Terra Firma

2007 will go down in economic history as a rollercoaster – it’s not often that we see a global credit crunch which requires over $0.5 trillion to stabilise, and a run on a major London bank. The former occurs roughly every quarter of a century, the latter on a century scale – though there were no major UK bank runs in the entire twentieth century. What is at least as surprising is that many in the financial markets appear to believe that these are events that can happen without wider economic consequences. A prevalent belief – backed up by the remarkable resilience of equity markets – is that the losses are confined to those exposed in the sub-prime market, who have borrowed and lent imprudently.

OPTIMISTS AND SUPER-OPTIMISTS

This belief has two versions: the optimists and the super-optimists. The optimists hold that the actions of central banks (notably in the US and Europe) have staved off disaster by easing monetary policy. Interest rates, which had been on the rise since 2006 (back to normal long-run levels), have been eased back and money pumped into the market to restore confidence. The optimists see no reason to think that this will not be repeated – that the Fed, in particular, will continue to lower rates as and when necessary to underpin markets, and as a result equities have rebounded.

The super-optimists go one step further: they think that monetary policy has now become so sophisticated that the business cycle itself has been abolished. Whereas the economic history of capitalism has been punctuated by booms and recessions, on this view, policy-makers have now mastered the tools of macro-economic management and, having started in the early 1990s, the long boom will go on indefinitely, unless these same policy-makers make serious mistakes. Here, the trick was to free central bankers to set interest rates with inflation targets in mind, so that, as a result, low inflation expectations have become embedded in markets.

BUSINESS CYCLES IN THE PAST

The super-optimists are right about one thing – inflation has played a central role in downturns in the past. But it is not the only component: exchange rates and government borrowing have been familiar components too. The ‘stop – go’ cycles in the post- Second World War UK economy were initially caused by the use of Keynesian demand-management expansions of domestic demand, leading to an increased demand for imports. Balance-of-payments and currency crises followed and the brakes were then slammed on domestically to restore the current account to equilibrium. This cycle eventually became fine-tuned to the electoral cycle: politicians would expand domestic demand up to elections and, once in power, administer sterner medicine, in the hope that another boom would come along just in time for them to face the electorate again. It was not, of course, entirely successful – and devaluations and external help were needed from time to time. Harold Wilson had to face this music in 1967, and Callaghan and Healey needed the IMF to bail them out in 1976.

But whereas the UK is a relatively small open economy, the US could weather such balance-of- payments storms more easily. The dollar acted as the world’s reserve currency, and with around 25 per cent of world GDP, others had to live with the US’s growing appetite for consumption and imports. Yet even the US could not live with inflation, and its own business cycles were in large measure driven by its desire to hold the inflationary line. And its war expenditure in first North Korea and then Vietnam eventually broke the Breton Woods currency system.

WHAT CHANGED IN THE 1980S AND 1990S?

In the last decades of the twentieth century, the world economy changed a lot – probably more than in any previous peacetime period of comparative length. There was an extraordinary explosion of technical progress, with information technology and the Internet the main driving forces. For many now, it is hard to imagine what life was like without mobile phones, laptops and the web.

In itself, this was transformational. But there was more good news: the Berlin Wall collapsed and, with it, the Soviet Union. China turned to capitalism (with an authoritarian face). These new markets provided an opening that bears comparison with the opening up of the US in the nineteenth century.

And then there was the collapse of oil prices – after the trauma of the 1970s’ OPEC years. Instead of marching up to $100/barrel and then on to $200, as many predicted at the end of the 1970s, oil prices fell back to $10 from the mid-1980s for more than a decade, punctuated only briefly by the first Gulf War. Lower prices eased the US costs of importing oil. In the UK, the oil effect was rather different: North Sea oil had on its own ‘solved’ the balance-of- payments constraint: in the Thatcher years the trade deficit simply no longer mattered, while the revenues could be used to lower taxes and further boost the economy.

These were indeed the lucky decades – technical progress boosted growth and productivity, the opening of China injected cheap labour, and commodity prices fell. All three factors suppressed inflation – it was dead for the period. And with the death of inflation came the ability to soften monetary policy and to use it to smooth out markets – and to head off the business cycle.

