If Debt is the Problem, Easy Credit Won't Fix the World Economy

It was Mark Twain who said, ‘facts are stubborn but statistics are more pliable’.  He is also reputed to have been first to lay down the Law of the Instrument, popularised by 1960s psychologists, which states, ‘to a man with a hammer, everything looks like a nail’.  What a perceptive analyst of the present economic situation he would have been!  The facts of China’s economic slowdown are plainly enough reflected in its trading partners’ disappointing exports but its GDP growth statistic is pliable; it continues to hover around 7% as an annual rate.  But China is not the only country where a certain degree of elasticity is evident in the officially published data.  In the advanced countries, statisticians expended much effort in the inflationary 1980s and 1990s in devising ways to massage the consumer price figures with a view to minimising reported increases and maximising falls.  Now, after inflationary forces have weakened, they cannot avoid giving the impression, through their data releases, that deflation is at hand.  Perhaps, however, this is not so inconvenient an outcome for central bankers earnestly seeking pretexts to keep their monetary policies on their most accommodative settings in the course of recorded history.  These distinguished authorities have sensed, ever since the 2007-09 financial crisis, that something is seriously amiss with the global economy.   Because the instruments they have in their tool-boxes are monetary, they readily assume the challenges they face must also be monetary in character.  We should not, perhaps, judge them too harshly for embracing the Law of the Instrument; it is only human nature to accept the assumptions that underlie this prescriptive rule.  All the same, after seven years of trying and failing to restore such a state as they themselves might recognise as normal, some central bankers might have been expected by now to be questioning whether the problems of the global economy are, indeed, primarily monetary.

In defence of the central banks’ approach, it is often said they fully acknowledge the likelihood that monetary measures alone will be insufficient to revive economic growth, but they are ‘buying time’ for others to take effective action.  In fact, it is only ECB policymakers who have spoken in this vein.  From the time when the ECB was established, its leading figures have been exhorting euro zone governments to do more to introduce structural reforms in their national economies and to strengthen the arrangements underpinning the single currency. Their attitude has been no different post-crisis from what it was pre-crisis, except that, in recent years, they have spoken with an even greater sense of urgency than before.  Even for the ECB, however, monetary ease is no longer justified as ‘buying time’ but in terms of warding off deflation.  For other central banks, there was never much mention of ‘buying time’.  The Federal Reserve has not been looking to the US Administration to restructure the US economy; it has not even been assuming such restructuring is needed, or politically practicable.  The Fed’s ultra-easy monetary stance has, rather, reflected the belief that zero rates and massive central bank balance sheet expansion are the ways to confront the malaise in the economy.  The Bank of England has not been waiting on any action that Mr Osborne might take.  The Chancellor’s actions have influenced the BoE’s monetary stance only to the extent that Mr Carney and his colleagues have sought to offset the expected short-term negative effects on overall GDP of cuts in public spending.  The Bank of Japan (BoJ) set out on its QQE policy in April 2013 believing that was how best to revive inflation and growth.  Even though it was part of the broader strategy, dubbed Abenomics, its aim was precise.  The fact that the Abe Government has been slow to implement the structural elements in the overall strategy appears to have had little bearing, one way or the other, on the BoJ’s determination to press on with QQE.

It is a strange prescription that applies easing credit-measures that encourage more indebtedness, when excessive debt has been diagnosed as having precipitated the economy’s crisisWe return, therefore, to the question why central banks have not by now suspected that what ails the advanced economies is not to be treated primarily with monetary remedies.  It is, to be sure, a strange prescription that applies easing credit-measures that encourage more indebtedness, when excessive debt has been diagnosed as having precipitated the economy’s crisis and as underlying its continuing weakness.  Central banks might have been expected to prefer policies that facilitated a reduction in aggregate public and private debt, so as to minimise risks of a recurrence of the financial breakdown.  Admittedly, there are few central bankers who believe debt has been at all excessive, beyond specific sectors such as the housing market.  For them, it may seem that more debt is, indeed, part of the solution, provided that prudential controls prevent credit-bloated sectors from inflating.  However, the soaring ratio of debt to output in the years prior to the financial crisis points to excess, or at least to a serious divergence between the demand for credit, satisfied by lenders, and the level of economic activity.

It is in this divergence that a clue lies as to the true nature of the structural weakness of the economy.  Only through the ever more generous provision of credit, it seems, was it possible to maintain ‘normality’ in the advanced economies pre-2007.  This is why central banks, in the wake of the crisis, were desperate to get the banks to lend again.  It largely contributes to their present feeling that ultra-accommodative monetary policies must be maintained for a while to come.  Indeed, some commentators, observing the central banks’ extreme reluctance to take any action that would reduce the supply, or raise the cost, of credit are beginning to wonder if central banks will ever feel able to withdraw monetary accommodation.  Leaving aside any damage the crisis may have wrought, the central banks might well see valid grounds to shy away from tightening, merely on the presumption that the pre-crisis trend in the credit/output ratio has persisted to the present.

