Stephen King: To stimulate or not to stimulate? That is the question

Who is right? The Americans want to see other parts of the world offering more economic stimulus. The Europeans think there's been too much stimulus already.

The arguments on either side are easy enough to spell out. The US believes it has kept the world economy afloat over the last couple of decades. By running an ever-widening balance of payments current account deficit, the US has imported more than it has exported and, hence, has offered a stimulus to the rest of the world.

In the process, however, the US has become over-burdened with debt. The results of this debt addiction include the housing bubble, its subsequent bust, the sub-prime crisis, the credit crunch and the highest level of long-term unemployment in the post-war era. For President Barack Obama and his colleagues at the US Treasury, it's time for someone else to do the heavy lifting to keep the global economy's head above water.

For the Europeans, it's a different story. For them, the crisis stemmed from an earlier period of binge-borrowing, associated with excessively rapid money supply growth, low interest rates, reckless government borrowing and a failure to recognise the massive growth in leverage. They have no desire to follow the American model of old, because they can see the unfortunate results.

The US may not have been the worst-hit country during the financial crisis, but the US was, nevertheless, the epicentre of the crisis. Why should European policymakers emulate a model which has so clearly ended in failure? For them, now is a time for austerity. It's payback time for years of ill-discipline and an opportunity to reassure nervous financial markets that borrowing really is under control.

These contrasting positions partly reflect differing abilities to tap the world's capital markets. The US enjoys the huge benefit of having the world's reserve currency. At times of financial distress, investors typically flock to buy dollars, selling more or less everything else in the process. As a result, it's proved relatively easy for the US to fund what is now an absolutely huge budget deficit. Foreign purchases of Treasuries have risen substantially over the last 18 months, driving 10 year yields down to a paltry 3 per cent. Budget deficits across Europe are mostly a lot lower than America's yet, for many countries, borrowing costs are a lot higher. Spain, for example, has to borrow at a rate of 4.5 per cent, and much of its debt is probably being bought up by the European Central Bank because a nervous market is no longer interested.

But there's a lot more to this difference of view than the ability to tap capital markets. The Germans, for example, are able to borrow at a remarkably low interest rate of only 2.6 per cent, yet Angela Merkel and her colleagues have no wish to follow America's road to perdition, as they see it.

It's partly a matter of history. America's 20th-century economic crisis was the Great Depression, a time of collapsing activity, mass unemployment and deflation. Germany's crisis was its hyperinflation of the 1920s, when people carted money around in wheelbarrows and when cigarettes became an important alternative medium of exchange. The Americans are prepared to take monetary and fiscal gambles to prevent a collapse in activity. The Germans fear that such gambles will simply see the return of excessive inflation. Already, they're worried that the shenanigans taking place elsewhere in Europe are beginning to contaminate German values. Not surprisingly, then, they're ill-disposed to delivering a European economic stimulus in response to American overtures.

There is also, however, a particularly awkward economic question to be resolved, and it goes right to the heart of the debate about the success or otherwise of Keynesian stimulus measures. Keynes thought economies could settle down at levels of activity well below full employment. He also believed that the market, left to its own devices, would not be able to generate any kind of rebound. The result would be deficient demand and persistently high unemployment of the kind seen in the 1930s. Companies wouldn't hire enough workers to reduce unemployment for the simple reason that each company, on its own, would be unable to see the collective increase in demand created by a return to full employment across the economy as a whole. What was needed, instead, was an intervention by policymakers in the form of a monetary or fiscal stimulus that would jolt the economy back on to the full employment path.

That's fine as far as it goes. But how should full employment be defined? Should we be aiming for a return to conditions as they were before the crisis unfolded in 2007 and 2008? Or should we accept that the boom which preceded the bust was, itself, undesirable and that no policymaker with a reasonable grip on reality should be hoping to see its return?

If so, we need to adjust our expectations of what can be achieved by Keynesian policies. The economic world isn't composed of simple binary choices along the lines of full employment versus unemployment or recovery versus recession. If we're coming out of recession, but we don't want a return to the conditions that preceded the recession, we have to accept that, pre-recession, we were probably living beyond our means.

To that extent, Keynesian policies have limitations. They have certainly helped to prevent a Great Depression Mark II. But they cannot take us back to where we were before the crisis because, at some point, we need to get a grip on the excessive debts which led to the crisis in the first place.

The Europeans recognise this constraint more than the Americans. That's hardly surprising. Europe finds itself attacked from all sides: too much debt in the likes of Greece, Portugal and Spain and too little debt in Germany. Europe's fiscal crisis may be partly of its own making but it also reflects growing uncertainty amongst the world's creditors that recovery can only be delivered via ongoing fiscal stimulus. Japan's government debt, after all, has expanded hugely over the years, reflecting persistent budget deficits, yet its economy remains flat on its back.

Keynesian policies may prevent the worst from happening, but they cannot take us back to a world of leverage where creditors are forever dipping into their pockets to provide money for the profligate to spend on all sorts of madcap ventures. Eventually, debtor nations need to adjust their spending habits. The US, the UK and others have been living beyond their means for many years and will probably have to accept that the level of output and its growth rate are now permanently lower than they appeared to be before the crisis began.

