Stephen King: Misguided thinking of those who say recession would purge the system
Monday 11 February 2008
I never thought I'd associate the economics profession with sadism, but I'm beginning to wonder. In recent weeks, I've read an increasing number of articles suggesting that a recession would do the world economy a power of good. The protagonists' arguments follow in the best traditions of John Major's approach to economic policy. It was the mild-mannered Mr Major, after all, who once said "If it isn't hurting, it isn't working". But who, though, deserves to be hurt? Shock therapy sometimes works, but policymakers shouldn't bank on this approach all the time.
Back in the early 1980s, when inflation was rife, shock therapy was used on both sides of the Atlantic to try to deliver some semblance of price stability. For the UK, this meant a tough budget from Geoffrey Howe, the then Chancellor of the Exchequer, a massive appreciation of the exchange rate and an open commitment to monetarism. The policy eventually succeeded (even though there was another rather serious inflationary hiccup in the late 1980s) but only at the cost of a huge temporary increase in unemployment and the concomitant devastation of entire communities.
For the US, a similar approach was adopted. Under the stewardship of Paul Volcker, the Federal Reserve stamped its authority on the inflationary process in aggressive style. The monetary medicine contributed not only to a double-dip US downswing at the beginning of the 1980s but also to nasty economic outcomes elsewhere in the world, most obviously the Latin American debt crisis.
As most of us would not choose to re-embrace the economic conditions of the 1970s (when growth was stagnant yet inflation was out of control), I guess it's possible to argue that, over the long-term, the shock therapy worked. But does this mean that, again, we need a dose of shock therapy? Do we, again, need to suffer for our earlier sins?
The early 1980s recessions were what I'd call "planned recessions". They were the price to be paid for reclaiming longer-term economic stability. Inflation, after all, was a particularly unpleasant beast. Its unpredictability led to huge misallocations of resources, lower economic growth and grossly unfair redistributions of income.
The recession that may be coming our way this year, however, is a very different animal. Should it arrive, it will surely count as an accident. As far as I know, no one, not even the most Machiavellian of policymakers, was arguing a year ago that a recession would be a good idea. So why, now, are people prepared to believe that a recession will act as a useful "cleansing" process?
The last one certainly didn't. The 2001 economic downswing, closely connected to the earlier stock market bubble, led to recessions in many parts of the world. Yet it's difficult to argue that these recessions purged economies of all excesses. Arguably, they made the earlier excesses worse. The US replaced its equity bubble with a housing bubble which, in time, contributed to today's sub-prime crisis. Global imbalances got worse in the current decade even though they were already bad enough in the 1990s. And central banks, the Bank of England included, are discovering that inflation has, once again, become a tricky adversary.
Recessions may be an unfortunate, and perhaps unavoidable, feature of market econ-omies, but to suggest that they can usefully purge the system is, with one or two historical exceptions, a step too far.
Recessions are brutal econ-omic events, associated with massive and indiscriminate job loss, regional deprivations and political turmoil. They lead, in turn, to huge misjudgements of policy. Think, for example, of the Smoot-Hawley trade tariff at the beginning of the 1930s, or John Major's disastrous commitment to the European Exchange Rate Mechanism at the beginning of the 1990s.
Even worse, they can also lead to extraordinary errors of moral judgement. Consider, for example, George Bernard Shaw's shocking embrace of Stalin's Soviet Union in the 1930s. His disgust at the collapse of Western economies was only matched by his blind refusal to see the secret behind Stalin's industrial success, namely the Bolsheviks' complete dependence on slave labour from the gulags.
Policy can, and should, be adjusted to minimise the economic fallout from recession. The moral case for doing so is simple. Recessions punish people on an arbitrary basis. Those guilty of earlier excesses too often escape without serious penalty, whereas those who innocently went about their business find themselves losing their job, their home and maybe even their sanity. It is simply too trite to suggest that recessions are a useful "purge". No system of justice could ever survive on those principles (unless, of course, it was run by Stalin). Recessions, then, are a form of economic tyranny.
The only case for having the occasional purge rests on the idea that policy adjustments increase the likelihood of future recessions. So-called "moral hazard" is created when changes in policy change our behaviour in ultimately unhelpful ways. Does the requirement to have motor insurance encourage us to drive our cars more dangerously? Does home insurance make us careless in securing our prop-erty when we go away on holiday? And, in response to an economic downswing, do interest rate cuts, tax reductions and bailouts of financial institutions make us collectively less risk-averse, leading to the next boom and subsequent bust?
There is some truth in this claim. But the problem lies not so much with the policies adopted during recessionary downswings but, instead, in the failure to adopt the appropriate pol-icies during the subsequent boom. The Federal Reserve, for example, should have raised interest rates much more aggressively in 2003 and 2004, when it became increasingly clear that the US economy was no longer facing the risk of a Japan-style deflationary downswing. The UK Government should, in recent years, have run a much tougher fiscal policy because, by doing so, it would have a lot more flexibility to intervene to support the economy during its hour of need and the housing bubble perhaps wouldn't have been so big. The world's financial regulators should have looked much more closely at the development of securitisation earlier in the decade and done something about it: there was, after all, no shortage of warnings.
Recessions can be regarded as the consequence of earlier periods of excess. If, then, we want to stop recessions, we need to reduce the excesses. There is no evidence that recessions themselves do the trick. If they did, their frequency would presumably have fallen. Yet recent economic history suggests, if anything, that their frequency is beginning to increase again.
But will policymakers act on excesses? The truth is, of course, that politicians have no incentive to do so. They all want to say, in the words of Harold Macmillan, that "you've never had it so good". And I'd argue that our monetary arrangements – not-ably the modern-day commitment to inflation targeting – are, on their own, not really up to the task, given the all-too-frequent occurrence of bubbles in recent times. If the arrangements had worked, the world economy perhaps wouldn't be in the parlous position it's in today.
Stephen King is managing director of economics at HSBC firstname.lastname@example.org
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