Nikkei Veritas – Market Eye column, 21st July 2010
The American writer James Thurber wrote a series called Fables for Our Time. One of these was about a bear that used to fall over after drinking too much, which naturally alarmed his family. At length he saw the error of his ways and wanted to show how fit and strong he had become since he had given up alcohol. To demonstrate this he used to stand on his hands, often falling over and alarming his family. Thurber’s moral was that “You might as well fall over forwards as lean too far backwards.”
Finding a workable middle course for the economy has become a worldwide debate. Famous economists, including Paul Kurgan writing in the New York Times and Martin Wolf in the Financial Times, are among those who fear that budget deficits are being cut back too sharply so that the world will topple back into recession. In this instance at least they follow the theories of John Maynard Keynes, who thought that the great depression of the 1930s was caused by the US government cutting back on its expenditure and trying to balance its budget when it should have been increasing the deficit to offset the fall in private sector demand. Milton Friedman also attributed the depression to poor economic policy, but thought that it was inappropriate monetary policies rather than fiscal policies that had caused the depression. Those who follow Friedman share the concerns of Kurgan and Wolf, for a different reason. It is the slow down in the growth of money which causes them anxiety.
Despite their important differences, both theories require high levels of debt to keep us out of trouble. Fiscal deficits require government debt to grow and money supply only expands when the debts of banks increase. For those of us who see the heart of today’s problems as being the excessive levels of debt that were built up prior to the financial crisis, the idea that we can only keep ourselves out of trouble by having more of it, which is common to both monetarists and Keynesians, seems like a council of despair. I think that either a shrinking money supply or an overly rapid return to fiscal balance would be dangerous, and it seems likely that if they occur, they will go together. But these are not the only dangers. If budget deficits are not reined in fast enough, then fears of inflation will rise and this could topple us back into recession just as easily and into a recession from which it will be exceptionally difficult to escape.
Keeping the balance between either falling over forwards or leaning too far backwards is much more difficult today than it has been, but this is the inevitable result of having built up too much debt in the past. In addition to keeping to the difficult path of growing, but not growing too fast, in the short-term, it is also essential that we move towards greater long-term stability by reducing the level of debt in the economy.
At the moment I think that we have a good chance of being lucky with the world as a whole neither growing too fast, nor too slowly. For this to happen, the countries with large current account deficits, like the UK and the US, need to grow relatively slowly, so that they can rebalance their economies which have become dangerously dependent on borrowing from abroad to finance domestic consumption. These economies need to save more by cutting back on their budget deficits and, at the same time, to export and invest more to keep demand from shrinking. Countries like China, Germany and Japan, which have current account surpluses, need to grow relatively rapidly and should therefore be relatively slow to increase taxes or cut back on government spending.
But even if we are lucky in the short-term, the long-term problem of debt will remain unaddressed. Debt has grown far faster than output over the post-war period and needs to grow more slowly. We cannot do this by shifting debt, as we are today, from the private to the public sector. Nor can we do it by ensuring that bank balance sheets, whose growth has been exceptionally strong, continue to grow rapidly. In place of debt, we must encourage its only known alternative, which is equity capital. This can be done in many ways but one measure is, I think, essential. At present debt is subsidised by the tax system in all major countries, because interest on debt is treated as an expense for corporation tax. It is extremely important that this foolish subsidy is ended.