Central bankers are by nature sober creatures so it was hardly a surprise to find Sir Mervyn King in downbeat mood last week. The Bank of England governor’s message was that recovery from the Great Recession will be long and arduous — a statement of the obvious if ever there was one. Events of the past week provided plenty of evidence to support King’s argument: the UK unemployment figures were dreadful, the sovereign-debt crisis in the eurozone is intensifying and consumer confidence is crashing.
John Cridland, director-general of the Confederation of British Industry (CBI), said business is hunkering down and forward--looking surveys of activity suggest he is right. For companies of modest means that are dependent on lines of credit from the banks, a tough winter is in prospect. It is not just European governments that are trying to reduce their debt burdens; European banks — which are loaded up with sovereign debt — are de-leveraging as well. All the ingredients are there for a full-scale credit crunch, leading to businesses going bust and a surge in jobless totals.
This much is obvious, but not especially helpful. The task now is threefold: to learn lessons from the crisis; to put in place a workable plan for recovery; and to ensure that the next phase of the downturn is as short and pain-free as possible. A bit more optimism from policymakers would help as well. We could do with a bit less of the “blood, sweat and tears” and a bit more of the “we have nothing to fear but fear itself.”
It is a moot point whether policymakers have learned the right lessons from the crisis. The Australian economist Steve Keen — one of the handful of practitioners of the “dismal science” to have spotted the crisis coming — was in London last week and it was interesting to hear his take on what went wrong.
Keen’s argument is that the sovereign-debt crisis is merely a symptom of the real cause of the problem: an exponential increase in private debt as a share of national income. In the early stages of a credit cycle, the private sector borrows to fund investment that pays for itself, but in the euphoric bubble phase, borrowing is used to speculate on rising asset prices. Debt grows much faster than income, but those borrowing the money assume they will be able to pay off what they owe from the rising capital value of their assets. This model of growth, in other words, is no more than a gigantic Ponzi scheme, named after the fraudster who paid out investors with money raised from the next wave of suckers.
The figures are quite startling. In the US, for example, private debt was 45 percent of national output — or GDP — in 1945. By the peak of the boom in the last decade, it was 300 percent of GDP, and it has subsequently fallen to 265 percent. Over the same period, public debt has risen by 30 percentage points, softening the blow of the private-sector de-leveraging.
Britain has followed a similar pattern: During the economic upswing, individuals used their homes as cashpoints, withdrawing £300 billion (US$467 billion) in equity as property prices rose. Since the crash, they have taken advantage of low interest rates to reduce their indebtedness. Equity repayment has been a little more than £50 billion, suggesting this process could have some way to go. The global economy is not going to return to sustained growth until debt is significantly reduced.
One way of doing this is through “nature’s cure” — accepting that it will take time for the debt hangover to wear off. In the meantime, governments also need to put their house in order, reducing their borrowing so that interest rates can stay low and so that finance ministries build up sufficient ammunition to deal with any future crises. However, this option does mean that the depression will continue for many years, because the result of the private and public sectors de-leveraging simultaneously is a hefty fall in aggregate demand.
In the US and the UK, quantitative easing (QE) has been deployed in an attempt to prevent private sector de-leveraging leading to a prolonged and deep contraction. Asset purchases by central banks boost the balance sheets of financial institutions and drive down the interest rates on government bonds, making other forms of investment more lucrative. The idea is for the money created by QE to flow out of the banks and into the wider economy.
Given the amount of money that has been created through asset purchases, the impact on growth rates has been disappointing. This is perhaps not all that surprising, given the desire of banks to hold more capital and the reticence of a debt-saturated private sector to borrow more. Ironically, the one bit of the economy that ought to be benefiting from QE — the small businesses in need of working capital — is still struggling to get the finance it needs.
Keen says the solution to this problem is for governments to change dramatically the balance between fiat and credit money in the economy. Fiat money is cash directly created by governments; credit money is created through a process known as fractional reserve banking, in which banks can lend more money than they hold as reserves. The assumption currently is that repeated doses of QE will oil the wheels of the fractional reserve-banking machine.
However, by increasing the quantity of fiat money, Keen says this process could be circumvented. What should happen, he says, is that governments should give the public a big dollop of cash. Those that had debts would be obliged to use the money to pay them down; those that didn’t would be able to spend the money however they wished. The result would be lower debt levels and greater spending power.
A more radical version of this idea would be a debt amnesty for those gulled into borrowing more than they could afford during the bubble years.
This, though, is not a realistic option: It would be seen as unfair by those who did not get into debt and it would be strongly opposed by the banks, many of which would go bust as a consequence. One thing we have discovered during the crisis — not that there was much doubt about it — is that the lobbying power of Wall Street and the City of London is immense. If they can head off the threat of a Tobin tax then they would certainly be able to nix a debt jubilee.
The attraction of Keen’s proposal is that it attacks the root cause of the problem while at the same time offering to shorten and alleviate the cold turkey as individuals try to kick the debt habit. Rising household incomes would spur consumption — the biggest component of GDP — and would encourage those companies sitting on big cash piles to invest rather than hoard.
Stronger growth would make it easier for governments to balance their books and reduce their debt-to-GDP ratios.
There would, of course, still be plenty of problems left to solve. The global economy, as King reminded us last week, remains grotesquely unbalanced. The financial system is not fit for purpose. The tendency to take on more debt than is good for us will remain endemic until labor increases its share of income.
However, confronting the issue of private indebtedness is crucial. Unless it is tackled, a crisis now deep into its fifth year will continue for years to come.
Larry Elliott is the Guardian’s economics editor
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