The same mistake again

While European countries argue about bank recapitalisation and the US authorities worry that we may fail to avert a meltdown, a key principle should be borne in mind. Recapitalising the banks is not enough. What needed to escape recession is a great surge of consumer demand. Just as a rocket needs a lot of fuel to reach escape velocity, so too does an economy to escape from a slump.

Last time around, the OECD countries together threw over a trillion dollars at the banks—rightly to prevent the financial system from seizing up. Although recapitalisation may be a necessary condition for recovery, it is certainly not a sufficient one. Demand is the key.

The western economies spent the expansionary years of 2001-07 living on private credit. But even before the Lehman collapse on 15 September 2008, economies were going into recession (eg, the US) and households and companies were spending less, using money instead to rebuild savings. In particular, Britain’s growth had been fuelled by consumer credit, obtained in part by people using their houses as ATMs; by 2007 the UK too was running out of steam.

Today, faced with the deep recession triggered by financial collapse and compounded by fiscal tightening, consumer demand is weak, not just in Britain but throughout the OECD. As a new IMF paper argues, fiscal austerity is contractionary. [1] Europe and the US are stagnating. In consequence, export demand has weakened and real investment has fallen since private investors see little reason to expand operations.

Fiscal tightening was a response to growing government debt, which in turn was caused by the combination of a brutal recession and the state-led bailout of the banks. With a new financial crisis about to break, the danger is that OECD governments will repeat past mistakes.

Yes, more money will be needed for bank recapitalisation and for dealing with other aspects of the crisis. But above all, money will be needed to kick-start the economy. Only the state can perform the kick-starting trick which, if successful over several years, will restore confidence causing private investment to accelerate.

What should the state do? Above all, it should invest in creating jobs and income for ordinary people. The obvious place to start is by using state-owned banks to invest massively in a modern and greener infrastructure.

Where is the money to come from? It can come in part from monetisation—if the Bank of England can adopt quantitative easing worth 5% of GDP to inject it into the banking system, it can surely do it to inject into the real economy. There has been no Philips curve (wage-push inflation) for more than a generation. Monetisation under conditions of deficient demand and spare capacity does not lead to inflation.

Critically though, the extra resources should come from redistribution; ie, effective taxation of both high income and excessive private wealth. That’s what the ‘Occupy Wall Street’ movement is about, and that why some brave economists (eg, Joe Stiglitz, Paul Krugman) are supporting them. When you already ‘earn’ a million a year or live in a house worth many millions, there’s no proof that you’ll be happier earning an extra million or owning bigger houses, luxury yachts and so forth. By contrast, there’s plenty of proof that more poverty and inequality are bad for society.

Monetary easing while tightening the fiscal screw in the name of ‘balancing the budget’ is entirely the wrong policy. The budget cannot be balanced today, nor even tomorrow. Cutting at ‘half the rate’ which some Labour politicians in the UK seem to want is little better. If we are to avoid the Japanese fate, what’s needed in addition to bank recapitalisation is a long period of consistent and well-targeted fiscal expansion. It’s a lesson which all OECD countries must take to heart.
_________________________
[1] The paper finds that ‘a 1 percent GDP fiscal consolidation reduces real private consumption by 0.75 percent within two years, while real GDP declines by 0.62 percent’ See Guardajo J, Leigh D and A Pescatori ‘Expansionary austerity: new international evidence’ IMF Working Paper WP/11/158; http://www.imf.org/external/pubs/ft/wp/2011/wp11158.pdf

No related posts.