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Will Keynes save the world again?

The economic news last week was remorselessly grim from every corner of the globe. Factory output in Spain was down 12,8% in the 12 months to October; November’s new car sales in China were 10,3% lower than in the same month in 2007, perhaps helping to drive BMW sales down 25,4% last month.

In the United Kingdom, the first three working days of each month sees the release of surveys detailing the health of manufacturing, construction and services.

Although their track record is not especially long, all registered record lows this month. It’s a similar story on the other side of the pond. The world’s biggest economy shed 533 000 jobs last month, and 1,25-million in the past quarter. The sheer size of these falls in activity and their geographical spread explain why policymakers have hit the panic button.

It was announced last week that America has been in recession since the end of last year and if the same methodology is applied in the UK, the recession would have started in April. Central banks are straining every sinew to get the credit markets functioning again, with the US Federal Reserve in particular massively expanding the scale of its support to financial institutions. Officials at the Bank of England and the Treasury have been perusing Keynes’s General Theory for alternative ways of driving down borrowing costs.

In one sense, what has happened over the past 18 months has been the obverse of the 18 months after the Wall Street crash of 1929. Back then, activity nosedived because policymakers did nothing. They sat back and watched banks collapse; they delayed cutting interest rates; they sucked demand out of already weakening economies by balancing budgets.

One thing policymakers cannot be accused of now is inactivity, yet nothing seems to be working.

There could be an obvious explanation for this. It takes time for economic policies to work, especially when the global system has suffered the sort of shock it received when the financial markets froze in August 2007. Combine that with the surge in oil and other commodity prices this year and the ingredients were there for a severe downturn. In the end, the policies pursued by finance ministries and central banks will work; we just have to be patient.

But politicians have elections to fight; they can’t afford to wait for recovery a few years hence. What is more, the voracious media beast demands that policymakers are seen to do something — anything — in the face of bad news. There is a school of thought which says that the picture is not nearly as bad as the screaming headlines and the breathless breaking news reports would suggest. If this really is Great Depression II, so the theory goes, why are the trains still so crowded, the shopping malls thronged, restaurants so busy?

There is something in this. While it is possible that the current crisis may develop into a 1930s-style slump, we are still a long way from a world in which US industrial production collapses by half, leaving a quarter of the workforce on the dole. But blaming the media for the recession is an example of the bubble-think that got the world into this mess in the first place.

The fact is, of course, that something did go fundamentally wrong. It was assumed that prosperity could be built on a mountain of debt because asset prices would continue to rise. It was assumed that countries such as Britain, the US and Spain could consume vastly more than they produced year after year, while the big exporting countries such as China could amass ever bigger current account surpluses.

And it was assumed that the resulting grotesque imbalances in the global economy could be smoothed out by financial markets, provided they were allowed to get on with the job of allocating capital free from the dead hand of meddling governments. All three proved to be utterly — and ruinously — misguided, and it is for that reason that the sky has fallen in.

Policymakers are clearly alarmed at the mounting job losses and are concerned that 2009 will see trains, malls and restaurants a lot less busy than they have been in 2008. The question is whether the use of unconventional solutions will amount to over-egging the pudding.

On the one hand, there is the risk of delay at a time when deflationary pressures are growing. There is talk of a classic Keynesian liquidity trap, when nominal interest rates fall close to zero and the authorities find it impossible to stimulate demand through lower borrowing costs. Prolonged deflation makes matters worse because real interest rates remain positive no matter how severe the recession becomes.

On the other hand, there is the risk that policymakers could be storing up big inflationary problems by hitting the panic button too quickly. In case the current economic pain is being caused by the inevitable time lag between policy being eased and policy becoming effective, then adopting the policy known as quantitative easing may prove reckless.

The solution proposed by Keynes in the 1930s was for central banks to buy up long-dated treasury bonds and gilts to drive down long-term interest rates. There are other ways of going about quantitative easing — cranking up the printing presses for one — but if this is to be done, then manipulating the long end of the bond market is the way to do it. One feature of the financial crisis is that long-term interest rates have not come down nearly so fast as official short-term rates. In the US, for example, 30-year mortgages are barely any cheaper than they were in the summer of 2007, despite the biggest housing slump in the nation’s history.

Official buying of long-dated bonds was Japan’s eventual solution to its problems after the lost decade of the 1990s and when Ben Bernanke said last week that the Fed was thinking of doing something similar, it had the desired effect: 30-year bond prices went up and, as a result, long-term interest rates went down.

Problems would arise if the Fed and other policymakers were overestimating the severity of the downturn and/or latent inflationary pressures caused by previous interventions. In that case, they would merely be substituting a bubble in the bond market for a bubble in the housing market, and when that bubble burst we would see a collapse in bond prices and a devastating rise in long-term interest rates.

The spectre of Alan Greenspan looms large. As far as policymakers are concerned, though, that of Herbert Hoover looms larger. –

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Larry Elliott
Guest Author

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