Adrian Hamilton: Governments have used up their economic ammunition

If politicians feel at sea, they're not alone. No one knows the answer
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The Independent Online

We are now in the third phase of the Great Economic Crisis of 2008. The first phase was the credit crunch, when the banks and their nefarious practices brought the the worlds's financial system to a shuddering halt. The second was when that impacted on the real economy to make a likely slowdown turn into a full-blown recession. And the third was when politicians got involved to take desperate counter-measures.

It is those counter-measures which are now being tried and found wanting – or at any rate inadequate to the magnitude of the problem. No one should blame the politicians for that. It is not as though they haven't tried. Virtually every country has thrown money at the problem in schemes to prop up its banks, take the debt off their books, to flood the system with money, direct financial institutions to lend, to reduce taxes, raise public expenditure and, above all, to cut interests rates.

Gordon Brown is quite right that this is a global crisis in which everyone is involved. He is quite wrong to say everyone is doing the same thing. They are not. We have gone for tax cuts to increase consumption. Others such as France have preferred to beef up public expenditure on infrastructure projects. We have chosen to break all previous restraints on public borrowing. Others such as Germany have preferred to keep within budgetary disciplines.

The scale is enormous, beyond anything that has ever been tried before. Yet governments, as Barack Obama commented after the US Federal Reserve reduced its interest rates to virtually zero this week, are also beginning to run out of shots in their locker. Having pulled down interest rates to where you can go no further, and having pushed the limits of borrowing to the absolute maximum in spending packages and failed to stop the slide, what the hell do you do?

The simplest answer is to do more of the same, only different. From lowering interest rates, you move to printing money in an effort to force free the flows of lending and borrowing and lower long-term interest rates. It is risky. It has brought down governments and societies in the long history of desperate rulers trying to do just that. But it is the only logical next move and one which the Bank of England is busily preparing for.

At the same time, you can (and governments no doubt will) cut taxes further, raise expenditure, buy up more toxic assets, provide more capital to financial institutions and even go one step further by taking over banks completely, using them as an instrument of counter-cyclical lending. Push hard enough, goes the theory, and eventually the logjam will break.

All this presumes that the danger now is deflation, when loss of confidence brings about a spiral of falling prices and demand that has to be stopped in its tracks. What marks this crisis out as different from most of its predecessors, however, is that it exploded just as the developed world was heading towards a slowdown. Floating on a sea of unsustainable debt, the US, Britain and – when you look at the figures – China, India and South Africa were all enjoying growth rates that could be maintained only when there was excess liquidity and low interest rates.

What we are seeing now, and the banking crisis is as much a symptom as cause, is an unwinding of that position. Just as the banks are having to draw down debt and beef up their finances, so too are individuals and companies. Just as it took a decade to build up this position of gross imbalance, so it will take years – five years at least, some believe – before house prices, debt and consumption are brought back into some kind of sustainable balance.

Given that, there is little point in further cutting taxes to boost spending when the consumer is intent on the opposite (and is probably wise to do so). Instead of directing expenditure towards consumption, it should be directed towards protecting the vulnerable in the short term and promoting the skills and infrastructure needed in the long term. In the same way, reducing interest rates to nil will not do the trick so long as banks and financial institutions see cutting their debts as the only safe means of securing their futures – and that may take some time yet.

Forcing them to lend is probably precisely the opposite of what you should be doing. The sooner they get their balance sheets secure, the faster they will do that of their own accord.

If politicians feel all at sea at the moment, they are not alone. Nobody knows how this crisis will pan out. All we can sense is that banks, consumers and businesses alike are all battening down the hatches in the face of the storm and nothing that governments do seems likely to make them change their mind.

a.hamilton@independent.co.uk

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