Austerity and politics: a convincing economic alternative remains elusive

In an editorial, the Guardian looks at the current global financial situation, sees Western economies stuck in an economic slump as neither austerity or Keynes-lite has worked and asks what is the convincing economic alternative to get out of the current situation.

Regular readers know what the Guardian editors are seeing is the result of policymakers and financial regulators pursuing the Japanese model for handling a bank solvency led financial crisis.  Under this model, bank book capital levels and banker bonuses are protected at all costs.

As a result, the real economy is made to carry the debt service burden of the excess debt in the financial system.  This causes capital to be diverted from reinvestment and growth to debt service.  A diversion that puts the real economy in a downward spiral.

To offset this decline in the real economy, governments pursue expansionary fiscal and monetary policies.  Unfortunately, these policies, like zero interest rates and quantitative easing produce their own economic headwind.

The result of pursuing the Japanese Model is policymakers and financial regulators have condemned the real economy to a Japan-style economic slump.

There is a convincing economic alternative.  The alternative is to adopt the Swedish Model for handling a bank solvency led financial crisis.

Under the Swedish Model, banks are required to absorb the losses on the excess debt in the financial system.  This removes from the real economy the debt service burden of the excess debt.  As a result, rather than channel capital into debt service, capital is channeled into reinvestment and growth.

With capital being channeled back into the real economy, there is no need to pursue monetary policies that create their own economic headwinds.  As these policies are abandoned, the removal of their economic headwinds creates more growth in the real economy.

That the Swedish Model works is very well known.

It was first tried by the FDR Administration and according to the NY Fed, it broke the back of the Great Depression.

Most recently Iceland tried it and their economy is one of the best performing economies in the world.

Here is the news, in three parts. Tens of thousands of European workers take to the streets in a historic concerted action to protest soaring unemployment and unprecedented austerity. The Bank of England'sMervyn King warns that Britain's slump will be longer and more painful than he and the government had imagined. American newspapers burst with talk of a looming "fiscal cliff" of tax rises and spending cuts: if the squabbling politicians in Washington fall off that New Year's eve ledge, runs the conventional view, they will bring the US and the world economy crashing down with them. 

Three flashpoints in three distinct parts of the global economy in just one day. There was a time when even one of these would have been guaranteed front-page fodder, but four years into this slump – the worst the west has faced since the 1930s – we are well used to bad news coming in threes, fours or more. 

And it is easy to see common threads drawing together these separate crises. First, it is slowly dawning on policy-makers in each region just what a mess they are in. Mervyn King warns that, five years after the collapse of Northern Rock, Britain is still only halfway through its crisis – even while Angela Merkel talks ofanother half a decade of misery in the eurozone. Even in America, which on headline economic figures would appear to be best-off, the unemployment rate is stuck nearly two percentage points above where Barack Obama's top advisers forecast it would be by now. 

But it is not just the scale of the slump, it's also the sense among policy-makers of having run out of options.

Hopefully the policy-makers have run out of options other than adopting the Swedish Model.  After four years of slump it is time to end this financial crisis.

In Wednesday's inflation report press conference, Mr King hinted yet again at the shortcomings of the bank's policy of pumping more money into the bank system....

The governor's opposite number in Washington, Ben Bernanke, has got round the ineffectiveness of the Federal Reserve's QE programme by getting more and more experimental – and less and less convincing. ....

As for the eurozone, the strike action only confirms what the figures suggest: that austerity is hurting rather than working. And yet the only European solution is to keep doing more of the same, as summed up this week by chief economist at Standard Chartered bank, Gerard Lyons: "Cut. Economy shrinks. Firms don't spend. People can't. Debt dynamics worsen. So cut." ...

And in all cases, the outline of a convincing economic alternative – beyond either austerity or Keynes-lite – remains disastrously, dangerously elusive.

The Swedish Model isn't elusive.  Policy makers haven't adopted it because they are relying on the bankers who caused the financial crisis for advice on how to end the crisis.  The last thing the bankers are going to recommend is making the banks take their losses and seeing their cash bonuses reduced to zero.