Terra Firma

One year on from the breaking of the credit crisis, any lingering naivety about the scale of the impacts on the global economy has long since dissipated. After a series of false dawns of recovery – after the initial lowering of interest rates, the quasi-nationalisation of failing banks and mortgage lenders on both sides of the Atlantic, and the injection of huge sums into the financial markets on a wholly unprecedented scale – the reality of the economic downturn and its deep structural characteristics are finally being recognised.

With that recognition comes both political and economic consequences. At the immediate political level, the meltdown in support for Gordon Brown and the Labour government has been sudden, brutal and probably terminal. The Republicans in the US may reap a negative dividend too. The economic consequences are more profound and they will confront governments of all and any political persuasion.

THE SHORT TERM

In the second year since the credit crunch broke, the action is moving from the financial markets to the real economy. Consumers are hurting, particularly in the US and the UK. They face a squeeze which has several mutually reinforcing dimensions. First, the fundamental assumption that economic growth would go on and on without interruption, paying off their current debts using future income has been shown to be wildly optimistic. The business cycle has not been abolished and the future now looks very uncertain. Consumers are now very pessimistic – as survey after survey shows. They expect the economy to get worse. Therefore, quite rationally, they are pulling in their belts, cutting back on non-essentials and the consequences can be seen in the retail numbers.

Second, consumers’ existing wealth – their houses and their pensions – are worth a lot less than they expected and look like falling still further. This negative wealth effect takes time to feed through, but it will inevitably do so. It means that consumers will want to save more – and hence cut consumption further – as and when the scope to do so emerges.

Third, relative prices have gone up a lot – especially of energy and food. Finding an extra £500 to £1,000 per year to pay the household fuel bills and an extra £20 to fill up the car with petrol every time is extremely painful if the cost of the mortgage has already gone up and there are few savings to fall back on.

Fourth, the devaluation of sterling and the dollar puts up import prices and increases the cost of the family holiday abroad. This devaluation adds to the energy and food relative price effects and helps to exacerbate the main factors – inflation and expected future inflation.

Taken together, it is unrealistic to expect anything other than a sharp decline in consumer demand and naïve to expect any quick bounce back.

THE MEDIUM TERM

In the past – in particular before the great boom of the last two decades of the twentieth century – this short-term hit on consumer spending would have been met with a classic Keynesian response: increase public expenditure, cut taxes and lower interest rates. Unfortunately none can now be easily deployed.

The main reason is that they have already been deployed – in response to the 2000 sharp correction in equity markets. Then, governments in the US and UK embarked on a massive Keynesian boost. Real interest rates were dropped to zero or even below and, in the US, taxes were cut and in the UK, a very large expansion of public expenditure (mainly on health) took place. And it worked for the first half of this decade – recession was bought off, consumers kept spending and economic growth continued.

The problem was that what might turn out to be the last gasp of Keynesian economic policy carried with it the seeds of its own destruction. Low real interest rates encouraged the housing market bubbles which in turn burst with the credit crunch. The borrowing necessary to finance the tax cuts and the public expenditure has left governments badly exposed to debt and the debt markets. Wriggling around the definition of the “golden rule” cannot disguise the fact that further public expenditure increases (which are now inevitable as the economy slows down) will have to be met with higher taxes. Markets will check any significant further borrowing. Taxes have only one way to go – up.

That leaves interest rates. Here, most governments have surrendered control to “independent” banks. In the UK and Europe, politicians find themselves powerless to push down the nominal rates. Sarkozy might rail against the European Central Bank, but to little effect, and in the UK Brown, as the architect of the independence of monetary policy, dare not challenge its authority.

The banks have good reasons to be cautious. Inflation has resurfaced with a vengeance and central banks are given inflation targets. And inflation is back not because of a purely external shock outside the developed countries’ control. The gradual, but sustained, rise in world oil prices back to the levels at the end of the 1970s is in part a consequence of the great economic boom of the late twentieth century, and it has built up over precisely the post-2000 period of lax monetary and fiscal policy. In other words, the policy-induced sustaining of consumer demand in the US and the UK has contributed to the rising demand for oil, and helped push the price up – just as the crash in consumer demand is helping it down again.

Those who would claim that oil prices are outside our control would point to China and India – to the great increases in demand in the Far East. But what is this demand for? These are exporting countries – with the US and the EU equal to nearly half of all world demand. Add to that the impact of a falling dollar on oil prices, and the developed countries cannot so easily blame outside factors.

The external story about food prices is also far from obvious. Bio-fuels have not only done great environmental damage, but they have pushed up food prices too. What is going on in the supermarkets now is not simply some Act of God: bad policy has made an upward movement in prices so much worse. Add in the continued agricultural protection in the US and Europe and it is clear that some part of the responsibility for the food price effect lies much closer to home.

THE LONGER TERM

Governments’ room for manoeuvre is thus not great. There is no easy Keynesian fix this time around. So the question arises: is this going to be a short, but sharp, downturn or a long period of stagnation? As with all such macroeconomic questions, the trite answer is that it is too early to tell and it depends what governments do.

But there are quite a lot of reasons for expecting protracted pain. What lies at the heart of current difficulties is that developed countries – particularly the US and the UK – are consuming beyond their means. Debt, and the leverage which goes with it, are symptoms of a mistaken assumption that the good times would roll on forever – that the business cycle had been abolished. That means that the new assumptions will have to be balanced by adjustments to longer-term spending, saving and asset building. And that means that standards of living will have to go down and asset values will adjust down to this new more sober context.

The bad news is that this process has only just begun. A world in which US and UK consumers save say 7 per cent of their income is a world away from the last couple of decades, and of course in the short term, they will struggle to maintain their living standards – paying the mortgage, the fuel bills and, for some, coping with unemployment. They will use up their meagre reserves first.

For Europe, the story is more mixed. European economies – with the notable exceptions of Spain and Ireland – have not experienced the housing market excesses. Some have more export-orientated economies, and Germany and France in particular have much higher productivity than the UK. They also have the euro – increasingly a reserve currency – with the inflows strengthening its value, pushing down inflation and hence enabling the ECB to have lower interest rates.

But there is – eventually – good news too. The vicious circle identified above of a post-2000 Keynesian expansion encouraging the rise in oil prices will reverse. Already, petrol sales by volume have fallen 20 per cent in the last year in the UK and in the US, oil imports are falling. China will be hurt by the falling dollar, the rising energy price and the downturn in demand for its exports in Europe and the US. Its demand for oil will be correspondingly lower than many currently predict. As in the early 1980s, the current high oil prices carry the seeds of their own destruction. Conflict and tension over Iran may spill over in the short run into yet higher prices, but Iraq will rejoin world markets and lots of new resources will come gradually on stream.

If oil prices fall back, so will inflation. And the fall-off in consumer demand will eventually find its own level. House prices have, in the end, to be affordable – people actually have to be able to pay the interest, so a new equilibrium will eventually result.

This brings us back full circle to financial markets. Just how long this downturn will be depends in part on how quickly, and orderly, asset prices adjust. In due course, markets will stabilise and they will return to a normal pattern of gradual asset appreciation. That is indeed the good news – business cycles have downs, but they also have ups. The bad news is that the floor to which markets may fall may be quite low and that it may take time for living standards to adjust. We have been living beyond our means – how long it takes for this to sink in and for the necessary adjustments to be made will determine whether it will be short and sharp or slow and painful.


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