The global economy is once again trembling on the brink of a likely double-dip recession. In the US, employment growth was nil last month. Eurozone countries are still subject to much market distrust as to whether the crisis of sovereign debt of the PIGS countries can be tackled. As between the IMF, ECB and EU council of ministers, there is much dispute as to the way forward. The so-called emerging economies are the only sign of hope since their growth is still in high single digit or low double digit terms.
There seems to be a paralysis of policy in the developed economies. Fiscal policy should be the weapon at such a moment, but the markets are spooked about the sovereign debt issue. Although Keynesians like Krugman still urge boldness in spending in the immediate run and restraint in the longer run, there seems to be a reluctance on Obama?s part to commit himself to bold gestures. In the UK, the chancellor has set himself on a tough five-year path to eliminate the budget deficit completely, and hence fixed the growth of public spending at zero in real terms. There is no sign that he will alter this course. That is also true of much of the Eurozone.
Monetary policy has been the active ingredient for the last two years as fiscal policy has remained tight. Quantitative easing is just the old open market operations, but on a massive scale. Despite the QE policy driving interest rates down to near zero, there seems to be little impact on output. Inflation has entered the commodity markets and has thereby harmed the emerging economies? growth prospects.
The extra liquidity pumped out is sitting passively in corporate balance sheets and there is no evidence of ?animal spirits? to boost investment. Households are also deleveraging rather than spending. In this context, it is unclear as to what can be done.
The scenario is reminiscent of Japan in its decade of stagnation while it pursued a QE-type policy, driving interest rates to zero. How can the developed economies avoid that outcome?
Most economists agree that the state can at least undertake long-term infrastructural investments even if it has to convince the markets that this is sound fiscal behaviour. The UK has proposed a Green Bank, which will start next year, to finance green investment proposals. But this is a slow yielding path. Massive infrastructural investment on an ad hoc basis is desirable, but may not be feasible.
The only counter-intuitive alternative to a tight fiscal policy and a loose monetary policy would be to let interest rates rise by stopping QE and even reversing it. This would speed up deleveraging in households, which are into negative equity, though at the cost of much pain (this was the path followed in the recession of the early 1990s). A tighter monetary policy may allow some scope for fiscal easing. It will also make savers happier and drive them away from investments in gold and commodities, which is what they are into at present.
The most likely outcome is nothing. The governments will agonise, fail to be bold and wait for the normal cyclical processes to work themselves out. The recovery will be slow and prolonged, and the global economy will not get back to its historic growth path for two years, at least.
How did we get to this and why are the Keynesian nostrums not working? One reason is that in a globalised world there are no sovereign debts of the old style which can be met by printing money. Every sovereign state is just like a corporation, albeit a large one. The markets look closely at the determination of each government to meet its debt obligations from honest money. When S&P downgraded US debt, it was reflecting a judgement on the capacity and willingness of US policymakers to face the reality of overspending for over a decade. In Keynesian theory, governments never had to worry about debt because debt was taken to be held within the country, and was a matter of keeping the rentiers happy enough to buy as much debt as the government wanted to sell. It was said to be debt owned by one section of the country to another. Obviously, with much debt held abroad or with rentiers being pension funds duly concerned about the future liabilities, debt management has become difficult.
At the same time, there are some longer run structural considerations. The developed economies have an ageing population and, the US apart, they also have a stagnant population in numbers. The need to save more is obvious, both for pensions for a population that is living longer and with a shrinking active working generation. There are also costs of elderly care to account for. Keynesian policies were feasible when the baby boomers were adding to the work force. Now the limits have been reached.
The need for the developed countries to save more in the longer run can be consistent with spending in the short run. But that requires animal spirits in leaders, which is currently in short supply. Much can be done. But nothing will be done. We are into becalmed waters for a while. Just hope we don?t sink.
The author is a prominent economist and Labour peer