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A new guide for the perplexed Samuel Brittan Financial Times 10/07/09 At one of many recent roundtables on "the crisis" a well-known historian called upon economists to abandon the gods of their profession. If only there were still such gods. There are not even clearly defined schools of thought. A typical discussion will consist of a series of overlapping points of view, leaving the innocent listener at best "confused at a higher level". What follows is an attempt to outline the main issues. It is inevitably subjective and selective. The first issue is that of an economic stimulus. A recession is usually defined as a period of low spending leading to a decline in output and employment. Thus the case for an offsetting boost to spending, whether of a fiscal or monetary kind, might seem obvious. The main problems would then be how large it should be, and if and when to run it off. But opponents of a stimulus have surpassed themselves in ingenious objections. They say that people will save rather than spend any tax cuts because of justified fears of a later reversal, and that government spending will be too late. Above all they fear ballooning budget deficits on which more anon. On the monetary policy side there are the somewhat contradictory objections that it is impotent once short-term interest rates approach zero and that it stokes up future inflation. The main proponents of a stimulus have been the US and British governments. The main "sound money" opponent has been the German chancellor Angela Merkel. International discussion has reached a stalemate, with the US and UK authorities getting away with fiscal stimuli of 1 to 2 per cent of gross domestic product. Less noticed is the fact that the Chinese and Japanese authorities have this time followed the Anglo-Saxon countries. The whole question is likely to be reopened if, as is all too possible, there is a second leg to the recession. What has happened so far is at least an improvement on 1931, when the May committee recommended to the UK Labour government of the time a cut in unemployment benefits to reduce the Budget deficit. This led to the demise of that government and the creation of a so-called "National" one. Fasten your safety belt for the highly technical question of whether more money or more credit is required. The popular view is that the flow of credit needs to be re-established. The monetarist case has been well expounded by Tim Congdon in the June issue of Standpoint. "Although the cash injected into the economy by the Bank of England's quantitative easing may in the first instance be held by pension funds, insurance companies, etc. it soon passes to profitable companies with strong balances and then to marginal businesses and so on." Central bankers, if only to preserve their sanity, have taken both the money and the credit routes. Another technical question is whether governments should borrow long term to lock in present low nominal interest rates or switch to the short term to help expand money supply. The next question is whether the main danger is inflation or deflation. Fears of both have succeeded each other in rapid succession. This may be superficially reassuring, but the abnormal degree of uncertainty is not. The Goldman Sachs UK Economics Analyst convincingly demonstrates that there is practically no inflationary danger from domestic financial stimuli. But this leaves out the external threat of a renewed rise in energy and commodity prices. The most intractable question is what to do about the banks. The middle-of-the-road approach favoured by most governments is to recapitalise them on supposedly strict conditions and guarantee their depositors. Critics on both left and right believe this is far too generous and that it would be better to nationalise them or let them stew in their own juices. My sympathies are with the critics, but whether I would dare to take the risk is another matter. Looking further ahead, there is the question of how far to go in separating deposit from investment banking, for instance on the lines of the US New Deal's Glass-Steagal Act. Even more political is the question of international co-ordination. It does not take a genius to see that a stimulus is likely to be more powerful if several countries act together. But governments differ in beliefs as well as interests. Countries with floating exchange rates have more freedom of manoeuvre. I have left to last the question of what to do about long-term budget deficits, in the case of the US and UK running into double-digit percentages of GDP. The issue is bogged down in boring left-right arguments about tax versus government spending cuts. But far more important is the question of whether these deficits really need to be slashed. Are government budgets like those of families or firms which need to balance, except for investment narrowly defined? Or should they be seen as balancing mechanisms to offset spending excesses or deficiencies in the rest of the economy? Keynes's analysis pointed to the latter; but he never really resolved the issue.
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