Some analysts say that we have exhausted the growth impulses that have continued since the Industrial Revolution. I do not subscribe to this uber-pessimistic view, nor to the view that much supply capacity was destroyed by the financial crisis. (In a later article I will explain why.)
The corollary is that we are suffering from a shortage of aggregate demand. The intriguing question is why – and why can so little apparently be done about it? After all, it is supposed to be supply that limits what we can have. What we want is supposed to be limitless.
Aggregate demand has been depressed by not one economic malady but many. Several of these have their origins in one major shock – the extended period of financial excess and the subsequent financial collapse in 2007/8. In the aftermath, consumer balance sheets in many countries are excessively leveraged, so consumers are cautious about spending. Meanwhile, banks, weakened by the financial crisis and now hemmed in by tighter regulation, are reluctant to lend. Also, in several countries, including the UK, but importantly not the US, residential property remains over-valued, with the result that the market is frozen, while prices remain vulnerable.
And the weakness of the public finances pushes governments to reduce their borrowing. The origins of this weakness, though, predate the financial crisis. In the good times, government debt was too high, with the result that the downturn soon sent it to dangerous proportions.
Ironically, given today’s widespread pessimism, this excessive debt originated in over-optimism about the future.
Yet over and above these factors, we are simultaneously experiencing the failure of the greatest monetary experiment in history, namely the euro. Admittedly, the financial crisis made this worse but it did not cause it. This failed experiment is condemning the eurozone, which accounts for about a sixth of world GDP, to depression. The peripheral countries are lumbered with excessively high costs. Meanwhile they, and other countries, are forced to submit themselves to draconian and collectively self-defeating fiscal tightening, not least because without this they are perceived to impose a burden on the other euro members.
Outside the euro straitjacket, the sensible thing would be for these countries to go easy on the tightening and/or to default and devalue.
Yet the current depression isn’t all about the aftermath of the financial collapse and the euro crisis. The world suffers from a persistent tendency towards deficient aggregate demand, because umpteen countries are chronic over-savers, with a tendency to run large current account surpluses. These countries fall into three groups: the Asian rapid growers, led by China; the Middle East oil producers and Russia; and an oddball group of European countries comprising Germany, the Netherlands and Switzerland.
Can an individual medium-sized country such as the UK pull itself out of this mess by expansionary policy? To some extent. I have repeatedly urged more fiscal action to boost demand, based on increasing public investment and trying to pump-prime private spending.
Even so, I reckon that the feasible scope for such action falls well short of what is required to restore the economy to full capacity usage.
Why not go further? After all, any adverse reaction from the bond markets could be countered through aggressive Quantitative Easing. I have always thought, however, that the big danger lies not in the bond markets but rather in the foreign exchange markets. If they saw the UK going hell-for-leather in pursuit of “Keynesianism in one country” they would send sterling sharply lower. Now you might think that this would be a good thing, since it would improve our competitiveness. This is, after all, the policy that we warmly embraced in 2008.
But the danger is that another major drop of the pound would cause inflation to rise sharply and that would eat into consumer real incomes before any boost to net exports appeared.
Moreover, since this would be a “beggar-thy-neighbour” policy, it would be badly received by our trade partners, possibly provoking an unhelpful response.
Interestingly, neither of these objections holds against a policy of co-ordinated Keynesianism in many countries, as advanced by Gordon Brown. But political barriers against a new global stimulatory programme happening any time soon look formidable.
In the UK, as well as carefully calibrated fiscal action, the best hope for recovery rests with falls in inflation gradually causing real incomes to rise. Tuesday’s inflation figures should bring another instalment. Even so, recovery is going to be slow. Unfortunately, despite being unashamedly Keynesian, I reckon that we will have to endure high levels of unused capacity for some time while the severe structural problems described above are sorted out. Radical action by the UK alone could make our problems worse.
Roger Bootle is managing director of Capital Economics. email@example.com