By Derek Scott*
Published: December 22 2009 (Financial Times)
*[Derek Scott is a member of the Investment Advisory Board of Vestra Wealth and was economic adviser to Tony Blair, former UK prime minister, from 1997 to 2003.]
The current crisis reflects not the failure of capitalism, but the failure of the people running capitalism to understand how it works. This is bound to affect how we get out of the mess.
In simple terms, the prevailing consensus is to view the post-2007 crisis as the result of an external shock which could not have been anticipated. The remedy is to deal with the perceived cause (bankers or regulators) embarking on large-scale fiscal and monetary stimuli until the damaged “animal spirits” of households and business are restored. After this, things can get back to normal and stimuli be withdrawn.
In fact, the world’s problems did not come from an external shock but were created within the various economies (in the jargon, they are endogenous not exogenous) and resulted from the failure of policymakers to understand the implications of the re-emergence of genuine capitalism, including large-scale private sector capital flows, which puts a premium on the relationship between the anticipated rates of return and the real rate of interest as the means of combining economic dynamism with overall stability.
A series of monetary policy mistakes in the late 1990s meant that interest rates were too low, creating in several countries what Austrian economists such as Friedrich Hayek, called an “inter-temporal” problem. It is no coincidence that economists who did predict the crisis, notably in Britain the estimable Bernard Connolly, looked at economics in a similar way.
In essence what happens is that inappropriately low rates of interest bring forward investment spending by households and business (adding to demand when it takes place) from “tomorrow” to “today” so that when “tomorrow” arrives, budget constraints reduce spending at precisely the time when “yesterday’s” investment comes on stream, adding to supply. The only way to keep things going is even lower interest rates, bringing forward even more spending, so establishing the international Ponzi game that eventually burst in 2007.
The combination, on the one hand, of newly reinvigorated capitalism and the associated rise in productivity with, on the other, Bundesbank-style inflation targeting, adopted implicitly or explicitly by a number of central banks, proved fatal. The former should have led to a decline in inflation but inflation targeting allowed central banks to achieve “stability” while practically every other indicator was flashing “red”. It was this environment that fostered the “irresponsible” and/or “incompetent” behaviour of banks, regulators, households and the rest.
Once the bubble burst, policymakers adopted what might be termed Keynesian solutions to an Austrian problem though, in the case of Britain, Keynes would certainly not have been starting from here: Gordon Brown’s profligacy as chancellor in the “good years” has certainly left Britain more vulnerable in the bad times.
However, in general, this response was probably correct since the alternative might have led to spiralling debt deflation and even political collapse. Nonetheless, the notion that large deficits and increasing debt can be accepted with equanimity until the private sector starts spending again is too sanguine.
In so far as they do work, virtually all the various fiscal and monetary measures do so only through bringing forward yet more spending from “tomorrow” to “today”, whether this is through low interest rates, rising asset prices or incentives to buy cars. There can be no return to anything approaching “normal”, including normal levels of interest rates, until rates of return increase to enable businesses to be profitable at normal (in other words higher) rates of interest.
Without this, any attempt to normalise interest rates risks pushing economies off the cliff again; and policymakers will either have to tolerate a protracted period of slow growth and high unemployment or run faster to stand still by bringing yet more spending forward from “tomorrow” to “today”.
All the previous periods when high levels of debt in Britain and the US have been brought under control have been associated with either increased innovation and enterprise (Britain after the Napoleonic Wars, the US after the two world wars and later after Reagan’s “supply-side” economics) or have been periods of technological “catch-up” (for Britain and western Continental Europe after the second world war). In both cases rates of return rose.
Today, if rates of return are to rise, it requires not necessarily capitalism “red in tooth and claw” but certainly more capitalism rather than less. The problem is that in most countries policies are moving in the opposite direction: more regulation (it’s called “better” but it means “more”) and, from some quarters, a desire to replace Anglo-Saxon capitalism with European corporatism.