Not even the great economists of history can get us out of this fix

Every financial crisis is unique but the current crisis is so different even the best economists in history are unsure of how to get back on track. Never before have we seen a financial crisis result in such all-encompassing and explosive growth in public indebtedness.

By Jeremy Warner
8:25PM BST 26 Sep 2012
The Telegraph

Every big financial crisis has its own defining characteristics, but both in origin and consequence, such implosions tend to be remarkably similar. In virtually every case, you first see a long period of excess in financial risk-taking, where credit spirals out of control. This ultimately proves unsustainable, and in the resulting bust the process of credit expansion goes violently into reverse, causing often catastrophic economic damage, from which it will typically take many years to recover. There is no quick bounce back from recessions caused by financial crises.

In one important respect, however, the present maelstrom is unique. Never before have we seen a financial crisis result in such all-encompassing and explosive growth in public indebtedness. This is not a problem exclusive to Britain, nor is the UK even the worst example of it. To a greater or lesser extent, all advanced economies that were directly involved in the financial crisis have suffered the same phenomenon, with public debt climbing to previously unthinkable levels. This might be understandable in the event of a no-holds-barred military conflict, where nations are fighting for their very existence, but for public indebtedness to be approaching such extremes in peacetime is quite without precedent.

Admittedly, there have been a number of occasions over the past two centuries where individual countries have had much higher national debts, relative to GDP, but these have nearly all coincided with major wars, where the simple act of demobilisation alone has been self-correcting, causing public spending to fall and economic growth to come roaring back. That’s not going to happen this time around. To the contrary, low growth, combined with the mounting public spending obligations associated with ageing populations, threatens to make the problem steadily worse.

Already, three members of the G7 have debt in excess of 100 per cent of GDP, with one of them – Japan – at more than 200 per cent. Three of the remaining four are chasing hard. Almost everywhere, targeted dates for deficit elimination are being pushed further into the future. Far from climbing out of the hole they have dug for themselves, Western economies are sinking ever deeper into it.

Tortuous debate here in the UK over further benefit cuts and/or taxes on the better off finds its supercharged parallel in the US, where there is complete political stalemate over whether to tax more or spend less. President Obama has singularly failed to strike the hoped-for grand bargain on deficit reduction, while Britain’s Coalition shows every sign of rupturing due to open disagreement over tax and spend. Meanwhile, the public debt overhang continues to mushroom. Abject fiscal ruin approaches fast for many previously “rich” economies.

Watching Stephanie Flanders’s magisterial new series for the BBC, Masters of Money, it is clear that none of the three great political economists she profiles – Keynes, Hayek and Marx – has the answers to this problem. All three, in their different ways, offer plausible explanations of how the mess came about, but little in the way of realistic solutions.

A disciple of Hayek would argue that application of Keynesian solutions has actually worsened the mischief, by shifting liability for the bad lending of the past on to the public balance sheet. In seeking to address the crisis by rescuing the banks and engaging in counter-cyclical spending, governments have only set themselves up for further trouble down the road.

I don’t dispute the analysis, but when the alternative is mass liquidation, it is quite hard to see how governments could have done anything else. We sort of tried the destructive approach in the inter-war years, with disastrous consequences. I hesitate to say that what’s being applied in the eurozone periphery is Hayek-lite – that would be stretching the parallels too far – but you get the point. The fiscal and monetary austerity the euro is forcing on the periphery is squeezing these economies to death, with potentially grave socio-political consequences for Europe as a whole. The way things are going, Spain will soon be reliving the civil war of nearly 80 years ago.

However, it is equally obvious that Keynesian solutions aren’t working either. In the US, both the deficit and the overall national debt are now even higher than they were during Roosevelt’s New Deal. Deficit spending may admittedly have helped save the US from a repeat of the mass unemployment and general misery of the Great Depression, but the country is self-evidently struggling to re-stimulate growth and job creation, and it has been left with a seemingly intractable public debt. About the best that can be said for this deficit spending is that it delays and smooths the adjustment. Even Keynes, I suspect, would balk at today’s ongoing deficits.

As for Marx – well, the world has tried that too, and I think it fair to say that few would want to repeat the experiment. Warts and all, capitalism basically works. Communism does not.

Oddly, the 20th-century economist most likely to produce solutions – Milton Friedman – is absent from the BBC series, though Flanders says that’s because the BBC thinks there is only so much macro-economics the viewers can take. This is a shame, for Friedman was that odd contradiction in terms, a free-market interventionist. He was a passionate advocate of small-state economics, but he also believed that governments have a role to play in both preventing and solving crises through manipulation of the money supply.

Today, his teachings are a widely accepted part of the central bank’s armoury. True enough, central banks messed up spectacularly in allowing credit to spiral out of control in the boom – they broke his rules – but Friedman would undoubtedly think they are acting correctly today in attempting to counter the collapse in money and credit with zero interest rates and quantitative easing.

These techniques also offer a partial solution to the public debt problem, though not one that central banks, with their inflation remits, will ever willingly admit to. Governments may pay lip service to the virtues of fiscal consolidation, but ultimately it always proves too painful and politically unpalatable, and they end up inflating away the debt instead. Inflation of 5 per cent per annum would more than halve the real value of the existing stock of debt in less than 10 years, all other things being equal. This is essentially what happened in post-war America, where repeated bursts of inflation, manufactured through ultra-loose monetary policy and the “financial repression” of bond yields legally capped at 2.5 per cent, helped quite rapidly to reduce public debt to manageable levels.

It’s extremely unfair on creditors and cash savers, but losing 10 to 20 per cent of your money through the stealth tax of inflation is presumably preferable to losing the lot in mass default. Government bond investors take note: with yields at historic lows, you are in the midst of one of the biggest financial bubbles of all time.

But let’s not get too carried away here. To think that central bank money-printing offers a largely pain-free way out of our economic difficulties is sadly deluded. Carried to extremes, it ends in hyper-inflation, and in any case, in an era of low growth and the progressive loss of Western employment to technology and foreign competition, it does nothing for living standards. Wages may lag prices for years to come. Friedman offers some plausible solutions, but even he cannot magic away the consequences of years spent living high on the hog. One way or another, a price has to be paid.

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