The case for austerity rests on accepting this new reality. Austerity is hardly pleasant, but it might just prevent a repeat of the problems which, two years ago, culminated in the worst Western recession since the 1930s. That, in itself, would be some achievement.



Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

Start your day with The Independent, sign up for daily news emails
Voices
There will be a chance to bid for a rare example of the SAS Diary, collated by a former member of the regiment in the aftermath of World War II but only published – in a limited run of just 5,000 – in 2011
charity appealTime is running out to secure your favourite lot as our auction closes at 2pm today
News
File: James Woods attends the 52nd New York Film Festival at Walter Reade Theater on September 27, 2014
peopleActor was tweeting in wake of NYPD police shooting
Sport
Martin Skrtel heads in the dramatic equaliser
SPORTLiverpool vs Arsenal match report: Bandaged Martin Skrtel heads home in the 97th-minute
News
Billie Whitelaw was best known for her close collaboration with playwright Samuel Beckett, here performing in a Beckett Trilogy at The Riverside Studios, Hammersmith
people'Omen' star was best known for stage work with Samuel Beckett
PROMOTED VIDEO
ebooks
ebooksA year of political gossip, levity and intrigue from the sharpest pen in Westminster
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Carlton Senior Appointments: Private Banking Manager - Intl Bank - Los Angeles

$200 - $350 per annum: Carlton Senior Appointments: Managing Producer – Office...

Carlton Senior Appointments: San Fran - Investment Advisor – Ind Advisory Firm

$125 - $225 per annum: Carlton Senior Appointments: San Fran - Investment Advi...

Sheridan Maine: Commercial Finance Manager

Up to £70,000 per annum + benefits: Sheridan Maine: Are you a qualified accoun...

Sheridan Maine: Regulatory Reporting Accountant

Up to £65,000 per annum + benefits: Sheridan Maine: Are you a qualified accoun...

Day In a Page

Surrounded by high-rise flats is a little house filled with Lebanon’s history - clocks, rifles, frogmen’s uniforms and colonial helmets

Clocks, rifles, swords, frogmen’s uniforms

Surrounded by high-rise flats is a little house filled with Lebanon’s history
Return to Gaza: Four months on, the wounds left by Israel's bombardment have not yet healed

Four months after the bombardment, Gaza’s wounds are yet to heal

Kim Sengupta is reunited with a man whose plight mirrors the suffering of the Palestinian people
Gastric surgery: Is it really the answer to the UK's obesity epidemic?

Is gastric surgery really the answer to the UK's obesity epidemic?

Critics argue that it’s crazy to operate on healthy people just to stop them eating
Homeless Veterans appeal: Christmas charity auction Part 2 - now LIVE

Homeless Veterans appeal: Christmas charity auction

Bid on original art, or trips of a lifetime to Africa or the 'Corrie' set, and help Homeless Veterans
Pantomime rings the changes to welcome autistic theatre-goers

Autism-friendly theatre

Pantomime leads the pack in quest to welcome all
The week Hollywood got scared and had to grow up a bit

The week Hollywood got scared and had to grow up a bit

Sony suffered a chorus of disapproval after it withdrew 'The Interview', but it's not too late for it to take a stand, says Joan Smith
From Widow Twankey to Mother Goose, how do the men who play panto dames get themselves ready for the performance of a lifetime?

Panto dames: before and after

From Widow Twankey to Mother Goose, how do the men who play panto dames get themselves ready for the performance of a lifetime?
Thirties murder mystery novel is surprise runaway Christmas hit

Thirties murder mystery novel is surprise runaway Christmas hit

Booksellers say readers are turning away from dark modern thrillers and back to the golden age of crime writing
Anne-Marie Huby: 'Charities deserve the best,' says founder of JustGiving

Anne-Marie Huby: 'Charities deserve the best'

Ten million of us have used the JustGiving website to donate to good causes. Its co-founder says that being dynamic is as important as being kind
The botanist who hunts for giant trees at Kew Gardens

The man who hunts giants

A Kew Gardens botanist has found 25 new large tree species - and he's sure there are more out there
The 12 ways of Christmas: Spare a thought for those who will be working to keep others safe during the festive season

The 12 ways of Christmas

We speak to a dozen people who will be working to keep others safe, happy and healthy over the holidays
Birdwatching men have a lot in common with their feathered friends, new study shows

The male exhibits strange behaviour

A new study shows that birdwatching men have a lot in common with their feathered friends...
Diaries of Evelyn Waugh, Virginia Woolf and Noël Coward reveal how they coped with the December blues

Famous diaries: Christmas week in history

Noël Coward parties into the night, Alan Clark bemoans the cost of servants, Evelyn Waugh ponders his drinking…
From noble to narky, the fall of the open letter

From noble to narky, the fall of the open letter

The great tradition of St Paul and Zola reached its nadir with a hungry worker's rant to Russell Brand, says DJ Taylor
A Christmas ghost story by Alison Moore: A prodigal daughter has a breakthrough

A Christmas ghost story by Alison Moore

The story was published earlier this month in 'Poor Souls' Light: Seven Curious Tales'