The Times – Economic Opinion, 29th December 2010
Most macro-economic theories had egg all over them when the financial crisis broke. Only a few economists, among whom I am naturally proud to be included, warned of the looming problems. The signs of trouble lay in excessive asset prices and too much debt. But most economists saw nothing to worry about because asset prices and debt have no place in their theories.
In the immediate aftermath of the crisis there were some signs of contrition. Dr Bernanke, the Chairman of the Federal Reserve, who had previously insisted that asset prices did not matter, appeared willing to reconsider the question. Such doubts seem now, however, to have been forgotten. Few of those who give recommendations on economic policy have changed their views to reflect our sad and dramatic experience. They forget that those who refuse to acknowledge past errors are likely to repeat them. It has been said with more wit and truth than charity that “Science advances obituary by obituary.”
The traditional and unreformed schools of economists, such as Monetarists and Keynesians, want further stimulus to the economy by increasing debt. Keynesians want faster growth in national debt and Monetarists in bank debt. The major division today is between those who see more debt as the way out of our current difficulties and those few iconoclasts who saw debt as the cause of our troubles and now fear that more debt will add to them.
Since World War II the world economy has grown well, but growth in output has been dwarfed by growth in debt. In the US debt has tripled as a percentage of GDP, with private sector debt growing five times as fast as output. This raises two major questions. Why has it occurred and how long can it continue? The first is quite easy to answer. It has paid! Despite the dramatic increase in private sector debt, there has been no comparable long-term rise in the losses suffered by lenders and thus nothing to discourage them from even more lending. Economic policy has been responsible for this. When an economy slows, bankruptcies rise and the losses suffered by lenders make them cautious about new lending. To stop such caution causing the economy to contract, governments and central banks have stepped in. Debtors, and thus of course lenders, have been bailed out by increased budget deficits, lower interest rates and, on occasion, by direct support for failing companies.
Until recently these policies appeared to be successful. Recessions and periods of rising defaults have been mild and short-lived. Governments and central banks have combined to ensure that there has been no increase in the overall risks run by lenders. The specific risks run by bankers and other lenders, which are that individual borrowers will default, have remained in place. But lenders have been insured by official action against the risk of a general rise in the level of defaults. Had this been allowed, it would have discouraged lenders and stopped the growth in debt relative to output. This would have had the short-term disadvantage of making recessions sharper and more frequent. But it would have had the huge advantage of avoiding our recent asset bubbles and the major recession which has followed. We suffer today not only from a severe loss of jobs and output, but also from the dramatic rise in budget deficits which has weakened our ability to cope with another debt crisis.
A clear sign of the limits to our ability to support ever rising debt has been given by the Irish crisis. Before the trouble broke, Ireland had a very low national debt and was running budget and current account surpluses. Its problem was the huge level of debt in the private sector. When borrowers ran scared that they wouldn’t be repaid, the government was forced to make its implicit promise to bail out lenders into an explicit one. Excessive private sector debt suddenly became an excess level of national debt.
For the past 60 years output has grown far more slowly than debt. It has been rightly said that what can’t go on for ever, will stop. Keynesians tend to respond by saying that this is a long-term problem and, quoting the master “In the long run we are all dead.” The Irish crisis suggests, however, that we are all now living in the long-term.
Excessive worries about the short-term outlook for the economy were the fundamental cause of the current crisis and radical short-term measures were, I think, needed to deal with the result of past errors. But it is surely time to turn our attention to the long-term issues of debt and excessive asset prices. There are obvious steps that should be taken and equally obvious steps that should be avoided. One positive step would be stop subsidising debt as we do today, by making interest an allowable expense for corporation tax. One thing we should not do is push up asset prices through central bank buying, known as quantitative easing. We have an asset bubble in bonds and, although US share prices are nothing like as overvalued as they were in 1929 and 1999, they are at levels equal to the other peaks of 1906, 1937 and 1968. Although this does not mean that the bubble will burst next year or even in 2012, we are running large and unnecessary risks. The Federal Reserve’s policy of asset buying, known as QE 2, seems to me to be most ill-advised.
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This article first appeared in The Times
http://www.thetimes.co.uk