THE BEAR'S LAIR The correct recovery paradigm
By Martin Hutchinson
The potential swine flu pandemic has emphasized once again the vulnerability of
the global economy to being knocked off an even course by unexpected events,
not all of which are as obviously based in past economic policy as the US
housing finance disaster. Wars, epidemics, serious terrorist attacks and
doubtless in the future ecological crises are all capable of devastating the
finely tuned modern economic system. The government panic and misguided
activity of the last six months have, however, made one thing abundantly clear:
the world urgently needs a better designed paradigm for producing recovery.
Ordinary recessions, a product of a predictable business cycle, don't seem to
be much of a problem, and nor do stock market crashes taken by themselves. The
last 30 years are full of examples of such events, during which governments
either did
nothing or confined themselves to moderate monetary and/or fiscal stimulus. In
1987, for example, monetary authorities in both Britain and the United States
loosened policy after a stock market crash, preventing it from spreading.
Likewise in 2001, both countries loosened monetary policy in face of a stock
market crash, though in that case US policymakers kept rates too loose for so
long.
The problem is that those remedies, both of which are generally popular with
business and the public at large, are only effective when used in moderate
doses against moderate, conventionally caused recessions. In 1987, the stock
market crash took prices down to reasonable levels, and policy prior to the
boom had not been over-expansionary, so stimulus worked well. Likewise in
2001-03, the US budget was close to balance and so the moderate fiscal stimulus
of the early Bush years did its job, particularly as it was accompanied by a
modest supply-side effect from the 2001 tax rate cuts and a much larger one
from the 2003 partial removal of dividend double taxation.
However, loose monetary policy in the US and UK in 1970-73 led to much higher
inflation without producing much economic recovery. Similarly, Britain's
mid-1970s fiscal stimulus under Harold Wilson produced a sterling crisis but
did not cause the economy to recover. Fiscal and monetary stimuli are thus the
equivalent of aspirin, effective in small doses against mild illnesses, but
ineffectual against major maladies and dangerous if taken in excessive
quantities. One need not be a pessimist, as I am, about their efficacy in the
current crisis; one need only look at the huge fiscal and monetary stimulus
employed in 1990s Japan to realize that fiscal and monetary aspirin can kill
the patient if used against a serious disease.
Policymakers therefore need a recipe against serious economic traumas, which
prevents these traumas from turning into the Great Depression or Japan's
miserable post-1990 trajectory. It is reasonable to suppose that exogenous
shocks to the economic system are more likely in a world of globalization,
rapid communication and high population density than in the
slow-communications, lower-population less integrated world of the 19th and
early 20th century. One way or another, we can confidently expect at least one
major economic crisis per generation, generally from a cause that is either
non-economic or wholly unexpected beforehand, and we had better learn how to
deal with them.
The first point to note in dealing with these serious crises is that the policy
aspirins effective against lesser economic ills are positively harmful in these
cases. This time round, the Bush "stimulus" of 2008 was not only ineffective,
it dangerously increased the government's borrowing requirements, reducing
financial flexibility and increasing the capital starvation caused by the
flight to quality in late 2008. Monetary stimulus used after 2001 to counter
the effects of the stock market downturn produced the much more dangerous and
widespread housing bubble.
The huge additional monetary and fiscal stimuli implemented since September
have not yet imposed their costs but may be beginning to do so. The first
quarter gross domestic product (GDP) deflator came in contrary to expectations
of deflation at a 2.9% rise, while 10-year Treasury bond yields have now broken
decisively above 3%. Both inflation and interest rates can be expected to push
sharply higher in the months ahead.
To determine the policy response to a serious economic crisis, it is first
necessary to consider what you are attempting to achieve: an economy in rapid
recovery, generating large numbers of jobs at good pay rates, with capital
formation and entrepreneurship active, inflation low or even negative and
government reined in, so that the budget is either in balance or moving rapidly
back towards it. The best recoveries from economic catastrophe have all taken
this form - you can consider the British 1820s' recovery from the Napoleonic
Wars and post-war depression, the US 1920s' recovery from World War I and
post-war depression; the US 1945-60 recovery from the Great Depression; the
German and Japanese 1950s recoveries from World War II; and many others. Even
in the Great Depression itself, Britain, which followed these policies, fared
much better than the US and Germany, which didn't.
Attempted recoveries from catastrophe that have not taken this form have not
worked. The German money printing of 1919-23 led to the Weimar hyperinflation
and the impoverishment of the middle class. The British attempt to recover from
World War II through Keynesian government spending and economic planning never
got off the ground and lagged similar efforts in France and Germany, let alone
Japan. Notoriously, Japan's attempt to achieve prosperity through public sector
infrastructure in the 1990s didn't work. Russia's post-communist attempt in the
1990s to achieve prosperity through dodgy privatization and cheap money failed
catastrophically. In each of these cases, other excuses can be made for
failure, but the overall picture is clear: only the hard money, high savings,
balanced-budget approach can be relied upon to recover from a real crisis.
These policies have succeeded in the past centuries against wars and major
economic collapse, but there is no reason to believe they will not work against
other types of catastrophe, such as major epidemics or ecological disaster
(which does not include only global warming; economic catastrophe could also
result from uncontrollable pollution or a "nuclear winter" period of famine and
disruption resulting from volcanic activity). In each case, there would be
special factors to be dealt with, such as a catastrophic loss of population,
the abandonment of some central economic activity that had caused the pollution
problem, or relocation of much of the planet's agriculture or industry to take
account of new conditions. Nevertheless, there is no reason why the same
central economic objectives should not hold true, whatever the cause of the
initial disaster.
If a high saving, low-inflation, reined-in government environment is the
necessary state for economic recovery from disaster, then the correct policies
to pursue become obvious:
Interest rates should be increased to provide adequate returns for savers and
rebuild the capital stock.
Public spending should be reined in sharply, in order to get closer to budget
balance without having to increase taxes, which inevitably dampens activity.
Economic losers should be starved of capital and liquidated, in order to free
up resources for the new industries that need to arise.
Inflation should be treated as a leper because of its erosion of savings, while
a moderate amount of deflation should be welcomed, as it will increase the
value of capital and thereby produce more and better new businesses.
Trade should be freed up, in order that new business opportunities appear and
Joseph Schumpeter's "creative destruction" can work its magic.
Labor laws should be eliminated as far as possible so that wages and employment
can re-set to market levels, while labor mobility within the domestic economy
should be encouraged. (However international labor mobility in a recession
depresses living standards in the higher-wage economy, allowing unscrupulous
employers to drive wages down to Malthusian levels.)
Against a major economic collapse, only these policies will work. They were
employed by Lord Liverpool in 1815-25 Britain, by Andrew Mellon in the US in
the 1920s, by Dwight Eisenhower and William McChesney Martin in the US after
1951-52 (when the US savings rate was over 10%, far higher than today), by
Konrad Adenauer and Ludwig Erhard in Germany from 1948 through 1963, by Shigeru
Yoshida and Hayato Ikeda in Japan from 1949 through 1964, and by Neville
Chamberlain in 1931-37 Britain.
Maynard Keynes would grind his teeth in thwarted academic fury at the policies
proposed. He disliked Chamberlain, disdained Mellon and Liverpool and would
have hated the others. Yet they - not he - were true architects of economic
recoveries and their policies, not his failed nostrums, should be adopted
today.
Martin Hutchinson is the author of Great Conservatives (Academica
Press, 2005) - details can be found at www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-09 David W Tice & Associates.)
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