With so much bad news from the financial markets, it is becoming difficult to see the wood for the trees. This is my attempt to identify the main economic problems we face, and to explore their policy implications.
Problem 1. Sovereign Debt
Put simply, governments throughout the West have borrowed, and continue to borrow, too much money. They have become accustomed to living far beyond their means, and seem to be unable to stop. Some countries have already hit the point of no return, while others are fast approaching it. What the markets are most concerned about is the prospect of sovereign default – that is, governments holding up their hands and saying, “sorry, we just can’t pay you back.” Sovereign defaults in major economies (like Italy) would likely have disastrous knock-on effects.
Problem 2. An exposed financial sector
The reason sovereign default is such a big problem is that governments bonds have long been considered more-or-less the safest kind of investment. They form the ‘security’ part of most portfolios. Indeed, one of the main ways we have tried to make our banks safer since the financial crisis is to force them to invest more in government bonds. So if the sovereigns go, so do many of our banks. And there does come a point where more bailouts just aren’t possible.
Problem 3. Sclerotic growth
Normally, one wouldn’t be too worried about sovereign debt. Governments are seen as going concerns, with extremely secure revenue streams. How can you run out of money when you are legally entitled to force people to give it to you? The difficulty comes when your growth rates are so low that there isn’t enough money to give. Then you have a big problem.
Of course, I’ve long argued that a quick bounce back from the recent recession was unlikely. Those countries that experienced a major credit-fuelled boom were left with severe economic distortions. Unsustainable bubbles had built up in financial services, housing and construction and the public sector. Given that these sectors form a major part of many country’s GDP figures, and given that a necessary part of the economic adjustment process was that these sectors would shrink, it was always hard to see where significant growth was going to come from.
But there’s also a broader point here. We may actually be witnessing the inevitable breakdown of the modern, bureaucratic welfare state. Countries are finding themselves with too many unproductive people for a dwindling stock of productive people to support. To put it more colourfully, the parasites are taking over the host, and they are slowly strangling it to death.
Problem 4. Low private sector confidence
The one peculiar thing about the current outbreak of economic doom mongering is the there a lot of private enterprises that actually look pretty good. Particularly in the US, there have been strong earnings and good profits reported, and cash flow looks very positive. Yet businesses aren’t investing. Why? The main reason is a lack of confidence – they don’t want to invest in projects that will take time to come to fruition when the future is so uncertain. And who can blame them? When political failure is raising the spectre of sovereign default and financial collapse, when severe deflation and hyperinflation both look like genuine possibilities, and when you don’t know where the next tax or regulatory burden is coming from, who would want to take on any extra risk?
The first policy implication is straightforward enough. Governments have to come up with credible plans to eliminate their deficits and stabilize, then reduce, their levels of accumulated debt. Put simply they need to cut spending and live within their means. But they also need to do more than that. They need to fundamentally reform the state. They need to roll back bureaucracy, free up entrepreneurs, and reduce the burden of welfare. We cannot achieve what we need to achieve through efficiency alone. And we cannot pretend that governments can continue to do everything they currently do. We need a programme of reform that rivals the post-war settlement in its radicalism, but which heads in precisely the opposite direction.
The second policy implication concerns the financial sector. We need to accept the fact that we can’t keep bailing out failure, and find a way of managing it instead. The government needs to develop a credible method for ‘resolving’ banks that become insolvent. It needs to come up with a plan for winding up failed financial institutions without threatening the system as a whole. We’ve wasted three years obsessing over bank bonuses and arguing about whether retail and investment banking should be separated, but it’s not too late to switch our focus to something that would actually make a difference.
The third policy implication is that central banks desperately need to maintain monetary stability. That means keeping the money supply constant in the absence of changes in velocity, but increasing it if velocity falls and decreasing it if velocity rises. The second half of that task is not easy. Indeed, there’s a good case to be made for it being impossible. Firstly, in times of uncertainty, velocity tends to be volatile. Secondly, velocity can’t be observed directly. Thirdly, changes in the money supply take time to filter through the system. Fourthly, even if you could overcome those first three points, you still wouldn’t have a simple formula to work to – the economy is full of complex interrelationships and feedback loops, and people’s psychology and expectations play a far more important (and unpredictable) role than economic ‘scientists’ care to admit. Simply avoiding a severe deflation, on the one hand, or a hyperinflation, on the other, might be the best we can expect from central banks.
The bigger picture
What we are witnessing now are the concluding chapters of a credit-cycle that began in the early 2000s, when the US Federal Reserve decided to avoid the recession that should have followed the collapse of the dot-com bubble by flooding markets with easy money and cheap credit. But one could also argue – as Detlev Schlichter does – that we are really approaching the endgame of a much larger economic super-cycle that began when President Nixon closed the gold window in 1971 and removed the last vestige of restraint from government’s fiat money systems.
It is easy to construct an apocalyptic narrative from where we are today. One can easily imagine sovereign defaults triggering bank failures, which in turn would trigger more sovereign defaults as incompetent governments rushed to throw money at every emerging problem. You can picture financial collapse sparking a severe monetary contraction and plunging us into a 30s-style depression. Or you can see governments making a last-ditch attempt to monetize out-of-control debts, and prompting a hyperinflation that would also lead to systemic collapse and widespread economic depression.
And while, yes, there are those who argue that a more rational system would emerge phoenix-like from the ashes – ushering in fiscally-disciplined governments, a sounder international monetary regime, and greater freedom for private enterprise – it is more likely that wholesale collapse would lead to the resurgence of nationalist socialism. That would spell an end for liberty and private wealth-creation, and could even mark the return of large-scale international conflict. This is a Road to Serfdom that the world has walked before.
But as I said, it is easy to contruct an apocalyptic narrative. And when the headlines are dominated by doom and gloom, it is very tempting to do so. But we should also remember what Adam Smith said: “there is a great deal of ruin in a nation”. The reality is that doomsday is probably not upon us. If we get things wrong, then, yes, we may face a prolonged period of Japanese-style stagnation. But it is also possible that we could get things right. We could emerge from our current troubles with a brand of capitalism that is more robust, and better able to deliver real, lasting, sustainable prosperity than ever.
Ultimately, economics is all about choices. Right now, we just need to make the correct ones.
This article was first published by the Adam Smith Institute.