The longer the economic crisis goes on, the less credible sticking plaster solutions become. Four years in, Europe is heading into a nasty recession, China is flirting with a hard landing, the governor of the Bank of England is warning of a systemic banking crisis and George Osborne has announced spending cuts that will continue for the next six years. The United States is the one part of the world where the news has been better recently, with signs of life returning to the housing market and a welcome fall in unemployment.
What's happening in America – where the Federal Reserve has used two rounds of quantitative easing (QE) to boost the money supply and announced its intention to keep interest rates low – has encouraged the belief that recovery will eventually come, provided the policy response is big enough for long enough.
It remains to be seen whether this is indeed the case, since there have been false dawns galore since the financial system froze in 2007. The real strength of the US economy will be revealed early next year, when tax breaks supporting consumption and investment are removed and when the world's biggest economy starts to feel the impact of the slowdown on this side of the Atlantic.
Deadly limbo
An alternative way of looking at the crisis goes like this. We now inhabit a world of the living dead: a eurozone that will not collapse but cannot be reformed; banks that are kept alive by gigantic quantities of electronically generated cash but do not lend; homeowners who are sitting in homes worth more than they paid for them but are able to stay put because interest rates are so low and lenders have no desire to crystallise losses, and policy that is neither one thing nor the other.
There is a story, almost certainly apocryphal, that John Maynard Keynes and Friedrich Hayek used to discuss the state of the world while sharing on air raid warden duties on the roof of King's College Chapel in Cambridge during the second world war. Were they alive today, the great economists would – from their different perspectives – no doubt have harsh things to say about the way the global economy is currently being managed.
Hayek would say that the zombie-like state of affairs has been due to the refusal to allow banks that lent irresponsibly to go bust. His analysis of the crisis would be that too much easy money led to too much unproductive investment. While not cavilling at the suggestion that spending should be maintained during a slump, Hayek would argue that the aim of policymakers should be to return to a situation where production was sustainable and profitable. If that meant letting banks go under, then so be it. If nature's cure took time, then so be it.
Since the crisis began, policymakers in the west have prided themselves on avoiding the mistakes made by Japan in the 1990s. Hayek would say that western leaders have repeated the big policy error made by the Japanese – allowing over-leveraged banks crippled by non-performing loans to stay in business – with the same baleful results.
The US did allow one bank to go bust, when it failed to save Lehman Brothers in September 2008. Market mayhem ensued, amid fears that other banks would go under as well, and there was a complete change of approach. Banks were recapitalised courtesy of the taxpayer and provided with unlimited quantities of cheap money to keep them afloat. Hayek would say that this was merely a sticking-plaster solution, albeit the biggest and most expensive piece of sticking plaster the world has ever seen, and would point out that last week – more than three years after the Lehman bankruptcy – the only thing that had changed was that the centre of the problem was no longer the US but Europe.
Italian banks are even more dependent on their financial lifeline now than they were in 2008; last week's co-ordinated action by six of the world's leading central banks was prompted by evidence that Wall Street was no longer prepared to lend money to European banks. Sooner or later, Hayek and his followers would say, there has to be a purging of the system to remove the rottenness, and what has happened over the past few years is merely deferring the inevitable. Interestingly, it is not only free-market economists that believe in the power of creative destruction. The term, although it came to be associated with Joseph Schumpeter, originally came from Marxist economic theory, which held that each phase of development emerged out of the wreckage of a system that no longer worked. Socialism would follow capitalism, just as capitalism followed feudalism. The Marxists believe the attempts to muddle through are doomed to failure.
Creative destruction
There is, of course, not the slightest possibility that policymakers will opt for the creative destruction approach, at least not willingly. Nor, though, is there any great appetite for adopting a pure – as opposed to pseudo – Keynesian approach. If he were alive today, Keynes would caution against a Hayekian catharsis, but would also be critical of blanket austerity at a time when demand is weak and confidence low.
Keynes would have approved of the action to slash official interest rates. He would have approved, also, of the attempt to manipulate market interest rates lower using QE. But he would be alarmed at the weakness of private-sector investment, particularly given the large amount of cash sitting idle in company bank accounts. Keynes would conclude that the "animal spirits" of commerce are currently low, and so it is up to governments to prime the pump through higher public spending.
In the early stages of the crisis, that is what happened. Monetary policy and fiscal policy were supportive and – Keynes would say – the result was the tentative recovery seen in the second half of 2009 and early 2010. Then, however, the financial markets started to look askance at the size of government budget deficits and spooked finance ministries into taking over-hasty remedial action. The result has been that public demand has been sucked out of western economies at a time when private demand is weak. The result has been a slide back towards recession. Keynes would say that instead of worrying about deficits, governments should be worried about unemployment: get growth going again, and the deficit will look after itself.
Policymakers' riposte to Keynes would be the same as it would be to Hayek: get real. If we take no action to rein in deficits, we will be slaughtered by the markets; bond yields will go up sharply, negating the impact of cheap money. Keynesian fiscal policy, in other words, will only be possible when the markets share Keynes's belief that jobs matter more than the level of national debt, and given the way economics has been taught in universities for the past 30 years, that moment may be a long time coming.
As things stand, economic policy lacks intellectual coherence, monetary policy is governed by a belief in the need for unrestricted credit, and fiscal policy by a belief in "expansionary contraction". It is a mishmash based on one big assumption; given time, the grown-ups can fix things. There are three possible responses to this: they can fix it given time; they can fix it if they use a different toolkit; they can't fix it at all because the system is bust. You decide.
Facebook
Twitter
Instagram