The last few days have seen a new development – a development that is so far barely showing up on the media’s radar screen – but could yet prove to be both the most important and, if ignored, the most dangerous development yet in the economic crisis of 2008.
In the story of 20th century recessions, there were two big ones. There were the late 1920s and 1930s (1930s in the US) and the 1970s. They were both awful, although for most economies the earlier crisis was the worst, but they were also very different.
The 1970s crisis was sparked off by the escalating price of oil – this pushed up prices and led to inflation, while unemployment rose at the same time. The twin curses of rising inflation and unemployment were referred to as stagflation.
The earlier downturn was kicked off initially via a crash in asset prices, followed by various banking crises and the nasty period of depression – which saw falling prices, or deflation.
In the mid 1990s, what has become known as the lost decade of Japanese growth, was quite similar to the 1930s depression. Asset prices fell, losses at banks mounted, followed by banking collapse. Japan experienced deflation – and the central bank of the Rising Sun suffered the shock of discovering that once prices are falling, conventional monetary policy becomes largely ineffective. You can’t set negative interest rates – otherwise consumers stick their cash under their mattress, and once deflation falls to a level so that even zero interest rates are ineffective, then the central bank is truly stuck.
This begs the question, which of these two crises from the past is the current crisis most alike? It is an important question, because the economic medicine required is quite different. In fact, if the wrong medicine is diagnosed, things could actually be made much worse.
When he came up with his famous theory of general employment, Keynes was working during the midst of depression-torn Britain. His recommendations were adopted by the Roosevelt government in the US in what became known as the ‘new deal.’ Keynes’ cure to a depression involves measures designed to get demand up. So that’s cuts in interest rates, government spending designed to create employment, and tax cuts aimed especially at low-income earners. Why the low-income earners especially? Well this was not necessarily a moral argument, rather the idea was based on economic theory. Low wage owners tend to save less, so if they have more disposable income they are more likely to spend any new money.
Keynes’ theory was all about getting people to spend – because when that happens demand rises, new jobs are created, even more people spend, and a fortuitous upward spiral is created.
The medicine Keynes developed was designed for a depression; for a period of falling inflation and employment, leading to low demand. Depressions can occur when a downward spiral of pessimism sets in. In times of trouble people tend to save, this leads to less money being spent, demand falls, unemployment rises, and people save even more. Keynes’ ideas were designed to break this downward spiral.
The crisis of the 1970s was the opposite. In fact, many would argue that the root cause of the 1970s period of stagflation was the Keynesian economic policy of previous governments. Subsidies had made business inefficient, job creation schemes had meant labour was employed in areas that weren’t productive, and decades of policy designed to get demand up, had created inflationary pressures.
The surging rise in oil, caused by the Arab oil embargo, was just the catalyst – goes the argument. Inflation only set in because the foundations for inflation were already in place. Margaret Thatcher and Ronald Reagan pursued policies which in many respects were the opposite of Keynesianism. Chancellor Geoffrey Howe upped the rate of interest in the midst of recession, for example.
Alan Greenspan was worried about deflation – that is why he cut US interest rates to 1 per cent. Maybe he was wrong, certainly many believe today’s credit crunch is down to him, creating an unsustainable credit boom.
Ben Bernanke probably knows more about the 1930s depression than anyone else alive. As an academic he made his name on his studies into that period.
But, which one is it today? If it is 1970s type inflation, then now is not the time for cuts in interest rates. As painful as it may be, we may need even need higher interest rates.
But if it is 1930s, then the current inflation surge is just a one-off, governments and central banks should instead revisit the policy recommendations of Keynes.
Evidence has emerged over the last few days that the current crisis may be closer to the 1930s – and to find out why, read the next article.
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