, etc (the irony).
ii) A new round of quantitative easing given the caveats outlined in the Rogoff inflation strategy mentioned above.
iii) Maintaining a grip on current public expenditure. I’m afraid that Osborne went down this road and removed the reverse gear and steering wheel in doing so. History will judge him harshly but we can only choose where to travel from where we are not where we were or where we wish we were.
iv) New taxes to support this tight control of the current deficit. A mansions tax would seem like a logical step. Just as congress/the President should allow the Bush tax cuts to expire, it is reasonable for the UK to seek new taxes on the wealthy. A new tax on properties above a certain amount – £750,000 say – with an exemption for those on low incomes living in those properties (ie pensioners in the main) would be positive fiscally but economically it would have marginal impact.
v) In the longer term, we have to save more as a nation and borrow less. Building new houses to lower prices is part of that. We also need to think about innovative savings policies, eg an automatic (with volutary withdrawal) saving deduction in a personal account for all those earning above a certain amount with more generous savings incentives for those on lower incomes. These policies would have to wait for recovery before implementation.
vi) We need to get serious about the eurozone. This is also a longer term consideration in the main. Both main parties have fallen into the trap of calling for European leadership while not even sitting at the negotiation table. To sit at the negotiation table we have to be prepared to contribute. If the eurozone survives with a new fiscal union created then for all intents and purposes the UK is once again on the outside as it was prior to 1973. The eurosecptics will have seen their renegotiation happen and it won’t be pretty. The EU will become simply a rubber stamp for policies agreed in the Eurozone and prejudiced in favour of the euro bloc.
vii) We need long-term policies to raise to global competitiveness of the UK. This means investing further in our strengths: research, our universities, creative industries and biotech clusters etc. We must also address our weaknesses: technical skills, start-up and growth capital, translating research in new globally competitive products and services. A strategic industrial policy is needed by all means but the future of the UK will be as a globally competitive service based economy. What are the modern policies that are needed to achieve that?
We are at the end of the road. The global economy has changed. The economic ideas we have at our disposal are either wrong or just not practical. In the short-term it will be a case of muddling through and doing our best in very tight constraints. In the medium-term, it is about erecting the institutions to promote the type of economic behaviour that can prevent what seems the likely outcome of becoming an island of austerity.
Despite our current predicament, there is hope. Few voices are offering real solutions and yet real solutions – a new institutional mix – are available. While it appears that we are caged in the economics of no way out there is a thin ray of light. Will we be honest with ourselves enough to locate it even though none of our maps contain the answers? Or will we remain in the darkness arguing about who was to blame for getting us here while we descend further into the darkness? The choices are narrow. Which way will we choose?