Since its collapse in the autumn of 2008, the world economy has gone through three phases: a year or more of rapid decline; a bounce back in 2009-2010, which nevertheless did not amount to a full recovery; and a second, though so far much shallower, downturn this year.
The resulting damage over the past four years has been huge. The world economy contracted by 6 per cent between 2007 and 2009, and recovered 4 per cent. It is 10 per cent poorer than it would have been, had growth continued at the rate of 2007, and the pain is not yet over. Today, we are in the first stages of a second banking crisis. It may already be too late to avoid a “double dip”, but it may still be possible to avoid a triple dip. For this we need a robust intellectual analysis of what is required to ensure durable recovery, and the collective political will to implement it.
Backdrop to the crisis
Economics is in a mess. With the shattering of the dominant Chicago School paradigm, whose rational expectations hypothesis ruled out, by assumption, the kind of collapse we have just experienced, two old masters, Friedrich von Hayek and John Maynard Keynes, have risen from the dead to renew the battles of the 1930s, equipped this time with explanations for what has gone wrong. We can label these “money glut” and “saving glut”.
The Hayekian argument for the slump is that lax monetary policy made it possible for the commercial banks to lend more money to businesses than the public wanted to save out of its current income. Hence, a whole tranche of investments – “malinvestments”, Hayek called them – was being financed by credit creation, not genuine saving. This led to a bubble in the real estate and financial sectors which powered a consumption boom. When (belatedly) the money tap was turned off, the bubble burst and the American economy slumped. The slump is simply the liquidation of the unsound investments.
By contrast, the problem for Keynesians was not insufficient saving, but insufficient investment. Investment is governed by uncertainty, while saving is a stable fraction of income. Keynes’s economy tips over into recession when, for some reason, profit expectations decline relative to the volume of saving being done. Businesses start to prefer liquidity to investment. This pushes up the rate of interest, or cost of borrowing, just when you want it to come down. Saving and investment are then brought back into balance, not by a fall in interest rates, but by a fall in incomes. The recession of 2008-2009 was caused by a collapse in investment, not by overindebtedness; overindebtedness was a consequence, not a cause.
Both explanations have an international dimension. The Hayekian story starts with the overissuing of dollars by the US Federal Reserve, made possible by the dollar’s role as the world’s leading reserve currency. This enabled Americans to live beyond their means and to spend more than they produced.
The Keynesian story starts with Chinese oversaving. The Chinese save a much higher proportion of their incomes than their economy, as organised, can absorb. It was the voluntary recycling of excess Chinese savings into the US economy by means of the Chinese central bank’s purchase of US Treasury bills which allowed the United States to become the world’s “consumer of last resort”. The “money glut” in the US was a consequence, not a cause, of the more fundamental “saving glut” in China.
The two stories are derived from contrasting theories about how a market economy works. The first sees it as a self-regulating mechanism, in which the “invisible hand” smoothly channels the self-interested actions of individuals towards a social optimum in the absence of monetary disturbances. The Keynesians accept the social value of the market system, but deny that, in the presence of irreducible uncertainty, it is optimally self-regulating. The “invisible” hand guides economies not to a social optimum but to “underemployment” equilibrium. As such, government intervention is needed to ensure full use of potential resources.
On a cool view, there are elements of truth in both explanations of the recession. We do not have to choose between American profligacy and Chinese frugality. Our policies for recovery have to deal with both contributions to the unravelling of prosperity.
Austerity v stimulus
The differences just described over the origin of the crisis underpin the present debate between austerity and stimulus. According to Meghnad Desai, writing in the Financial Times of 15 September, “The long recession is a Hayekian phenomenon and not a Keynesian one . . . The need is to deleverage, not to spend.” The private and public sectors alike need to increase their saving, even though this will reduce aggregate demand in the short run. Letting assets find their proper value will bring genuine demand at realistic prices and punish those who have taken wrong decisions.
There will be more pain in the short term, but the Keynesian alternative of stimulus delays the adjustment, unfairly forcing taxpayers to pay the price of rescuing those who took too much risk. The boom was the illusion; the slump is the opportunity to liquidate the malinvestments.
To this, Keynesians pose two objections. First, they deny that there was “too much” spending in the US economy before the collapse.
