Terra Firma

Red ink is the order of the day across the developed economies’ public accounts. The scale of the deficits is a matter of degree, with the Anglo-Saxon economies taking the more extreme Keynesian route, and the Eurozone economies proving more constrained by the inability to reach for the devaluation option and the residual disciplines of the stability pack. In the UK and the US, the deficits are breathtaking, with neither country having much chance of repairing the damage for at least a decade.

The mortgage on the future is enormous – and this at a time when the concerns should be in the opposite direction, to provide a decent legacy for future generations. It is the current generation’s excess spending and borrowing which is responsible not only for the financial mess, but also the environmental damage too. In the UK and the US, the solution to the problem of excess consumption and borrowing is yet more spending and borrowing, and on a scale which is an order of magnitude greater.

ENTER QUANTITATIVE EASING

The fiscal stimuli are unprecedented. But, remarkably, they are not considered enough. The full force of monetary policy has been brought to bear too. Quantitative easing (QE) has not been the instrument of choice. It has been deployed only after everything else failed. Once interest rates had been reduced effectively to zero, further monetary stimulus could only be achieved by pumping money directly into the economy – buying up government and corporate bonds. The money to buy the bonds is ‘created’ by the central bank – hence the popular perception of printing money.

As with the fiscal stimuli, it is far from clear that this will work. It depends upon what happens to the new money and how the economy, more generally, reacts. The money might be hoarded rather than being used to expand the credit base in the economy with banks and financial institutions pursuing the opportunity to strengthen their balance sheets. In the wider economy, the perceptions matter greatly. If QE is seen as an act of desperation, then the result might be higher precautionary saving rather than spending and investment.

AT THE MERCY OF THE MARKETS

In this brave new mortgaged world, the power of government is much weaker than politicians would like us to believe. In smaller and more vulnerable economies, the verdict of the market can be fast and vicious. Iceland stood no chance once the full extent of its banking debts was exposed. Ireland has fared better – but then it has the advantage of being in the Euro. It has no option but to cut public expenditure, and cut it hard.

For the UK, the signs are ominous. Already sterling has been devalued by a quarter – making sterling’s earlier crises in the 1960s and 1970s look rather trivial. The painful fact facing Mr. Brown is that when he sets out plans to borrow £175 billion per annum, he needs to be mindful of the question that then follows: ‘from whom?’ The answer is that savings have to fill this gap and quite a lot of this has to be from overseas.

Why would anyone lend to Mr. Brown? Given that there is no seriously credible plan to reverse the borrowing and get out of the mess which is partly of his creation, investors might anticipate that the printing press will be his solution: not only are the deficits unfunded, but they may be unfinanced too.

That would mean inflation – as in the 1970s – as a mechanism for wiping out the creditors. Markets tend to see through this ploy and a sterling crisis is a possible response. Mr. Brown might even find himself faced with a run on the pound and investors’ reluctance to buy gilts. This is an altogether familiar scenario from the 1960s and 1970s – and the solution may have to be emergency budgets and a sharp hike in interest rates. There may have to be another budget this year and if the election is in 2010, expect two budgets then too.

REVERSING QE

An interest rate hike is quite likely, and indeed it is already happening in the bond markets. Less thought has been given to the implications of reversing QE. It adds a third level of pain to the reversal of public spending and interest rates. To reverse QE, the Bank of England has to suck cash back out of the economy, and in turn this should further push up long-term interest rates. In normal times this is a tough call, but when the economy has a large capacity gap and very high unemployment, it may be extremely painful politically.

To date, markets have relied upon the assumption that independent central banks will do ‘whatever is necessary’ to deal with the consequences of inflation, and that it is the central banks that will be in charge of pushing up nominal interest rates and reversing QE. But ‘independence’ in a democracy is a relative term. It works as long as the consequences do not become politically too difficult. The idea is that independence provides a check – but in the end, Parliament and Congress are sovereign.

It is therefore worth thinking through whether central banks can really head off the inflation as a means of defaulting on public debts. Will voters take kindly in a very serious situation to seeing their mortgages cost much more and more jobs being shed as demand is choked off? The answer is far from obvious and recent evidence from government behaviour is that the overwhelming weight is put on the interests of the short term.

There is, too, the serious issue of intergenerational equity in what has been going on. Why should the younger generation pay for the sins of their parents? They did not create this debt. It is not their fault that the population is aging and that much of the health, care and pension liabilities are unfunded. Why should they pay the higher taxes, and the interest on the debt, for which they are not responsible? For them, a bout of inflation writing off the creditors is not necessarily a bad thing. That, after all, is how the public finance mess was sorted out in the 1970s.

GAMBLING ON CREDIBILITY

Mr Brown has never needed the confidence of markets more, and never had less of it. The irony of his precarious position is that credibility may now rest on two things: that he might lose the next election; and that Mr Cameron will do the necessary painful surgery. If markets believe his days are numbered, and if they believe that voters will decidedly reject him giving the Conservatives a substantial majority, then they may ride out the next few months.

But if Mr Brown’s popularism over soaking the rich works and voters turn back to Labour, then confidence may collapse – and quite quickly. If few want to lend, there could be a serious (and quick) crisis. Not only would the Budget have to be rewritten, but the IMF may be needed too. Then Mr Brown would be precisely back to where the Labour government was in the 1970s. Dennis Healey promised to raise tax on the rich ‘until the pips squeaked’, and needed the IMF to bail him out. The famous 1976 ‘Letter of Intent’ forced Labour to impose the necessary cuts. To complete the repeat performance, it is not inconceivable that the IMF would force the recent Budget to be rewritten.

In the UK and the US, the deficits are breathtaking, with neither country having much chance of repairing the damage for at least a decade

AND IN THE LONGER TERM

Recessions end. The fall in output cannot continue indefinitely. A bottom will be reached. This recession is bad mostly because of the policy failures – in particular, the loose monetary policy conducted after the crash in 2000. The sub prime crisis is the product of that misguided monetary policy (and poor financial regulation). Independent central banks have proved no panacea. The current response – yet more spending, more borrowing, low interest rates and QE – have probably made things worse and will, in any event, have to be reversed.

But what of the longer term? Should we assume that it will be business-as-usual again, as the Treasury predicts? Is it sensible to assume that 3.5% growth will resume and then continue in perpetuity? Looking at the wider consequences of this sort of economic growth, the answer is probably ‘no’. The climate, biodiversity and food supplies probably cannot withstand the sorts of levels of global consumption envisaged. Another three billion people by 2050 (more additional people than the entire world population in 1950), and double-digit growth rates in India and China are unlikely to add up.

This is what makes this recession different. It is not just that consumption (and borrowing) since 2000 has been unsustainable in the short term and has caused the crash. It is also that it is unsustainable in the long term. The right response is to adjust our spending to what the planet can withstand.

That means something rather different – lowering standards of living now and increasing savings for the future, not mortgaging it. As with current spending, if something is unsustainable, it cannot go on indefinitely. Mr Brown is finding that out about his fiscal and monetary policies now. Future prime ministers will discover it with regard to the environment more generally – however much economic growth they might promise the voters.

Dieter Helm is an economist, specialising in utilities, infrastructure, regulation and the environment, and concentrates on the energy, water and transport sectors in Britain and Europe.

© Dieter Helm