The IMF met again last weekend and did not really get the world out of its trouble. The problem is, of course, that we do not know quite what sort of trouble still persists. The world is extremely uncertain and the remedy is not clear. Indeed, for the last two years or so, we all have been having the same discussion and yet there is no resolution. In the meantime, a government has changed in the UK and Larry Summers has moved on in the US. There is, thus, a depletion of the Keynesian Guard. Of course, the ultra Keynesians?Krugman and Stiglitz?think Summers and indeed Obama?s reflation package are not Keynesian enough. Unemployment persists to be high and the growth rate of GDP, while positive, is low. They would argue that a bigger reflationary package is needed.
In the UK and elsewhere in Europe, the mood is not for reflation at all. The urgency is about cutting the deficit and the debt burden down as proportion of GDP. Europe?s weaker economies Greece and now Ireland, not to forget Spain and Portugal, are still not out of trouble at all. Martin Wolf, Samuel Brittan and Robert Skidelsky have all been arguing against this deficit cutting strategy. Given that the output loss was anywhere from 4% to 7%, they would like a reflation that takes the economy above its trend growth rate and then slowly converge back.
The question is, Who is Right? Are the Keynesians right or are the deficit busters? Will we have a double-dip recession? Why suddenly is there talk of an exchange rate war across the world? There are anti-immigration lobbies gaining ground in Europe. After 15 years of globalisation and sustained expansion of flows of trade, labour and capital movements, is the world about to lurch back in 1930s-style protectionism?
My own view has been for some time that the recession was not a Keynesian one; i.e., it did not arise from lack of effective demand. It is a Wicksell-Hayek recession where overexpansion of credit, caused by excessively low interest rates leads to mal-investments. It is the banking system that becomes the problem as it ceases to function. This theory was popular before Keynes wrote his General Theory. After Keynes?s triumph, economists forgot about banking and credit cycles and modelled every crisis as a result of lack of effective demand to be cured by fiscal action. Macroeconomics became an income-expenditure story with output playing a passive part and finance totally absent. Recovery was assured by fiscal action almost automatically.
But a Wicksell-Hayek recession is not amenable to fiscal reflation. Indeed, Hayek took the extreme point of view that it would make things worse by distorting prices further. There is some point to what he says. Despite nearly zero interest rate, there is little investment. Consumers are not spending the money they get but are saving it. After all, they entered the crisis with a high level of debt. Such credit as is being taken up goes into corporate deleveraging. We have already seen this in the Japanese recovery from its banking crisis. The recovery is long, slow and tepid.
There is reason to believe that this may be the case again. There are longer-run forces impinging at the same time. One is the loss of competitiveness of the western economies relative to the so-called emerging economies. This is along run shift, which Keynesian policies are unable to correct. The exchange rate wars are partly a form of tariff war to allow the older industrial countries to withstand the competition of the newer ones, especially China. But the reason for the loss of competitiveness is also in the economic theory underlying. Neoclassical as well as Keynesian economics makes no distinction between value and price. Sub-prime housing is just as valuable as widgets if the stock market says so. Classical economics made a distinction between the two and took the value of the product?its cost of reproduction?as the measure of wealth. Sub-prime housing does not become wealth because there is a house price bubble nor does it become valueless when the bubble bursts. It remains whatever the cost of building a house is.
Through the long expansion, western economies invested in activities by looking at the market bubble. Now they have few productive investments that can allow them to compete. In Keynesian economics, it does not make a difference if you dig ditches and fill them up again as long as wages are paid and spent on consumption goods. But at the end of the day, you have not added to the wealth of the economy.
The crisis of the western economies is a crisis of economics not of capitalism. There are older theories that may yet guide us out of the crisis if only we could revive them. I doubt though that the world will listen.
The author is a prominent economist and Labour peer