Those 'animal spirits' will have to be tamed

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The Independent Online
SO THE recession is over. Why, asked a thoughtful colleague, did we have one in the first place?

Clunk. One of the extraordinary features of economists is that for all the forecasts, graphs, equations, learned papers and, of course, television sound-bites that their wonderful profession produces, it is very hard for them to give a straight answer to this simple, but vital, question.

Of course, they will say something. Some will blame the Government. They will point to the excesses of the Lawson boom and, in particular, to the surge in house prices that first encouraged an orgy of consumer spending and eventually introduced the expression 'negative equity' into popular conversation.

But the US has had almost as deep a recession as the UK. Germany looks like having an even deeper one, France is in grave trouble and Japan, while not yet technically in recession, may well have its worst one since the oil shock of 1974. The idea that it is all the fault of our government, which has somehow been uniquely stupid, won't wash, unless one believes that all governments are inherently stupid - a consistent but unhelpful view.

The answer, in as far as there is a single one, is vastly more interesting. We seem in this current recession to have gone back to the 19th century business cycle - or rather we have seen the closest approximation since the Twenties to the classic business cycle. For this cycle has been caused not by inept politicians (as in the Thirties), or a sudden hike in the oil price (as in the early Seventies and early Eighties), but what in Lord Keynes' famous phrase was an excess of 'animal spirits'. While economists have been wrestling with the causes of the business cycle for at least 150 years, it is only in the last one that it has become clear just how little most economists understand human nature.

The fact that there should be some sort of cycle seems rooted in history - witness the biblical seven fat years and seven lean ones - but it was not until the 19th century that there was sufficient data for it to be studied in any detail. During that century the British economy expanded at an average of about 2.5 per cent a year. But progress was very bumpy. It would run up quickly for four or five years, fall back for two or three, have a couple of years when nothing much happened, and then have another growth spurt. Each cycle would be slightly different in timing and depth, but it seemed inevitable that there should be such a cycle.

Other industrial countries suffered in much the same way. The key element was that the upswing brought a cumulative expansion, and the downswing a cumulative contraction. It was self-evidently wasteful: people were thrown out of jobs, businesses went bust, families suffered.

As a result of these evident costs, explaining the business cycle - and subsequntly trying to curb it - became a major preoccupation of economists. There is an enormous amount of literature on the subject, from the cranky to the apocalyptic. At the latter end of the scale come Karl Marx and the American economist Thorstein Veblen, who both saw the business cycle as a symptom of the fundamental weaknesses of capitalism. (For true enthusiasts, there is a wonderful study of 19th century cycles, Business Cycles, by the Moravian-born US economist Joseph Schumpeter, published in 1939.)

In seeking to explain the cycle, mainline economists such as Sweden's Knut Wicksell, Cambridge's Alfred Marshall and others after them, developed two central concepts - the multiplier and the accelerator - which anyone sensitive to what has happened in the last half-dozen years will immediately recognise as common sense.

The multiplier takes effect if one person receives some additional income and spends part of it, say, on a taxi, so transferring some of the spending power to the taxi driver, and so on. The accelerator concerns investment. A company finds that it is running flat out and tries to boost production by building a new factory. Spending on investment boosts total demand even further, thereby accelerating the pace of the boom. Both mechanisms, naturally, work in reverse. These two ideas, plus the role of interest rates in matching savings and investment, are the core of our understanding of the business cycle.

To explain is not to cure. Most of the policy work on what governments might do to iron out the cycle was carried out in Britain between 1925 and 1935, particularly by Sir Ralph Hawtrey, Keynes and Sir Dennis Robertson. What emerged from this - spurred by the Thirties Depression - was the body of theory we call Keynesianism, whereby governments took responsibility for levelling out the cycle and used fiscal policy to do so.

It seemed to work. There was a business cycle in the Fifties and Sixties, but even the 'bad' years saw only a standstill in growth - they did not see real recessions in Britain. Whether this was really the result of policy, or whether things just happened that way, has never really been answered. In the most thorough study of the UK during that period, J C R Dow reckoned that our counter-cyclical policies might actually have made matters worse, for governments tended to try to boost an economy that was already recovering and clobber one starting to decline. Governments still try to follow counter-cyclical policies, but we now have less faith in their ability to get their timing right than we used to. 'Fine tuning', which described the detailed attempts to balance the economy in the Fifties and Sixties, is out of fashion.

The early Seventies recession, the first serious one since the Thirties, could be explained by special circumstances, the oil shock. The early Eighties recession was largely confined to the US and the UK, both of which had serious inflationary problems, the attack on which helped push the countries into negative growth.

But there was really no such excuse in the late Eighties. What happened was pure 19th century business cycle stuff. You can see the multiplier in the way in which yuppies bought portable phones and phone dealers rushed out and bought BMWs, and the BMW dealers . . . and so on. You can see the accelerator better in Japan, where industries brought on vast amounts of new capacity just as the market collapsed. Everyone - bankers, business leaders, home-buyers and politicians - got a bit carried away. If you want a symbol of Keynes' 'animal spirits', take a look at Canary Wharf.

So the answer lies partly in those two mechanisms noted above, and partly in human nature itself. If only people were able to remind each other, next time a boom threatens to take off, that they should be cautious and prepare for recession by saving, not spending, then the subsequent slump would be less serious than the last. But will they? We will see in 1997.