The present crisis has global policy makers running in circles over possible solutions. The nature of the Dismal Science (Economics) is that there are usually more opinions than the people debating the issues. The remarkable aspect of the present crisis is that the solutions offered seem to be insufficient for the present problems. There are two major problems that the global economy needs to grapple with are, (1) deleveraging from the high levels of debt, and (2) reinvigorating demand.
The first issue, especially the problems related to sovereign debt, seems to have assumed centrality and the other issue(s) have been brushed to the background. It is imperative to note that the first issue can be solved only if the second problem is overcome. But the present intellectual framework has completely failed in dealing with the issue of reinvigorating demand. The first two years (2008-09) was the only time when policy makers seem to have attempted to seriously grapple with the issue of declining demand and attempted to increase the faltering demand. Over the last two years, they seem to have given up on the task. Instead, the mistaken belief seem to have been that if the banks could be ‘induced’ to lend money to consumers, that would magically solve the problems of reigniting consumer demand. The banks were provided various incentives and low cost capital – all of which they gratuitously accepted but decided to invest in government debt, thereby creating a remarkable circularity. This is clearly reflected in the falling bond yields the world over.
The stimulus measures were well intended but wrongly conceived. The net result is that it has accentuated the present crisis for the sovereign nations. Bailing out banks without corresponding assurances and guidelines for good behaviour will go down as the single most important mistake during the course of the present crisis. Instead, policy makers seem to believe that if interest rates are retained at sufficiently low levels, especially when there is a credit shortage, it would facilitate the banks to ‘earn their way out of the hole’ by lending more thereby making larger profits from high spreads. This mistaken belief is reinforced the successful example of the early 1990s when Greenspan (interest rates dropped to about 3%) attempted this with success. Unfortunately, the difference between the two periods could not have been more different: the early 1990s was the start of a multiyear boom exiting out of years of stagnation and an era of high interest rates. A natural corollary of this is the belief that increasing the supply of money accompanied by low interest rates will serve as a trigger to solve the present problem. Though, increasing the supply of money may be a better alternative to inaction during debt deflations, especially when there is a ‘balance sheet’ recession. This is because monetary policy induced measures are premised on the assumption that there will always be an ever increasing number of willing borrowers in the private sector.
The deficiency of the present intellectual framework is largely responsible for this blunder. University Departments, Businesses and think tanks encourage borrowing money, especially when interest rates are low. The mistaken logic is reinforced by the assumption that demand will remain constant forever. Companies and individuals continuously make the same mistake as they assume that the current well being witnessed during periods of economic buoyancy will continue forever. The longer the period of economic buoyancy, the more the attraction of this view. That view would have worked but for two major problems: high levels of present debt and, the attendant onset of debt deflation. In such times, profit maximisation is not the main motive for the private sector, rather it is the survival as falling asset prices over a period of time gradually erode the networth. This happened during the Great Depression and then again in Japan. The case of Japan shows us that debt deflations are more dangerous than inflationary spirals. Japan is an excellent case of an economy afflicted by prolonged debt deflation. Over the past two decades Japan has lost the equivalent of nearly three years of GDP due to falling land and stock prices since 1990. During a deleveraging cycle, no amount of increase in money supply or a decline in interest rates convince a borrower to assume more debt. The problems created by high existing debts are invariably aggravated by increasing job losses, general decline in demand and an overall decline in networth.
Hence it is time policy makers seriously consider measures that put money (non-debt surplus) in the pockets of households and businesses. Though in the initial years, it will invariably be used to pay down debt, over the long-term it will lay the foundation for a strong recovery.
The first issue, especially the problems related to sovereign debt, seems to have assumed centrality and the other issue(s) have been brushed to the background. It is imperative to note that the first issue can be solved only if the second problem is overcome. But the present intellectual framework has completely failed in dealing with the issue of reinvigorating demand. The first two years (2008-09) was the only time when policy makers seem to have attempted to seriously grapple with the issue of declining demand and attempted to increase the faltering demand. Over the last two years, they seem to have given up on the task. Instead, the mistaken belief seem to have been that if the banks could be ‘induced’ to lend money to consumers, that would magically solve the problems of reigniting consumer demand. The banks were provided various incentives and low cost capital – all of which they gratuitously accepted but decided to invest in government debt, thereby creating a remarkable circularity. This is clearly reflected in the falling bond yields the world over.
The stimulus measures were well intended but wrongly conceived. The net result is that it has accentuated the present crisis for the sovereign nations. Bailing out banks without corresponding assurances and guidelines for good behaviour will go down as the single most important mistake during the course of the present crisis. Instead, policy makers seem to believe that if interest rates are retained at sufficiently low levels, especially when there is a credit shortage, it would facilitate the banks to ‘earn their way out of the hole’ by lending more thereby making larger profits from high spreads. This mistaken belief is reinforced the successful example of the early 1990s when Greenspan (interest rates dropped to about 3%) attempted this with success. Unfortunately, the difference between the two periods could not have been more different: the early 1990s was the start of a multiyear boom exiting out of years of stagnation and an era of high interest rates. A natural corollary of this is the belief that increasing the supply of money accompanied by low interest rates will serve as a trigger to solve the present problem. Though, increasing the supply of money may be a better alternative to inaction during debt deflations, especially when there is a ‘balance sheet’ recession. This is because monetary policy induced measures are premised on the assumption that there will always be an ever increasing number of willing borrowers in the private sector.
The deficiency of the present intellectual framework is largely responsible for this blunder. University Departments, Businesses and think tanks encourage borrowing money, especially when interest rates are low. The mistaken logic is reinforced by the assumption that demand will remain constant forever. Companies and individuals continuously make the same mistake as they assume that the current well being witnessed during periods of economic buoyancy will continue forever. The longer the period of economic buoyancy, the more the attraction of this view. That view would have worked but for two major problems: high levels of present debt and, the attendant onset of debt deflation. In such times, profit maximisation is not the main motive for the private sector, rather it is the survival as falling asset prices over a period of time gradually erode the networth. This happened during the Great Depression and then again in Japan. The case of Japan shows us that debt deflations are more dangerous than inflationary spirals. Japan is an excellent case of an economy afflicted by prolonged debt deflation. Over the past two decades Japan has lost the equivalent of nearly three years of GDP due to falling land and stock prices since 1990. During a deleveraging cycle, no amount of increase in money supply or a decline in interest rates convince a borrower to assume more debt. The problems created by high existing debts are invariably aggravated by increasing job losses, general decline in demand and an overall decline in networth.
Hence it is time policy makers seriously consider measures that put money (non-debt surplus) in the pockets of households and businesses. Though in the initial years, it will invariably be used to pay down debt, over the long-term it will lay the foundation for a strong recovery.
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