Thursday, 16 January 2014

The morning after the night before

Like a terrible hangover that takes an age to clear the developed world has been limping along, since the aftermath of the financial crisis.  There is lack of vigour, a kind of listlessness that Larry Summers has characterised as “secular stagnation”.   Economies, unable to return to the optimistic per-party state they enjoyed from 1995 to 2007, are now settling for survival rather than growth – the pounding headache makes future endeavours unthinkable – we are definitely in the bunker. There are four connected things going on here: dehydration, nausea, a sense of injustice and finally despair – sounds familiar? Secular stagnation is not inevitable we can find a cure. But as Larry tells us “ without a clear diagnosis of our problem and a commitment to structural increases in demand, we will be condemned to oscillating between inadequate growth and unsustainable finance”. And he goes on to say that " A strategy that relies on interest rates significantly below growth rates for long periods of time virtually guarantees the emergence of substantial bubbles and dangerous build-ups in leverage"  - which is exactly where we are low growth, poor levels of employment, low levels of investment - but the very high risk of bubbles and other financial risks.

The Morning after the night before


Dehydration:  World demand is drying up:  people, businesses and governments are getting used to surviving on less and the political elites are demanding more austerity.  This promotes an environment where, at the zero bound of interest rates, those who do have money prefer to see it dwindle slowly rather than risk investments that may (or may not) pay off in the longer term.  We are in dire need of liquidity (Coke is strongly recommended) and there is no refreshment in sight.

Nausea:  We are also going through bouts of nausea that bubble up because we have poisoned ourselves and have neglected to take proper nourishment.  We swing violently from feeling unwell to feeling truly terrible, small sensorial events can bring about a violent reaction and a messy result.  The concentration of money into a relatively small number of hands, when interest rates are so low, creates the same kind of queasiness; we are now extremely sensitive to bubbles as huge sums of money chase very few opportunities to secure sensible risk reward.

Injustice: The morning after the night before it’s always the same question – why should it happen to me?  Rather that apply the remedy quickly and effectively we are busy playing the blame game, unable to see cause or remedy (“it was the Crisps, honest”) when it’s clear for all to see that the alcohol has caused the contagion.  In the same way politicians have looked over their shoulders at the policy decisions and have blamed the entire problem on excess in the noughties, this is getting in the way of good decision making.

Despair: There comes a point where the intoxicant knows that it can get no worse, but the problem is that this goes on for an indefinite period of time.  We have the same with interest rates.  The developed world has had negative real interest rates for 3-4 years this has not been sufficient to prompt savers to invest nor prompt borrowers to borrow.  We now know that we need an interest rate of -2 or -3% to create some sort of equilibrium between inflation and growth – sadly this is not seem feasible.  So we soldier on understanding that we are at the bottom but that the pain could last indefinitely.

The after effects of the “mother of all parties” are not uniformly felt.  The Eurozone has a humdinger whereas in the UK we have seen a bounce this year as enormous flows of foreign Direct Investment have landed on our shores (a kind of bubble).  These in-flows have given us the “pick-me-up” we needed, which then triggered some consumer demand, which in turn has triggered and up-tick in investment and business activity.  But the proponents of the secular stagnation believe, and they may well be right, that this is just a bubble, which will fade and die.  So how do we solve the puzzle of: pooled wealth in the hands of ultra-risk adverse investors, an increasing share of income held by “owners of capital” rather than employees and a zero bound that is insufficient for interest rate equilibrium.  Well as always there are three options.

Hair of the dog

The liberal wing think we need to force up demand so restoring a situation where reasonable growth and reasonable interest rates can coincide (equilibrium).  This would be achieved through increased government spending, taking advantage of the current period of latent capacity to renew and infrastructures and invest for the future (no better time to re-build Heathrow airport). It’s not clear to me why government spending should be more efficient that private consumption (encouraged by tax cuts or helicopter money).  The bearded economists among us will say that taxing the rich (pooled money) and spending it effectively (no risk of more saving here) is the first best option.

Take on some oxygen (inflation)

Some have argued that what we need is inflation (pump it up man) to reduce our debts and to give savers / hoarders a good reason to invest their money.  Central banks have done their bit here, though quantitative easing that has increased money supply (if not velocity).  The problem is that without great circulation velocity this extra money just sits in pools adding little to the real economy.  Olivier Blanchard (the IMF chief economist) has responded arguing that policymakers should target higher inflation to generate sufficient demand and then use macroprudential policies manage any financial instability.  Macroprudential policies might very effectively filter out some “excess in savings”  (like mortgages and foreign direct investment) while leaving “good” savings free to investment in the economy. The problem is this inflationary argument is that it’s probably too difficult for Central Banks to regulate against all “bad bubbles” whilst letting good investment do its work.

Take it like a man

The monetarists believe in taking the pain or even piling on the pain (so we don’t forget how bad it was).  They promote austerity (going on the wagon indefinitely) in public spending, monetary policy (no QE for them) and temper this with supply side reforms (open and efficient markets). Some EuroZone economies have been leading proponents and they are hardly good advertisements for this restorative – but time will tell.

The problem here in deciding and implementing the first best option (whatever that may be) is that politics get in the way.  If the first best option was more public expenditure to drive growth and cut the investment gap, Republicans, Tories and other conservatives would be manning the barricades. Alternatively, austerity with supply side reforms would risk a the same reaction for Liberals - so we muddle along.  Any way the jury is out on what would be the first best option (and it's quite likely we will never find out) so in the meantime can I suggest that we rely on Mr P.G.Wodehouse and his patent restorative!

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