Terra Firma

The credit crunch has now been in full swing for nearly a year. At each stage, the end has been confidently predicted and politicians and policy-makers have forecast at worst a growth pause before a return to the good times of the last two decades. For these optimists, the credit crunch is primarily a monetary phenomenon, exacerbated by the irresponsible lending of a few admittedly large banks to people who should have known they could not afford the houses they bought.

The optimists have had to downgrade their expectations at each twist of the credit screw: now recession is widely expected in the US, the UK looks very exposed and Europe is beginning to feel the effects of its rising (and increasingly reserve) currency. Even in China, with its own high and rising inflation, the shock waves are beginning to be felt.

In one sense, the optimists are right: this is the business cycle, and unless the gloomier predictions of the peak oil (and now food crisis) brigade are believed, the process will work itself out. The business cycle has not been abolished, capitalism produces booms and busts, and the likes of Prime Minister Brown have not – and cannot – abolish it. The problem is that this cycle is likely to be a particularly vicious one and getting out of it will require better policy management than so far witnessed either side of the Atlantic.

THE DEBT MOUNTAINS

The form and nature of the downswings in business cycles depend upon the scale of the excesses and irrational exuberance that preceded them. In this cycle, there has been a long time for these excesses to build up, and at the centre has been the expectation that things can only get better – that the world economy (and the US and the UK at the core) had discovered the secrets of eternal prosperity. Growth would go on ad infinitum at about 2-3 per cent of GDP.

Once this belief takes root, then consumers, companies and governments all start to leverage up with debt that will be paid off in the future from the proceeds of all that growth. If we are going to be many times better off as the century unfolds, then we can spend more now. And if we spend more now, companies can gear up to meet that demand, paid for from future profits. And finally, governments can be confident that tax revenues will rise, and hence gear up too, to be paid for by richer future taxpayers.

It all looks like a virtuous circle, but parties tend to come to an end, and intensity of hangovers tend to reflect the degree of excess. With hindsight, it is easy to see the scale of the illusion. Growth measured by GDP tells us almost nothing about how much we can sustainably consume. In the UK, productivity growth has not been particularly sparkling, and the three decades of North Sea oil and gas are coming to an end. The balance of payments problems have returned. These structural factors will exacerbate the cyclical adjustment processes.

What particularly spurred on consumer spending was the house price effect – in both the US and the UK. Whatever the rationale for the spectacular rises in prices, the impact was to make people feel much wealthier than they really were. They could pay off that debt by selling their houses. Hence there was no need to save for retirement and for precautionary reasons.

THE PAINFUL PROCESS OF DE-LEVERAGING

So although we are all better off by virtue of the great late-twentieth-century boom and the new technologies it delivered, we are not as well off as we thought. The challenge for consumers is how to rebuild their balance sheets – how to get their savings back up to a long-term sustainable level. That means cutting spending, perhaps sharply, and indeed that is what is beginning to happen.

As consumers cut back, so companies will find a drop in demand. Profits fall and dividends are cut. All that debt turns out to be much more risky than it once appeared – much of it is really equity risk disguised as debt (often through fancy financial instruments and accounting). Robust companies can turn to equity markets and retain earnings to rebuild their balance sheets. Those in more desperate straights will need emergency rights issues. Banks are noticeable in the second category.

The corporate effects are likely to be deep and long-lasting. The bigger corporates in more traditional (inelastically demanded) sectors now have considerable advantages, whilst the asset-light, newer and smaller entrants face the full force of capital market restraints.

GOVERNMENTS AND BORROWING

Then come governments. The (Keynesian) theory goes that this is the time for governments to carry on spending – to plug the demand gaps left by consumers and companies. Deficit financing becomes an economic virtue. This is the apparent lesson learnt from the Great Depression of the 1930s. Monetary authorities too should slacken the reins, easing monetary conditions

And indeed that is precisely what is happening – by design in the US and by force of circumstance in the UK. The question, however, is whether this time it really makes much sense or whether it is simply postponing the inevitable reckoning. For if the fundamental problem is too much consumption and too little saving, then this adjustment will have to be made: consuming beyond the sustainable level cannot be maintained indefinitely. And the long-run level of savings depends upon the real interest rate, which in turn is roughly the same as the sustainable growth rate – say 2 per cent real.

After the almost zero real interest rates following the 2000 stock market crash, in 2006, the real interest rate began to creep back towards 2 per cent. That, in turn, proved the catalyst, and put the skids under the housing market and triggered the sub-prime crisis. Now monetary authorities have reversed interest rates again, driving them back towards zero in real terms (especially in the US). That may buy some temporary release, but so far not much. Indeed the striking feature of the last year has been how little difference lower interest rates have made – except to lower exchange rates and encourage inflationary tendencies.

The other main policy response has been the gradual nationalisation of risk. First, retail deposit risk was effectively nationalised and now mortgage risk is being added. In other words, governments – and taxpayers – are taking the hit for the banks’ profligacy. This really does make a difference, but it also has a corollary: the government’s balance sheet is worsened, and it means that taxpayers will have to play a part in writing off the bad debt elements.

BACK TO CONSUMERS AGAIN

The nationalisation process is a method by which we collectively take the hit. And the implication is that taxes will be higher (or public spending lower) in the future. Our unsustainable consumption has come home to roost. The question now is whether consumers realise this: if they rationally predict the higher taxes, they will themselves take a more conservative view about their own balance sheets and offset the short-term higher public expenditure by further reducing their own expenditure. The more powerful this expectations effect, the less effective the old Keynesian remedies.

THE LONG-TERM EFFECTS OF THE SHORT-TERM CRISIS

The credit crisis is not going to go away anytime soon. It will now work its way out in the real economy. The adjustment process is likely to be slow and painful. All that bad debt needs to be paid off – someone has to bear these costs. It could be a sharp deep recession, with then the rebuilding of balance sheets or a gradual slow drift to a decade of slow growth. It is simply too early to tell how the adjustment processes will work out.

In past serious business cycle downturns, one solution has been inflation: in effect, the debtors default through a process which undermines the creditors. It happened in the 1970s, and indeed in the early 1990s, when inflation topped 10 per cent. That might happen again, but there is a price to pay for this: undermining the long-term savings incentives. Debasing the currency is a trick many politicians through the ages have resorted to – and the consequences have rarely been benign.

This time around there is a special set of reasons why the inflationary route should be avoided. Inflation now is a risk in response to the rises in energy, commodity and food prices. But these are probably structural changes, not solely business cycle phenomenon. They are relative price effects which will change the structure of economies. Nuclear power, coal generation and renewables are the industries to benefit and to which investment should shift. And agriculture is where the responses to the effects of food prices should be felt. Buying time – which is what inflation does – is not a sensible policy response. It just makes the eventual adjustments harder to bear.

So what needs to happen? House prices need to fall. Wages need to reflect the rises in relative prices of energy and commodities. Consumers need to save more. Companies need to inject more equity. Governments need to get their spending under control – and probably raise taxes. The result is a sharp contraction in consumption, but more room for investment.

What about demand and the Keynesian concerns? The answer for the UK is that it is a small open economy: there is plenty of demand in the world economy relative to its size. As North Sea oil and gas run out, the exchange rate will inevitably fall, boosting exports. For the US, which is large and much more a closed economy, the dollar devaluation will probably not be enough to stimulate demand sufficient to head off a painful recession. And for Europe, with a rising currency, it can afford the luxury of lower interest rates as the rising exchange rate squeezes out inflation.


Dieter Helm, Professor of Energy Policy, University of Oxford & Fellow in Economics, New College, Oxford

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.

© D.R. Helm, 2007