Crisis, Which Crisis

Here is a repost from my other blog. This first appeared on 16 Feb 2009.

It seems to me that behind the economic slump is not just one crisis but, at least, three:

• a banking crisis;
• a debt /demand crisis; and
• a trade crisis.

Of course they are linked - each impacting on the other – but dealing with the slump means responding to all three crises at the same time. My argument is that fixing all three simultaneously will not be easy.

The banking crisis is the most talked about. Banks have “assets” which no-one wants to buy and so the true value, if they have any, is unknown. Consequently the solvency of the banks is in doubt, and so interbank lending froze up two years ago and banks remain stuck.

The solution is to get the doubtful assets off the banks balance sheets. Recapitalising and offering insurance on bad loans might work, but the only sure way is too strip out the bad stuff and lodge it in a “bad bank”. If nationalisation is the only way to clean up the banks then so be it.

The debt crisis is more interesting. I keep reading - usually accompanied by expressions of shock – that total UK debt had reached 300% of GDP. But debt amounting to 3 times annual income is not that strange. If you have ever had a mortgage then you were probably allowed to borrow three times your income. The real crisis is that the appetite for risk has gone. Businesses and households want to hold cash rather than make risky investments. So there is a huge switch from lots of debt and credit to everyone trying to reduce their debts and increase saving.

This is the classic Keynesian crisis and the solution begins by expanding the money supply. But, partly because the banks aren’t doing their job and partly because people are holding on to cash, it isn’t working. The Bank of England is expanding the money supply as much as it can but broad measures of money are barely growing.

The other solution is for the government to borrow and spend – fiscal stimulus. The government is on the case, but I think it needs to do more.

The trade crisis has been developing for some years. Britain, the US and some other countries have been running large current account deficits, while others – like China and other Asian countries – have been running current account surpluses. The other side of the coin is that while trade flows go one way financial flows go the other. The surplus countries in effect lend their money back.

The solution to this one is for Britain, the US etc to save more and for China, etc to consume more. That may not be obvious, but as a matter of economic arithmetic, domestic savings less investment is equal to the trade balance; so more savings means less of a trade deficit.

Now I can see a difficulty here. Can the government deal with the second crisis and the third crisis at the same time? If government borrows enough to keep the economy going then it simply replaces the borrowing which firms and households no longer undertake, and the trade position will not improve.

The real answer to the trade imbalance is for the surplus countries to save less or borrow more (which is the same thing). So China’s fiscal stimulus and Germany’s fiscal stimulus are more important to the recovery than our own.