TOO GOOD TO LAST

Faced with such extraordinary benign conditions and for so long, it was not surprising that what was ‘special’ began to be assumed as ‘normal’. Irrational exuberance inevitably followed, and indeed the surprise was that it played out for so long. Eventually, the day of reckoning came in 2000 as equity markets fell back sharply – indeed, so sharply that in real terms they remain well below their peaks nearly a decade later.

The irrational exuberance masked other trends too, which signalled a return to more normal times. Oil prices started their gradual and continuous rise towards the $100 mark. The US trade deficit began to edge towards the cliff which would trigger a dollar sell-off. For the UK, the oil was running out and the old balance-of-payments problems began to return. But for all the warning signs, the new conventional wisdom about the ability of central banks to keep the business cycle at bay held sway. And they acted in 2000 with an extraordinary zeal – cutting real interest rates to zero. As a result, the real economy kept going and economic growth did not seriously falter. It appeared to work.

But this time, the growth was much less sustainable. It was built on cheap debt and consumer and government spending financed by that cheap debt. GDP kept going up – but more as an accounting illusion than a reality. GDP comprises the credit of spending and investment, but takes no account of the debit of the debt. And when interest rates started to return to normal in real terms in 2006, the day of reckoning could not be postponed for much longer.

THE SUB-PRIME CRISIS AND THE CREDIT CRUNCH

And so, in 2007, the irrational exuberance came to a shuddering halt in the housing markets in the US (but also eventually in the UK, Spain and Ireland too). The sub-prime market had been built into a sophisticated pyramid of debt, and both lenders and borrowers were in serious trouble. Put simply, the real economy could no longer support the financial economy.

The credit crunch itself was in many ways merely a symptom of an underlying real economy problem. The credit crunch came about because of a loss of confidence – but that loss of confidence was caused by the weaknesses in the property markets. Those have not gone away.

Throughout 2007, it was like a slow fuse burning. First there was the sub-prime crisis, then calm returned: this was, the optimists argued, a painful problem in a box, with losers who would have to pay. But otherwise, the world economy (and the US) was in good shape. Next came the credit crunch itself, with the unprecedented injections of cash by central banks. But otherwise, the world economy was in good shape, the optimists replied. And, in any case, it showed that central banks would always bail out the markets, so equities were a one-way bet. Next came Northern Rock. Again, the optimists pointed out that this was the result of the strategy of a particular bank, exposed to the property market, and the UK government stepped in – showing that it would always bail out the banks.

NOT OUT OF THE WOODS YET

The optimists have had a good run so far. Yet it would be extraordinary, if it were to continue in such a benign way. For, once the immediate froth of events is wiped away, the real economy looks a lot more vulnerable. Back in the golden years of the 1980s and 1990s, the underlying conditions were those of the technical revolution that had direct applications to the core drivers of the economy. IT did what railways, cars and electricity had done in the past. Although technical progress is marching on, this sort of surge is unlikely to be sustained for the real economy. Low oil prices appear to have gone too, and the ability of the US to sustain its external deficit looks very exposed. Finally, China’s inflation is rising, and it will find it hard to continue to play the role of cheap labour to the world sufficient to head off the oil price effects.

For the optimists, the worry must be the dollar, and the consequences of its fall. If the Fed bails out the US economy to keep its growth afloat, then the rest of the world will need to brace itself for the consequences for the other currencies – for the euro predominantly, as it emerges as the competing reserve currency to the dollar; for the UK now without its North Sea cushion; for Japan still struggling with its own stock market implosion in 1989; and, perhaps most significantly, for China and its low-currency protection.

These factors all point to at least a return to normal after the golden decades at the end of the last century. They point to the possibility that history – and particularly the business cycle – has not yet been abolished. The super-optimists are therefore likely to be proved wrong. The challenge for policy-makers is to manage this transition back to normal without a major recession. The jury is out on whether they might pull it off – whether the optimists are right. Perhaps it is time for a bit of realism – and the return of economic realists. History, rather than having been abolished, might just have been postponed.


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