21st September 2012
This poses a problem for policymakers. They believe that they know what the problem was – debt – and therefore the way out of the crisis must be to reduce overall debt levels. Deleveraging, however, is inherently contractionary and serves to worsen the underlying weakness of an economy by reducing demand.
Despite the politicisation of the debate, all sides must ultimately confront this uncomfortable reality. Shifting the debt burden from the private to the public sector has given policymakers additional flexibility and time, but it has also created a perverse incentive for companies in the process of rebuilding. If governments are going to pay down debt either/both the private sector or households are going to have to spend into a slump.
In order to get a grasp of where we are it is important to understand the various theories underpinning current policy. At its most basic the government's case for austerity is that Britain's sovereign debt relative to GDP is growing at an unsustainable rate and must be brought down to ensure that bond markets do not decide to shun Gilts.
This reduction in the deficit will be achieved through cutting government spending, a measure that will have the additional advantage of allowing the private sector to move into areas where the public sector is withdrawing. The argument goes that these moves will promote economic growth because private companies are more efficient at delivering products and services than government.
One way of viewing this is the government appealing to the greed motive of private companies by offering them new areas to profitably exploit. Yet more than two years since the Coalition came to power there appears to be little sign of a vibrant economic recovery.
Ignore fear at your peril
Much of the debate aimed at explaining economic lethargy has focused on the role of government during a downturn. Keynesian economists such as Paul Krugman and Brad Delong have argued that the state should be taking advantage of historically low borrowing costs to raise money for infrastructure investment.
Their case is, in effect, that fear of bond markets is an abstract concern whereas the consequences of a sluggish economy – high unemployment, the threat of deflation, falling real incomes – are tangible problems. Under this scenario the private sector rationally responds to flagging demand by cutting investment and headcounts, which in turn exacerbates the demand shortfall and worsens the slump.
Perhaps then the divergence in policy thinking can be characterised along the lines of that old adage: greed and fear drive markets. Chancellor George Osborne's case is that despite the downturn greed will win out in the long term. His job is therefore to maintain a consistent stance so that companies are not dissuaded from taking a risk by expanding into new areas.
Keynesians (and post-Keynesians) seem to take the view that in the aftermath of a crisis it is fear, not greed, that is in the ascendancy. It may be counterproductive for the corporate sector to sit on large cash reserves, but with households and the government attempting to deleverage simultaneously they can rationalise the decision to remain risk-averse.
Moreover with falling real wages and shrinking government support it may also be rational for households to cut back their consumption to pay down liabilities. As J. W. Mason writes in his post defending David Graeber's book Debt:
""Greed" – mere desire for goods – can be satiated, or substituted with some other goods if the price is more favorable. But a money obligation must be met in full, come what may."
Debt as a bad metric
The case against debt has been a difficult one to answer. It is certainly the case that most financial crises over the past half a century have included a notable increase in credit levels before the bust. In the abstract, however, discussions on debt that paint debtors as sinners and those with excess savings as saints serve to confuse rather than clarify.
Ben Broadbent, external member of the Bank of England's Monetary Policy Committee, gave a speech on deleveraging in March in which he argued:
"No-one can have lived through the past four years without realising the importance of debt and the dangers of excessive borrowing. It is clear in the historical data that almost all financial crises are preceded by rapid growth in credit, and there have certainly been significant parts of domestic private-sector debt – most obviously lending to commercial real estate (CRE) companies, but also unsecured lending to households – that looked increasingly risky ahead of the crisis and have inflicted severe damage on lenders' balance sheets since.
"But I am not convinced that, as a general matter, non-financial domestic leverage was the key reason for the UK's financial crisis or, therefore, that it needs to return to some historical "norm" for us to declare the crisis at a definitive end."
Broadbent's point relates to domestic private-sector debt but perhaps it could also be applied to the government's balance sheet. Osborne now looks set to miss the targets he set out in his deficit reduction plan. Even those who initially backed the plan have voiced their concerns, with many now calling for a change in approach.
Fear of debt in the abstract may tie the Chancellor's hands, however. It is true that ultimately Britain must reduce its reliance on debt-fuelled growth but unless the government doubts the country's prospects for recovery then targeted borrowing should not be permanently off the agenda.
Indeed some contend that attempts to tackle government debt and deficits have obscured what should have been the central lesson of the crisis. Steve Keen, a professor in economics and finance at the University of Western Sydney, claims that:
"The private debt bubble t
his caused is unprecedented, probably in human history and certainly in the last century. Its unwinding now is the primary cause of the sustained slump in economic growth. The recent growth in sovereign debt is a symptom of this underlying crisis, not the cause, and the current political obsession with reducing sovereign debt will exacerbate the root problem of private sector deleveraging."
Whether he is right or not it is important to recognise that Osborne's policy choices in 2010 reflected his assessment of the situation and a number of economic assumptions about the behaviour of markets. Many of those who agreed with him have seen the facts change sufficiently to alter their views but there are still those willing to back the logic of scaling back government.
The question for Osborne is whether the changing facts have simply altered his assessment, which would simply require an extension of his deadlines, or if they have challenged his assumptions. Only the latter offers any chance of a real shift in policy.
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