Further Analysis of the Economic Crisis

After the meeting on the Crash of 1929, and lessons for today’ economic crisis, I have  made the two papers available for interested reader. The first paper looks at the Crash of 1929. You can read this here. The second looks at the Great Crash of 2007. You can read this here

Further Analysis

David Cameron has been amazingly successful at shifting the political battle onto his own ground; he has disguised a strategically weak position with tactical élan.  Labour has done the opposite; it has allowed a strong strategic position to be nullified by the darts and feints of the opposition.

Let me explain.  Cameron’s main argument – that the economic mess we are in is the result of the failing of big government – is the precise opposite of the truth.  The reason for the crisis was not that the state was too active, but that it was too passive.  For three decades, from the mid-1970s onwards, regulations on finance were relaxed, markets were unshackled, taxes were cut.

Paul Davidson, in his new book ‘The Keynes Solution,’ puts it this way:  “During almost all of the last four decades the public debate over economic policy has been dominated by the belief that if self-interested individuals are permitted to operate in a free market without government interference and regulation, and without worrying about other members of the community, the resulting free market will bring the economy to nirvana.”

Keynesian schadenfreude

Market fundamentalism has been found wanting these past three years.  The economics profession has stood aghast as, one by one, its sacred cows – self-correcting markets, rational expectations, efficient markets hypothesis – have been slaughtered.  Keynesians (and Marxists, to be fair) haven’t had so much fun in years; far from waiting for the hidden hand to work its magic, governments stepped in to prevent banks from failing, the financial system from imploding and the global economy from collapsing.

Only once in the entire crisis has a government opted for a “nature’s cure”, and when Hank Paulson let Lehman Brothers go to the wall, he unleashed four weeks of mayhem in the financial markets that only started to abate when governments took stakes in tottering banks in return for capital injections.

Even so, the near-death experience for the banks had an immediate and profound impact on the real economy.  Credit lines dried up and confidence collapsed.  Output and trade contracted at rates last seen in the 1930s.  Policy makers responded by cutting interest rates to historically low levels, loosening fiscal policy and pumping new electronic money into the banking system through quantitative easing.  This was not activist macro-economic policy, it was hyper-activist.  Credit creation by the state compensated for credit rationing by the banks; spending by the state filled the breach left by the squeeze on private spending.

By the spring of 2010 there were signs of the policy beginning to work.  Output stabilised and financial markets rallied.  While there are legitimate doubts – voiced by the IMF among others – as to whether the recovery is for real, the immediate threat of a 1930s-style slump may have passed.  The only doubt on the near horizon being the state of Dubai World and other large Government and Company debts like Greece, Russia, Ukraine, Lithuania, Hungary, Iceland and California.  It appears that Britain is exposed to debts of $13.4 bn in Greece, $8.2 bn in Russia and $51.2 bn in the United Arab Emirates.  But nearer to home Irelands debt is even greater where economic boom driven by easy credit and soaring property values have given way to precipitous bust.  Just for good measure 49 of the 50 states in the USA have debts and it is a constant battle to raise revenue for teachers and police salaries by floating bonds.  The USA really does believe in the “good fairy” but not taxation.  I can also hear you shouting what doubts are there on the far horizon?  Well I am not clairvoyant so I will leave this to a later date but as you are aware speculation is rife about nation collapse.

Only by the most convoluted reasoning can the crisis of the past three years, and the events in the previous thirty years that led up to it, be described as a failure of big government.  On the contrary, it was the deregulation of financial markets championed initially by governments of the right that allowed finance to strip away the prudential controls on its activities.

That’s why Cameron’s position is strategically vulnerable.  Making the case for interventionist social democracy has never been easier: The mess was caused by a weak state allowing a free rein to a cadre of irresponsible financiers; only a newly emboldened state could clear the mess up.

It is a mistake to underestimate the Tory leader.  There are those on the left who think that because he went to Eton he is, by definition, an upper-class twit.  But Eton churns out lots of smart people (Keynes included).  The current economic debate is not about the right’s responsibility for the crisis.  Nor is it about the opposition’s own uncertain response to it.  Instead, it is about which party has the most blood-curdling plans for spending cuts.  That’s some achievement.