There were no signs of general overheating: inflation was low, and there was no shortage of labour. What they would concede to the Hayekians is that cheap money made possible a great deal of misdirected, or speculative investment, which fuelled a wealth-driven consumption boom. But this is not the same as saying that there was overinvestment in the strict sense that further investment would have yielded a zero rate of return, or that there was too much consumption in general. It is absurd to believe that the demand for goods and services of those 46 million Americans living below the poverty line had reached the point of saturation. The houses and construction facilities built in the bubble economy are still there: they require an increase, not a reduction, in the incomes of the low-paid in order to become “affordable”.
But more fundamentally, Keynesians argue that, even if the Hayekian diagnosis is right, the remedy of austerity is wrong. It derives, they say, from the medieval medical practice of bleeding a sick person to purge the rottenness from his blood – a species of cure that frequently led to the death of the patient. Lionel Robbins, retracting his opposition to Keynesian stimulus policies in the 1930s, wrote:
Assuming that the original diagnosis of excessive financial ease and mistaken real investment was correct – which is certainly not a settled matter – to treat what developed subsequently [by austerity policies] was as unsuitable as denying blankets and stimulants to a drunk who has fallen into an icy pond on the ground that his original trouble was overheating.
(Compare this with the German finance minister, Wolfgang Schäuble: “You can’t cure an alcoholic by giving him alcohol.”) The point is this: if both the government and the private sector are trying to increase their saving at the same time, you don’t just liquidate the bad investments, you kill the economy as well, by reducing national income until everyone is too poor to save.
That is why I have been arguing in the UK that when private enterprise is asleep, for lack of effective demand, the state must step in to stimulate the moribund investment machine back into lively activity.
The truth is that the policy of all-round “cutting down” increases the problem of indebtedness. The bond markets have diagnosed accurately that, in the absence of growth policies, one lot of debts after another will become “unsustainable”. Both the national debt and the debts of private institutions will shrink automatically as a fraction of national income if national income grows, and conversely will grow if it shrinks. Growth, not debt reduction, should be the chief aim of economic policy today. Where there are too many debt collectors, they end up ruining themselves. The eurozone today is awful witness to this truth.
With austerity in the ascendant, the world recovery is petering out. Europe is on the edge of a precipice, in a feedback loop from bank insolvency to an explosion of sovereign debt to a second round of bank insolvency. The United States is in little better shape, with its fiscal policy paralysed and the markets expecting a Japanese-style stagnation.
Latin America, the Middle East and Russia are benefiting from a commodity boom. Of their main markets, however, the US and Europe are hardly growing, and China is slowing down as Beijing tries to rein in an inflationary bubble in real estate, and because its export-led growth depends on the continuing increase in American and European demand. If China’s voracious appetite for commodities slows, growth in Latin America, the Middle East and Russia will grind to a halt, which in turn will limit demand from them for Chinese goods. So the circle of pain widens, as each misfortune feeds back on itself.
The plain fact is that there is too little aggregate demand in the world, and the net effect of all the policies being pursued is to reduce it further. So, what will the future bring?
We know what happened in the 1930s: the world economy broke up. The conventional wisdom is that this is impossible today under any circumstances. The cliché has it that economic integration is irreversible; that the revolution in information and communications is ineluctably turning the world into a “global village”. However, this benign prospect ignores the possibility of great crises and collapses. People were saying exactly the same thing in 1914. Historically, globalisation has come in waves, which recede under the impact of crisis and catastrophe as economic life retreats to the relatively safe haven of national jurisdictions.
We have reached the end of that phase of globalisation in which we dealt with the problem of permanently mispriced currencies by means of recycling mechanisms that pumped up speculative bubbles. But what follows it? There are two alternative hypotheses, which may be described as Disintegration and Co-ordination.
The first hypothesis is that, as we fail to solve our problems globally, the global economy will start to fragment. At present, domestic demand is being suppressed both by countries that depend heavily on export-led growth and by countries that are trying to reduce their current account deficits. What this signals is that the global authorities are engaged in a simultaneous effort, for different reasons, to reduce aggregate demand.
