What to do, what to do

by Ingolf Eide

Martin Wolf has usually managed to moderate his inner interventionist. No longer, it seems. In his most recent column, he casts caution aside:

“The time has come to employ this nuclear option [the printing press] on a grand scale.”

Not doing so, he says, would ensure a renewed recession with increased unemployment, falling house prices, reduced real business investment and so on. I think he’s right that these unhappy events are on the way. Question is, would employing his nuclear option make things any better?

To answer that we need to understand why we’re beset by all these difficulties. Wolf sees the root problem as feeble demand. Again, I think he’s right, but only in the sense that it’s the most visible, proximate cause. There’s a deeper question he doesn’t address; why is demand so weak? If the reasons are structural, throwing money at the problem is unlikely to help. Indeed, it could just as easily make matters worse by impeding the necessary adjustments.

The key question, then, is whether pre-GFC growth was sustainable. If instead it was a hothouse flower, then trying to revive it outside of the conditions that allowed it to flourish is not only impossible but foolish.

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Looking back, the outstanding feature of this period was the growth in debt, particularly by households. Much of it, indeed most of it, flowed into property, fuelling the most extravagant and widespread boom ever seen. In some countries, such as the US, the aftermath is already well advanced, with housing prices down over 30% from the peak; in others, such as Australia, it’s hardly begun. The UK is somewhere in the middle.

If the only consequence had been a widespread real estate bubble, things would have been troublesome, but not disastrous. Unfortunately, there were others. The sense of growing wealth occasioned by the remarkable asset appreciation profoundly affected economic behaviour. Saving from current income seemed less and less necessary as the boom went on, and so consumption took more of the economic pie. If investment also remained strong, then growing external deficits necessarily followed. In addition to this indirect effect on savings, some borrowing also fed directly into consumption; at the peak of the boom in the US, for example, households were borrowing 5-6% of GDP through mortgage equity withdrawal against their appreciating houses. No other country quite matched this lunacy, but many shared the general trend.

Clearly, some of the resulting demand was unsustainable. When consumption is funded by borrowing (whether directly or via reduced savings because of the wealth effect from credit induced asset appreciation), it’s effectively stolen from the future. This essentially artificial demand disappears once the credit boom ends. On top of that, the need to restore weakened balance sheets means higher future savings will further depress demand in rough proportion to the earlier excess.

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None of this is hard to grasp. Still, this core structural impediment is usually ignored when responses to our current woes are considered. In part no doubt because it’s a particularly unpleasant thorn to grasp, but also because conventional economics has long paid too little attention to the effects of credit on the real economy. What we’re in (and are likely to remain in for a long time) is a balance sheet crisis, against which the usual nostrums are helpless. Even measures that until recently were regarded as extraordinary are losing their mojo.

Quantitative easing, for example, no longer makes sense. Since 2007, when the first open rumblings of the coming crisis sounded, base money in the UK rose from £70 billion to £200 billion; in the US, from $800 billion to $2.6 trillion.[1] As a result, excess bank reserves at the BoE and Fed are at unprecedented levels, in both cases roughly equal to 10% of GDP. The sort of illiquidity which QE can remedy is no longer a weak spot in the system (indeed, it hasn’t been for a long time).[2]

As for the alleged benefits of lower long term real rates brought about by QE, the picture’s far from clear. Ashwin Parameswaran at Macroeconomic Resilience argues that suppressed real rates can have “perverse and counterproductive effects”. It’s usual to focus on the plight of debtors, who clearly benefit from lower rates. That’s only one side of the equation, however. The world is full of savers and investors too, who (particularly in ageing demographics) may respond by “increased savings and reduced consumption in an attempt to reach fixed real savings goals in the future”.

Whether or not Wolf has considered such potentially perverse effects, he certainly recognises that illiquidity isn’t the problem. He has something quite different in mind in his call for gloves off QE: namely, the full-blown monetisation of government spending.