Theorists have attempted to explain, in terms of standard concepts, the unusual conditions over which central banks are presiding.  The most convincing of these accounts – certainly the one to have captured most attention – is the ‘secular stagnation’ hypothesis popularised by Prof Laurence Summers.   According to this view, a rise in global savings relative to global investment over recent years has depressed the equilibrium real rate of interest.  This has pushed market interest rates down towards the zero lower bound and, once that bound has been reached, central banks have felt obliged to have recourse to ‘non-conventional’ measures. When arguing the case for ‘secular stagnation’ as the source of present ills, theorists are inclined to point to the very limited demand for capital investment in cash-generating technological companies.  They have tended to overlook the substantial capital spending boom in recent years in the energy and commodity industries, which has contributed to the supply gluts now bearing down on raw materials prices.

Further, for the ‘secular stagnation’ hypothesis to hold water, it would surely need to demonstrate that what is happening now is radically different from anything that has happened previously in the course of recorded human history.  After all, interest rates in the advanced countries have been held for a prolonged period, in the memorable phrase of the BoE’s Mr Haldane, ‘at their lowest levels since Babylonian times’.  Even if it were accepted there has recently been a surplus of saving over investment at all, we should need evidence that the mismatch has been larger than ever before.  Yet there are likely to have been long stretches of history when economic agents had a strong motive to save, and the ability to do so, but when capital investment was weak.  The Late Roman Empire springs to mind as just such a period though there might have been others, perhaps including the early seventeenth-century.  Interest rates, even in real terms, were nowhere close to zero at these times.  This casts some doubt on ‘secular stagnation’ as an explanation for the current situation.  It is characteristic of latter-day economic analysts that they prefer to use the experience of the past thirty years as their yardstick of normality, probably because that is the only period for which they can call in aid statistics to back up their arguments, even though this approach leaves out of consideration a wealth of relevant historical considerations.

Where did all the credit created in the early ‘noughties go?

The question that should be asked is not why ultra-low interest rates and extraordinary measures have failed to restore economic ‘normality’.  That is a discussion that leads nowhere.  What central bankers need to answer is why, even before the crisis, the credit/ output ratio was rising so sharply.  Where did all the credit created in the early ‘noughties go, why could it not be redirected to support productive investments after the crisis, and why might more credit now be needed if economic growth is to be lifted, even temporarily, closer to its historical average? After all, growth in total credit (public and private) has been outrunning nominal GDP in the major economies of the advanced sector for some years past, yet real growth remains, for the most part, sluggish while inflation has been negligible, if not negative.

The solution to this conundrum appears to have two aspects.  One is the process of globalisation; the other is the dominance of ‘financial capitalism’.  The problem with globalisation is that it shifted production from high-cost to low-cost centres.  Capital was mobile but labour was much less so.  From the point of view of a relatively high wage-cost site in an advanced economy, this process enhanced the returns to capital but exerted downward pressure on the returns to labour.  Since the latter were the engine of consumer demand in such an economy, it should not have been a surprise that GDP growth suffered a blow.  It could only have been maintained through continuous support of wage-earners’ incomes, either from the government through fiscal policy or through the extension of credit.  Neither of those channels could remain open indefinitely.  But that was not the only structural weakness.  As for ‘financial capitalism’, by its nature it fostered illusions regarding the liquidity of the assets investors were holding.  Some of these illusions were shattered during the financial crisis but very little was done to prevent fresh ones taking root. Much of the growth in credit has been used up in generating such evanescent visions of wealth.

In retrospect, the period from 2009 up to the current time may well appear to constitute a distinct era.  It has been a period when the major central banks have believed that, given time and appropriate policies, they might be able to make the pre-2007 world order of globalisation and financial capitalism work effectively.  But the patience of politicians now seems to be wearing thin.  In last week’s briefing, we referred to Mr Abe’s turn way from monetary policy as a cure for Japan’s problems.  At the weekend, Mr Schaeuble was even more forthright. On the fringes of the G20 meeting in Lima, he said, ‘expansionary fiscal and monetary policy cannot solve structural problems.  We begin to see the limits of expansionary macroeconomic policy more clearly’. On returning to Germany this week, he declared that interest rates were too low, especially to meet the needs of long-term pension provision, and called for rates to rise ‘sooner rather than later’.  Against this background, the balance of political pressures on the Fed is probably not what it had expected a month ago.  Then, it appeared to be anxious that it would run into severe criticism, should it step away from a policy of ultra-accommodation.  At the G20 meeting, however, the mood, even among representatives of the emerging nations, was reported to favour an end to the suspense over timing of a first Fed rate increase.  The Fed’s Stanley Fischer, nevertheless, gave no strong indication that a move was imminent. Though, separately, Dennis Lockhart, usually a reliable weathervane of Fed opinion, spoke in support of a rate hike, the flow of data has subsequently been mixed.  Perhaps the Fed should take to heart another Mark Twain dictum, 'the secret to getting ahead is getting started’.

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About the author

Stephen’s career spanning five decades has made him one of the most respected and unique voices in the City of London. Disclaimer regularly publishes a selection of his elegant and thoughtful essays on the global economy, which he has been writing regularly since he founded Fifth Horseman Publications in the late 1980s. As well as an economist, Stephen serves as Treasurer of the Forum for European Philosophy and was elected to the Royal Institute of Philosophy.

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