All entries for Wednesday 14 January 2009

Three Myths of the Credit Crunch

Three myths are current in public discussion of the credit crunch and the recession that we face today: "We should make the banks lend out the money we've given them." "We can't spend our way out of this recession." Worst of all, "We are burdening our children with debt." What's wrong with them?

We should make the banks lend out the money we've given them.

Since November the following story has been in circulation; it started from Downing Street, but has found wide support. It goes like this: We, the government, have given the banks billions of pounds of your (the taxpayers') money. Instead of translating your cash into new lending, the banks are sitting on it. This is helping to drive cash-strapped businesses into insolvency, and is not fair. The banks are breaking a moral contract. We should now set targets for bank lending and punish banks that fail to meet them.

The story's wrong. We're forgetting something. Question: What was the worst case that the bank bail-out was designed to avoid? Answer: Bank failures on a catastrophic scale. And this has been averted. Our government bailed out the banks because the alternative was a financial Armageddon on the scale that ushered in the Great Depression. So far, this worst case has been avoided. For example, no British saver has yet lost a penny from deposits in a British bank. If the worst had happened, there would be ruined savers in every neighbourhood in the country. Conclusion: the banks are doing what the bail-out intended: they are holding our cash, because they need it to hold in order to stay afloat.

If we want bank lending to increase again, our government must increase the cash available still further, or at least extend its promises. That is approximately what the government is doing now, through credit guarantees to small businesses, for example.

Another version of the same fallacy goes like this. The Bank of England's discount rate is at a record low of 1.5%. Banks (including some mortgage lenders) are unfairly increasing the margin above this level at which they are willing to lend. Public pressure or legislation should bring lending rates down. But one cause of the credit crunch is that banks have underestimated the risks of lending. As a result, the gap between their borrowing and lending rates, which includes their evaluation of risk, has been too narrow. Restoring the banking system to health must provide for larger risk premiums than before.

At this point, pressure for more bank lending and lower lending margins may not be for the best. We are in this mess because banks lent unwisely. Pressing or guaranteeing them to do more of the same, especially for the sake of small businesses that have a high failure rate even in good times, does not seem to point a way back to prudence. As has been commonly observed, monetary policy in Britain as in the United States is simply running out of ammunition. Public spending may now be more effective as a way of keeping viable businesses afloat, and should take up the burden. Which leads us to the second fallacy:

We can't spend our way out of this recession.

In 1976, prime minister James Callaghan famously remarked: "We used to think that you could spend your way out of a recession and increase employment by cutting taxes and boosting government spending. I tell you in all candour that that option no longer exists, and in so far as it ever did exist, it only worked on each occasion since the war by injecting a bigger dose of inflation into the economy, followed by a higher level of unemployment as the next step." This has been widely cited recently by critics of the government such as (but not limited to) John Redwood.

If more public spending is the right answer today, why was it the wrong answer then? The reason is that that our economic predicament today is wholly different from that of Callaghan's time. In the 1970s, inflation and unemployment were rising together. That was the signal that the UK economy's problem lay on the supply side, not the demand side. The economy was rigid and uncompetitive. Industry was dominated by loss-making firms that were kept in existence by public ownership and public subsidy. The difficulties of the time required supply-side solutions: better incentives through increased competition and lower taxes.

Today, unemployment is rising and inflation is falling. This signals that the UK economy faces a deficiency of demand, not supply. Moreover, the loss of demand at home and abroad is on a scale not seen since 1929. A demand deficiency can be countered by monetary measures to some extent, but for the next few months the overworked cliché is correct: cutting interest rates is like pushing on a piece of string. (The cliché is overworked because, over a somewhat longer period, the monetary relaxation should have a powerful real effect through a more competitive sterling exchange rate.)

When demand is deficient, the quickest way to restore it may be through increased public spending. Tax cuts may be preferable in theory, since each of us knows better how to spend our money than the government does, but in the grip of current uncertainties it is likely that households will save most of any tax cut will be saved, and so the tax cuts will not contribute much to higher demand.

Rapid increases in public spending are likely to be inefficient since there is not enough time to plan them. The composition of any increase is likely to be determined more by competitive lobbying than by cost-benefit calculation. There may well be some degree of consensus that we need to invest in green technology, transport, and IT. As soon as you look at these in detail, you can watch the vested interests line up -- for and against nuclear power and carbon capture, motorway and airport expansion, and so on. However, if our immediate goal is to combat the worst consequences of the crisis, it may not matter if some projects are ill-chosen; at least they will create jobs and cash flows to replace those that are now being destroyed.

Here are two things that could and should be boosted right away -- and it would be efficient to do so.

• UK local authorities are planning for catastrophic shortfalls in council tax revenues at the same time as demands on their services are multiplying from citizens faced with losing their jobs and houses. It is shameful that local government cutbacks should be contributing to the economic downturn, rather than softening it. The government should immediately commit central funding to neutralize the effects of the recession on local government revenues.
• Iraq and Afghanistan have taken a heavy toll on the combat readiness of the UK's armed forces. The Ministry of Defence surely has a long shopping list of equipment that is needed just to reset the armed forces to their pre-conflict readiness. There is absolutely no reason to think we will need our armed forces any less in the 2010s than we did in the 1990s. We should start this restocking process now, and this will incidentally make a large contribution to the revival of UK manufacturing.

Can we use public spending to mitigate the recession? The answer lies with Obama, not Callaghan: Yes, we can.

It's true that using public spending in this way will widen the excess of spending over taxes, and cause public debt to balloon. This takes us to the third fallacy:

We are burdening our children with debt.

British politics needs an effective opposition. Just when I hoped the Conservatives were becoming one, George Osborne has come up with this: "Every child in Britain is born owing £17,000 because of Labour’s Debt Crisis."

This story is misleading, rather than false -- but it is deeply misleading on several different levels. It is true that higher public debt must be repaid sometime. As I noted here, however, the implied increase in Britain's debt implied by present policies is relatively modest and sustainable. The government deserves blame for the fact that Britain entered the recession with its current deficit in a bad way, but the accumulated level of public debt was modest, and we can easily withstand a proportionally large increase in it.

But the idea that we are burdening our children with debt is misleading at a deeper level. For one thing, they will inherit our private debts too. What is happening today will eventually lead to a considerable reduction in private debt, whether through repayment or default. At the same time public debt will be higher. So our children are likely to inherit more public debt, but less private debt.

And another thing: Our children will be better able to shoulder the public debt we will pass onto them in the future, if we don't burden them (and ourselves) with a Great Depression now. The last Great Depression impoverished families and children and threw millions of workers on the scrapheap of long-term unemployment. Worse, it paved the way to global economic disintegration and global war. Do we want to burden our children with that?

And a final thing: If it works, our children will live better than we do. As adults, they should share the burdens we face today. But I won't tell my children that. They'll say it's not fair.

Mark Harrison : 14 Jan 2009 17:05 |  Tags: Economics Keynes Recession |  Comments (4) |  Close comments |  Report a problem