How should the UK escape from a slump that seems sure to be longer and more costly than the Great Depression of the 1930s? David Cameron, the prime minister, has no doubt. In his speech to the Conservative conference last week, he insisted that: “The only way out of a debt crisis is to deal with your debts. That’s why households are paying down their credit card and store card bills. It means banks getting their books in order. And it means governments – all over the world – cutting spending and living within their means.” What would be the result of this advice? Prolonged stagnation, at best. That is what we have been seeing, after all.
What Mr Cameron recommends is even nigh on impossible. Why is that? Is it not common sense that if one has borrowed too much, one must pay it back? Alas, what makes sense for individuals does not make sense for an economy, because one person’s spending is another person’s income. Consider a closed economy. Income and spending must match. If the private sector decided to spend less than its income, to pay down debt and if the government also decided to stop borrowing, aggregate incomes would fall until they could no longer achieve what they wanted. All they would obtain, by following Mr Cameron’s advice, is a race to the economic bottom.
Maybe, one could persuade fewer indebted people to spend more, to offset the increased frugality of the indebted. In the UK, two groups are in a position to increase their spending on domestic output: non-financial corporations and foreigners. Indeed, the hope was that a surge in investment and exports would offset household and government frugality. But Mr Cameron’s government has done its best to block these escapes. In a stagnant economy, corporations see little reason to invest – and are barely doing so. As for foreigners, many – particularly in the eurozone, the UK’s principal trading partner – are following the UK's advice. Surprise! Exports are barely growing.
Is there another way out? Again, yes. One could work directly on the balance sheets. Highly indebted households could sell their houses to people who want them, but would not need to borrow. Maybe, one could sell the houses to frugal immigrants. But where would the British people then live? An alternative solution would be the one recommended by Andrew Mellon, the notorious US Treasury secretary in the Great Depression, who argued that the US should “liquidate labour, liquidate stocks, liquidate farmers, liquidate real estate”. Mr Mellon’s advice was at least logical. Putting large parts of the economy through bankruptcy would reduce debt quickly. This could also be done in a more organised way, via government-sponsored debt forgiveness. But both routes would devastate creditors, including the banks, and savage the economy. They would also undermine willingness to lend.
If debt destruction were desired, the least damaging policy would be inflation. At the least, no sane policymaker would choose deflation in an overindebted economy. Yet one government – that of Japan – did just that. The view in the UK is that deflation is inconceivable. I disagree. Monetarists should note that broad money and lending are stagnant. Yes, headline inflation is high, but unit labor costs are flat and nominal wage growth low. The UK could be just one negative shock away from deflation. With fiscal policy contractionary, banks weak and caution rampant in the private sector, the risk is not at all small.
That is why the governor of the Bank of England was right to tell the chancellor, in justifying the recent decision of the monetary policy committee to add 75 billion pounds in “quantitative easing”, that the deterioration in outlook “has made it more likely that inflation will undershoot the 2 percent target in the medium term”. It could indeed.
The pity is that the Bank’s new money is going to buy long-dated government debt. That will not achieve much, given how low yields already are. As the prime minister might say, policymakers need a bigger “bazooka”. It would be more effective if newly created money paid directly for government spending. The government could send 1,250 pounds to each citizen resident in the UK. It could also use new money to purchase private debt, including loans to small businesses. This is off-balance sheet public spending. If the chancellor decides to call it “credit easing”, that is absolutely fine.
There are two big points here. First, fiscal and monetary policy converge when interest rates are close to zero. The authorities have to co-operate closely, to prevent an unnecessary disaster. As Deng Xiaoping said: “It does not matter if a cat is black or white, so long as it catches mice.” Who cares if a policy is called fiscal or monetary, so long as it works? Second, without economic growth, it is almost impossible to deleverage an economy. The prime minister revels in his pre-Keynesian views. When weak demand is the immediate constraint on output, that is simply terrifying.