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I guess it was always going to come to this. The accumulated imbalances are simply too large to ultimately respond to lesser measures. Indeed, it’s the continued employment of those fiscal and monetary measures over recent decades (albeit on a lesser scale) that brought us to this impasse. At no stage were the necessary adjustments and corrections allowed to unfold. The political incentives all pointed the wrong way.

Now it’s true that for as long as belief in the efficacy of central banks and governments persists, such lesser measures may give the appearance of working, as they’ve done in the last three years. Once that faith begins to seriously erode, however, the game is up. I imagine Wolf sees that moment as nigh, and again, I think he’s probably right. The unfolding train wreck in the Eurozone is displaying all too clearly the limits of officialdom. They may cobble together another solution that the market is willing to buy, at least for a while, but it does look more and more as though the tide is inexorably going out. Recent events in the US are hardly more comforting.

Here’s what Wolf favours:

“Personally, I would favour the “helicopter money”, recommended by that radical economist, Milton Friedman. This would be a quasi-fiscal operation. Central bank money could pass via the government to the public at large. Alternatively, the government could fund itself from the central bank, directly. Better still, the government could increase its deficits, perhaps by slashing taxes, and taking needed funds from the central bank. Under any of these alternatives, the central bank would be behaving like any other bank, creating money in the act of lending.”

The distinction between these alternatives is presumably clear to him. To me, they appear to be different ways of expressing much the same thing; that is, monetisation of deficit spending. At any rate, he goes on to say:

“In current circumstances, a policy of direct financing of government by the central bank should recommend itself to monetarists and Keynesians. The former have to be worried by the fact that UK broad money (M4) shrank by 1.1 per cent in the year to July 2011. The latter would have to be pleased that governments could run still bigger deficits without increasing their debt to the public.”

That M4 is shrinking despite all the BoE’s efforts illustrates the strength of the prevailing headwinds. Once a credit boom ends, the deflationary undertow that accumulates over the course of any major debt buildup soon reveals itself, its strength proportionate to the extent of the preceding boom. The private sector belatedly sets about repairing its balance sheets, reducing consumption, cutting investment and focusing on saving. This time around, governments have been offsetting the debt households and businesses are trying to shed by furiously taking on their own.

In the US, for example, household indebtedness peaked in the second quarter of 2008 at $13.929 trillion; at the end of June this year, it was $13.298 trillion. Business borrowing didn’t peak until the fourth quarter of 2008 at $11.151 trillion; although it’s ticked up again in recent quarters at the end of June was still “only” $11.019 trillion. The financial sector is the standout: at the end of 2008 it was $17.119 trillion; the latest figure was $13.830 trillion. Across the three sectors, a reduction of $4.052 trillion, or 9.6%. Set against this, the federal government owed $5.243 trillion in March 2008; today, it’s $9.778 trillion, an increase of $4.535 trillion. Plus there’s another $186.5 billion in fresh state and local government borrowing.

Given UK deficits exceeded those in the US and Wolf says he’s looking to substantially up the ante, it seems he’s not kidding about the “grand scale”.

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It’s hard not to be sympathetic. Absent fiscal and monetary support, our credit pyramid would simply collapse; quite possibly, given its scale and scope, more dramatically than in the early 1930s. Equally, even with a continuation of fairly aggressive fiscal and monetary support, private sector deleveraging is likely to continue for many years to come, weighing on consumption, dragging down investment and keeping unemployment frustratingly high.

What to do, what to do.

Keeping demand up at all costs, as Wolf so fervently desires, has its problems, not least that demand isn’t homogeneous. It’s not an abstract aggregate, it’s the result of an almost infinite multitude of individual, highly idiosyncratic demands. So too with the supply that tries to meet it; it’s also bewilderingly complex, with much productive capacity suitable only for very specific ends. Helping these two mesh as sweetly as possible is what the market’s meant to do. One doesn’t have to be an Austrian to wonder if central bankers and politicians pulling at levers they (and we) only dimly understand is likely to help this process.