This is completely the wrong policy. Christine Lagarde, the new managing director of the International Monetary Fund, is right to argue that fiscal retrenchment in the teeth of a recession is suicide. The break will come when the deficit countries, unable to endure any further “bleeding”, start to resort to currency depreciation and protectionism. If the eurozone fails to organise growth policies, Greece and possibly other eurozone countries will resume their monetary and trade independence. Currency and trade wars will erupt across the globe: indeed, these wars have already begun.
The second hypothesis, Co-ordination, is what Gordon Brown calls a “G20 growth compact”. Essentially, he is calling for a revival of the spirit of international co-operation which produced the stimulus of 2009 and halted the slide into another Great Depression.
Elements of such a compact would include a reform of the global monetary system, aiming to end the era of current account imbalances; a reform of the financial system, aiming to avoid the excesses of bank lending that triggered the crisis; and macroeconomic policies that aim to boost world demand in the short run.
Progress has come on the second item. Basel III has accepted the need for the banks to hold more capital against their liabilities. Individual countries have also began to beef up their regulatory systems. In the UK, the Vickers report has proposed splitting the retail from the investment functions of banks. Hayek would have approved.
The more fundamental problem is the political power of the big banks. Not only does finance have to be reformed, it must be tamed. Winston Churchill put it well in 1925, as chancellor of the exchequer: “I would rather see finance less proud and industry more content.” So far no government has had the guts to stand up to the banks. This suggests that financial re-regulation will be emasculated.
On the other two items, there is no progress to report at all. Reform of the world monetary system needs be based on a grand bargain, mainly between China and the US, on reserves and exchange rates, but there is no sign yet of any serious attempt to achieve this. As for the third item, the only macroeconomic co-ordination is in the direction of cutting down, not building up, the world economy. There is no investment in growth.
Yet the world economy cannot cut its way out of recession: it has to grow its way out. If the bond markets force deficit reduction programmes on highly indebted governments, states must look to alternative instruments – such as national or regional investment or infrastructure banks – to mobilise private savings going to waste for want of profitable investment opportunities.
Sovereign wealth funds and pension funds would invest in growth if there was any growth going on. As it is, they invest in government debt, which carries low yields but is at least relatively safe. The former US deputy Treasury secretary Roger Altman has made the point that historically low yields on long-term government debt in the US, the UK and Germany can be explained only by anticipation of “negligible demand for capital”.
Of the two scenarios, Disintegration is the more likely. This is not just because political leadership is not up to the job of forging a global compact, but because the adjustments required of our current national economic models are too great to be undertaken voluntarily. Americans will need to consume less and export more; China and Germany will have to consume more and export less. Such change requires a fundamental rethinking of ways of living into which all three countries are locked.
In the US case, adjustment will require a break with a credit-fuelled economy, which is the only way American capitalism has of dealing with the vast inequalities of wealth and income that it has created by outsourcing most of its manufacturing to low-wage countries. There is little sign, however, of the US being willing to rethink its version of capitalism.
In the case of the Chinese, their country’s low consumption ratio, as Michael Pettis, on his blog China Financial Markets, points out, is “fundamental to the [Chinese] growth model, and the suppression of consumption is a consequence of the very policies – low wage growth relative to productivity growth, an undervalued currency and, above all, artificially low interest rates – that have generated the furious GDP growth”.
Germany, too, is locked in to export-led growth, and does not seem fully to understand that if it beggars its European neighbours by running a permanent export surplus, it will end up by beggaring itself.
If China and Germany insist on being 21st-century mercantilists – exporting more than they import – the rest of the world will start to protect itself against them. Germany’s policy will lead to the breakdown of the eurozone, China’s to the breakdown of the world trading and payments system.
The two scenarios – Co-ordination and Disintegration – have in common that they presuppose more reliance by countries or groups of countries on domestic sources of growth, and less on foreign trade. That is what we mean when we talk of a more balanced world economy. The sole question is whether the retreat from the wilder shores of globalisation will be orderly or disorderly: whether we drift into the bloc economics of the 1930s, or whether we have the wisdom to build a managed and modified form of globalisation, free from the illusion that everything can be left safely to the markets.
And here’s the point – a disorderly, acrimonious retreat from globalisation is bound to overshoot the mark, reviving the economics and the politics of the 1930s; but leading, in an era of nuclear proliferation, to consequences that are even more terrifying. So we must resolutely work for the best, without illusion, and with only modest hope.