The joke about Harry Truman asking to see a one armed economist so that they couldn’t say “But on the other hand” has lasted because it is true. How true was proved again this weekend when a group of ‘esteemed’ economists wrote a letter attacking George Osborne’s deficit reduction plan. Sure enough, another group of esteemed economists were soon on hand to defend George Osborne’s deficit reduction plan. What’s a Chancellor to do?
If the economy was roaring back to health we wouldn’t be hearing any of this. But it isn’t. While there are bright spots in areas such as employment economic growth as a whole is anaemic to non-existent and forecasts are being regularly downgraded. But it may well be an economic and political mistake to expect any better.
The economic mistake stems from the fact that surprisingly few economists have actually stopped to wonder what, exactly, the recession is. There is something approaching a consensus on how it came about and there is no shortage of often contradictory schemes to banish it immediately and forever. But few have asked what it is doing and why it is doing it.
For all the rhetoric about greedy bankers from the left and the Community Reinvestment Act from the right the underlying fact of both narratives is loose central bank monetary policy. Low interest rates, artificially pushed below their market rate by the sort of price fixing board which we were told had died with Soviet Russia, flooded banks with cash. When, in turn, this tidal wave of cash flooded out of the banks, the bubble was born.
During the bubble this money was borrowed heavily and spent heavily. Lots of economic activity took place which was paid for with this newly-created, borrowed money. A great deal of this economic activity, be it house building, banking or Woolworths, was reliant for its continuation on the continued availability of cheap credit.
This couldn’t continue indefinitely. Eventually this flood of credit overcame the downward pressure on inflation figures of Chinese goods and services and statistical manipulation and started to show up in the headline. Central banks tightened. Interest rates rose. All that economic activity which was reliant for its continuation on the continued availability of cheap credit ground to a halt, be it house building, banking or Woolworths.
This is what the recession is; the point after the limits of cheap money have been reached when the economic activity based on cheap money stops. Looked at like that, the policy landscape appears starkly different.
You could try, as the Keynesians suggest, using the government to step in as borrower and spender of last resort. This might work in the short term, allowing Ed Balls to trumpet “When Labour left office last spring the economy was strengthening with growth of 1.1 per cent in the second quarter of 2010”, but if you throw £150 billion of borrowed money at an economy you are bound to see some result. And it is suicidal in the long term especially in a country like Britain where the government had already been borrowing for years before the recession hit.
You could try, as the Bank of England and Federal Reserve have, fixing interest rates ever lower in order to keep this flood of cheap credit flowing. But this is simply to encourage borrowing to continue at the previous, unsustainable rate. Again, in the short term this may have some output effect but quite soon, already in the case of Britain, you are going to run into inflationary pressures again.
Either way, the use of fiscal policy, to replace private borrowing with government borrowing, and monetary policy, making it cheaper for everyone to continue borrowing, are wasted efforts. They cannot transform enterprises that rely on an inflationary credit environment into ones that will survive under natural conditions. Those enterprises will cease.
This gives policy options very different outcomes. The recovery will not look like a 45 degree angle rocketing gloriously from bottom left to top right on a graph. Rather, frantic attempts to push the economy up simply cancel out the economy’s downward tendency to give us a flat line, about what we have now. This is what happened to the US in the 1930’s and Japan in the 1990’s. Going into the next election with an economic record like that would be disastrous for the Conservatives and Liberal Democrats.
The alternative is to take a deep breath and go for a V shaped path, a deep but short recession. Of course, this guarantees the dreaded ‘double dip’ but given that the inevitable rise in interest rates makes this dead cert anyway it might be better for Osborne if it happened now rather than nearer to the election, as turnaround time between now and 2015 is disappearing all the time.
The economy is still riddled with enterprises that can only survive with infusions of cheap credit. The market will liquidate these sooner or later, and the coalition would be wise to get the harsh medicine out of the way now. Their failure to prepare the public for the coming pain may prove to be a costly political mistake.