Stephen King: In rush to embrace Keynes, are we forgetting the vital role of markets?
Monday 08 December 2008
There are moments in any economic cycle when one's worst fears are confirmed. Friday's US employment release provided one of those occasions. Those who were hanging on to the belief that, somehow, there was a disconnect between Wall Street and Main Street will have to think again.
More than half a million US jobs were lost in just one month, the biggest fall since the mid-1970s, a time when economic life was truly miserable. For those of us living in the UK, America's economic problems are particularly alarming. After all, our housing boom has been bigger than America's and our debt addiction is greater. US developments, therefore, may provide a lead indicator of what we, in the UK, need to prepare for.
Of significant concern is the fact that, for more than a year, the Americans have been loosening economic policy through a mixture of interest rate cuts, liquidity injections and tax cuts. If these policies have worked, they have only served to prevent an even bigger economic catastrophe. And, even if they have had an impact, the medicine is beginning to run out. Ahead of the Bank of England and the European Central Bank, the Federal Reserve is about to encounter a very strange world indeed. In a matter of weeks, it's likely that Fed funds, the key US interest rate, will drop to zero. If there is still no recovery, what will happen next?
As I've argued in recent columns, there is no shortage of "unconventional" policies which can then be pursued, ranging from buying mortgage bonds and corporate bonds through to the purchase of government bonds and the consequent flooding of an economy with "new" money. If banks are unable or unwilling to lend, the only way in which the household or corporate patient is likely to survive is to be placed on public sector life support. Outright purchases of private sector assets by the central bank, the government and, hence, the taxpayer, can help. Governments could go even further, creating state development banks or, if push came to shove, nationalising and controlling parts of the existing banking system.
What, though, does public sector life support look like? In the attempt to prevent a Great Depression mark II, and in our desire to castigate free market capitalism, are we in danger of forgetting about the vital role performed by markets? The problem is obvious and practical. Take, for example, the possibility that central banks start buying corporate bonds. On the face of it, this seems a sensible approach. Companies which have access to the corporate bond market – mostly large companies – will be able to receive funding without needing help from the banking sector. The banks would then be able to reduce their overall lending volumes, in line with their vastly reduced sources of funding, but still be able to maintain lending to households and smaller companies.
Too good to be true? Perhaps. Central banks are there to safeguard the value of the currency and to ensure a fully functioning financial system. They're not supposed to replace the financial system. Their ability to do so is extremely limited. To take one example, at the end of February 2008 the Bank of England employed 1,542 full-time staff and 211 part-time staff. I'm sure all of them are able, and some are doubtless very able, but it would be a hard ask for them to devote their time to the allocation of the nation's capital in an attractive way when the banks themselves employ hundreds of thousands of people and still haven't managed to get it right.
To his credit, Lord Mandelson noted in his Hugo Young lecture last week that New Labour has no intention of picking winners by Whitehall edict. Yet the logic of bypassing a poorly functioning banking system is that governments and central banks might have to do just that. The US is already struggling with these issues. For the most part, it appears that supplication is the order of the day. Hank Paulson, the US Treasury Secretary, allegedly got on bended knee to persuade Nancy Pelosi, the Leader of the House of Representatives, of the merits of his Troubled Assets Relief Plan. The leaders of America's car companies were following Paulson's lead last week, having abandoned their private jets in order to drive to Washington in a bid to receive a much-needed bailout.
While the intentions are doubtless honourable, the reality is likely to be a deterioration in incentives which can best be expressed through the concept of opportunity cost. Protecting industries which ultimately need to shrink will only happen if industries which should be allowed to grow are mercilessly starved of capital. Imagine how the world would look today had those policies been pursued over the last 30 years: no Microsoft, no Apple, no Vodafone, no Google... the list goes on and on.
While I may be overstating the case, the plain fact is that governments and central banks are not good at spotting investment opportunities. Governments hate the loss of one million jobs at a single company, even if it's an industrial dinosaur. They can cope more easily with the failure to create 100,000 companies each of which might have created 10 new jobs. Only the first, after all, creates headlines.
Markets, though, are not interested in headlines: they're concerned about returns and, as a result, they are able, for the most part, to allocate capital reasonably efficiently. John Maynard Keynes understood this. His view, though, was that markets could occasionally fail and that, on those rare occasions, there might be a need for governments to step in on a temporary basis, preserving jobs that might otherwise be lost and safeguarding businesses that might otherwise go bust in an attempt to bolster effective demand.
Temporary support, though, can too easily become permanent subsidy. The politicisation of finance and industry creates all sorts of dangers. It's important, therefore, for governments to consider not just the need to support demand in the short term but equally the need for an "exit strategy" longer-term.
Now, perhaps, is not the time to spell out an exit strategy in detail. Nevertheless, in the rush to embrace Keynesianism, there's a danger of forgetting a key lesson. At the microeconomic level, in the engine room of modern economies, it's important to provide the right economic incentives. A society that depends increasingly on government largesse is one in which the incentives will end up all wrong. And, in that kind of society, the cost will be felt not so much in high unemployment in the short term, but a lack of growth and innovation in the long term. Keynes's policies will, I think, be helpful. Too many people, though, seem to think they offer a free lunch. They do not.
Stephen King is managing director of economics at HSBC
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