Tuesday, March 12, 2013

Our economy is headed in the Japanese direction

In his Telegraph column, Roger Bottle argues for a change in policy so the UK (and EU and US too) doesn't end up like Japan.

The similarity is closest with the position that faced Japan after the bursting of its bubble in the early 1990s. And Japan is still waiting for a full recovery even now. 
Japan is still waiting despite the huge growth in the world economy that occurred for the first 15 years after its bubble burst.
Here interest rates are almost at rock bottom. In any case, for lower interest rates to do much good, the banking system needs to work properly. It doesn’t. It is broken. 
Remarkably, the Government has been lily-livered about taking tough action to fix it, while still relying on monetary policy to revive the economy.
It is not a case of the Government being lily-livered.  The Government adopted an explicit policy of not fixing the banking system.

The policy adopted by the Government was the policy of financial failure containment and its corollary, the Geithner Doctrine (Do nothing that would harm the profits or reputation of big and/or politically connected banks).

Unfortunately, this policy has a long track record of never fixing the banking system and never resulting in economic recovery.
This situation is in marked contrast to the recovery from the 1980s and ’90s recessions, when the banking system was robust. Indeed, banks were then eager to expand their lending. Even in the 1930s, we survived “the Great Depression” without a single bank going under. 
Admittedly, the pound has fallen recently, as it did in the prelude to the recoveries of the 1930s, 1980s and 1990s. And it could fall further still. But our major markets are in recession and manufacturing is much smaller. A major boost from net exports looks unlikely. 
This is not a normal recession.
It is a recession triggered by a bank solvency led financial crisis.

The response by policymakers and regulators of protecting bank book capital levels and banker bonuses at all costs is the very thing that leaves the UK, EU and US economies in a Japan-style economic slump.

End protecting bank book capital levels and banker bonuses, end the recession.
Because people are trying to put their balance sheets in order after the borrowing binge, they don’t respond to financial prodding in the usual way. 
So monetary stimulus is less powerful than normal.
There are a number of other reasons that monetary stimulus is less powerful.  At the top of the headwinds the economy is currently experiencing is the Retirement Plan Death Spiral and the threat to the social programs (both medical and retirement).  The response by individuals to both is to cut back on current consumption and try to save more.
However, with monetary policy bound to be in supportive mode, the effectiveness of fiscal expansion may be greater than usual. 
Accordingly, the case for an expansionary fiscal policy is stronger. 
Your humble blogger would argue that simply having an expansionary fiscal policy is inadequate.  The benefits of the expansionary fiscal policy are absorbed in servicing the excess debt in the financial system (substitute public for private debt).

What is needed to address the problem on three fronts.

First, the banks must be required to recognize upfront the losses on the excess public and private debt in the financial system.

Second, fiscal policy must be expansionary.

Third and critically important, monetary policy must be changed so that interest rates reach or exceed Walter Bagehot's 2% minimum.  This is not difficult to do.  Central banks have to halt Quantitative Easing and start pulling reserves out of the banking system.

While the third recommendation is counter-intuitive, it is necessary to end economic headwinds like the Retirement Plan Death Spiral that are triggered by the lack of return on investments.
Arguing against a relaxation of fiscal policy, the Prime Minister has said that there is no “magic money tree”. Yet there is apparently enough of a magic money tree to provide £164 billion in funding to the Government this year. 
And even the Chancellor would not advocate trying to cut this to zero immediately. So, on the subject of magic, the question should rather be what is so magical about the current planned level of borrowing? 
The issue is not one of principle but of pragmatism – it is all about the right amount to borrow. 
I think Mr. Bottle puts too fine a point on how much the government should borrow.

The market recognizes that the government is pursuing an expansionary fiscal policy to give the economy a boost.  So long as the money is being spent in a productive fashion that boosts the size of the economy and therefore generates a return in the long run, think repairing and improving infrastructure, markets will be very supportive.

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