There’s enough sense in what Cameron says to make it politically potent; hence his cleverness.  But it is still a flawed analysis.  He is right, certainly, to argue that governments cannot run budget deficits of £175bn a year permanently.  He is also right when he says that Britain was running a structural deficit of 2-3% of GDP going into the downturn.

But the deficit is the symptom of an economic problem, not its cause.  The bulk of the deficit is accounted for by the contraction in the economy since the start of 2008, which has sharply eroded tax revenues and pushed up the cost of welfare spending.  Only a small part of the deficit increase has been caused by discretionary tax and spending decisions by the ex-chancellor, Alistair Darling.  If the public finances had been in better shape in 2007, Labour would have been in a position to provide a bigger fiscal boost, but the upshot would have been broadly the same – a deficit this year in excess of 10% of GDP.

Scary proposals

If the lion’s share of the deficit was caused by the recession then, logically, the priority now should be to get the economy back on its feet as quickly as possible.  Conjuring up the ghost of Stafford Cripps is more likely to hinder this process – by scaring the pants off consumers and small businesses – than it is to help.

Cutting back too soon could drive the economy into a depression, warned David Blanchflower, respected economist and a former member of the Bank of England’s monetary policy committee, in the Guardian.  “The Tory economic proposals have the potential to push the British economy into a death spiral of decline that would be almost impossible to reverse for a generation,” he wrote.

So what is Labour’s problem?  Faced with the most propitious economic circumstances for a party of the centre-left for decades why is it so comprehensively failing to seize the moment?  There are plenty of suggestions flying about.  Some say it is all about Ed Miliband, it is said, simply he does not cut it with the public and has been a liability since his election.

Some say it is a combination of a deep recession and being in power for too long; the electorate is bored with Labour and rising unemployment was a convenient pretext for changing allegiance.  Some put it down to the foreign wars, or the private finance initiative or the fact that the gap between rich and poor is wider than it was in 1997.

Labours failure has been its inability to use the crisis to articulate a broader critique of market fundamentalism, or my usual description neo-liberalism.  And the reason for that is that from 1997 to 2010 Labour was complicit in the excesses of the market.  It was too weak or too bedazzled to control the City, but not so reticent when it came to plans for DNA testing and ID cards.  The supine approach to finance coupled with creeping social authoritarianism explains why Cameron’s attack on the big state resonates.

With anger at the banks still running high, it is still possible to seize the social democratic moment.  What’s lacking is an intellectual argument that challenges the orthodoxy of the past three decades.  That, though, requires an admission that much of what Labour has believed these past 12 years was wrong.  As things stand, that looks unlikely.

Keith


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2 Responses to Further Analysis of the Economic Crisis

  1. Appreciate it for all your efforts that you have put in this. Very interesting information. “It is not the oath that makes us believe the man, but the man the oath.” by Aeschylus.

  2. John Greenwood says:

    There is another lesson to be learnt from all this. Markets are important, when they work properly they act as a sort of auto-pilot. An auto-pilot in an aeroplane has to be set up with the correct control parameters; get them wrong and the plane crashes. Likewise markets operate according to a set of regulations and, as demonstrated in both 1929 and 2008, allow these to be compromised, and the market crashes.
    In both cases greed led to stupidity. People found they could get rich using dodgy trading instruments, these worked better if the market regulations were relaxed, Those in control, stupidly, deregulate the markets; Crash!
    Market fundamentalists are dangerous because they have this illusion of The Market as a sort of magic that automatically gives the right answer. This is like putting an auto-pilot into a plane believing that they will just work, without being aware of how easily they could be totally unstable, and then sacking the pilots!
    The reality is that markets are a human invention. Bits of machinery. They are a useful tools but only if set up correctly and even then cannot be trusted to respond properly in extreme situations. You still need the pilots ready to take over when intelligence is required.
    Just as you would not want to let stupid people anywhere near the auto-pilot in a plane, so you should not let stupid people have any influence on the regulations of markets. This extends to greedy people as greed leads to stupidity.
    There is no wisdom in markets or auto-pilots. You have to tell them were you want to go and then, provided conditions remain calm, they guide you in that direction. You need to check that you do not go off course.

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