One thing’s certain. When demand is hyped, whether by a credit boom or unfunded deficit spending, malinvestments proliferate. The less organic and sustainable the demand, the greater the errors that will be made as business tries to meet it. Someone has to pay for those real world errors, whether it’s lenders, shareholders, or all of us when the losses are in one form or another assumed by government. That they can apparently be paid for with dollops of freshly created money doesn’t change the underlying reality. It just disguises it, and further confuses us all.

The current complexity of economic and monetary matters, and the often disconcerting speed of change, aren’t just the fruit of globalisation and rapidly evolving technologies. Much of it’s rooted in the Alice in Wonderland quality that now pervades money and credit. It can feel like a world full of wormholes and time travel, where quite a number of impossible things do indeed happen before breakfast.

Few of them, unfortunately, are good.

In any case, I can’t help thinking deliberately goosing aggregate demand is more likely to perpetuate our problems than solve them. Highly individual, sustainable demand can’t successfully interweave with complex, specialised supply when the information needed to do so is being constantly and violently distorted. Cutting with the grain by smoothing the adjustment process seems a better bet than impeding it, particularly if we devote some of the saved resources to protecting the more exposed and vulnerable amongst us.

Does thinking that way that make me a liquidationist, one of the unaccountable sadists Wolf sees peopling the other side of his argument? I obviously don’t think so. What to me seems called for is a sort of compassionate realism; trying to understand the deeper nature of our economic problems, accepting those things (as the old prayer has it) we can’t change, and then carefully seeking to unravel the knots rather than binding them ever tighter.

Wolf’s approach risks everything. Quite apart from the fact that I don’t think it would work in the long term, if the full resources of the state are thrown into the battle, along with the very nature of money and credit, where’s the fallback position?

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That said, there is a powerful case for cushioning the deleveraging that’s underway, since left to its own devices the deflationary collapse would be shattering. More as a cautious retreat under fire, though, rather than a frontal counterattack.

Back in the early days of the crisis, we badly erred in holding bondholders immune. Not only was it inefficient, it was unjust. When financial institutions faltered, their bondholders (like any others in a failing commercial enterprise) should have been forced to take a serious haircut or, better yet, had their holdings converted to equity. The financial system would have been left in a far stronger position to weather the storm. The approach still has merit, but given how far things have deteriorated governments would almost certainly have to chip in with additional recapitalisations as the great unwinding slowly progresses.

As for the central long term goal, surely it’s the restoration of a natural balance between sustainable supply and demand. Without that, no recovery can last. I think we must accept that much pain and toil lie between here and there, even if all goes comparatively well. The multitude of errors made in recent decades can’t be wished away, however much we’d like to do so.

Excess credit, togther with the general profligacy and distortions it encourages are what brought us to this pretty pass. Is more of the same really likely to get us out?


1  Fiscal policy has been no less aggressive. From 2007-2010, the UK averaged deficits of 8.9%. Much the same holds true in the US, although their deficits post crisis rose a little more slowly. Taking a much longer view, the UK managed a surplus in only five years since 1973, curiously enough exactly the same tally as the US, although the years didn’t exactly coincide. In any event, anyone wanting to claim deficit spending hasn’t really been tried has a hard row to hoe.

2  I do wonder at times if these huge excess reserves might one day wreak unexpected havoc. Contrary to conventional wisdom, their overall level is entirely in the hands of the central bank. Individual banks may succeed in getting rid of some (through making loans or purchasing investments), but they inevitably come back into the system somewhere as soon as the recipients spend or deposit the proceeds.

If the markets become more confident, or more inclined to speculate, it’s not hard to imagine an accelerating rush by individual banks to deploy reserves. All of it, at the system level, entirely fruitless. Not an easy beast to rein in, I’d have thought, if first it bolts.

I see two options for central banks were that to happen. Either vaporise sufficient reserves (through sales from their portfolio) to neuter this impulse; or, raise the rate they pay on reserves to a high enough level to discourage the process. Neither seems attractive. Brave indeed would be the central banker who embarked on the former in these tricky times. As for the latter, with the reserves outstanding it would surely not be cheap.