Tuesday, January 06, 2009

The paradox of thrift and the stable door of credit

‘Shutting the stable door after the horse has bolted’ is generally taken to mean a reaction so late as to be completely ineffective. But it’s worse than that. If you want to get the horse back into the stable, then shutting the door will actually be counterproductive.

And so to David Cameron, who is crusading against debt and spending, because “We're in this mess because of too much debt”.

Well, not quite. We’re in this mess because of the sudden, massive fall in the availability of debt. Certainly, having borrowed a fair old whack over the years up to 2007 has made us more vulnerable to a credit crunch, so ‘less spending fuelled by borrowing’ might have been decent advice back then.

But now the horse has bolted and the credit has crunched.

And Cameron is raging with ever shriller incredulity against Labour’s open-stable-door policies, demanding that the stable door be slammed shut and barricaded now, not held open even wider!!! And if you don’t think too carefully, it can strike a chord. But it’s utterly wrong.

The normal operation of a market economy requires a regular flow of borrowing – by individuals to buy houses, by businesses to embark on new ventures. It’s not an evil. And, given the current drought, increasing it back nearer towards normal (rather than superabundant) levels is a precondition of recovery.

His proposal to use the tax system to motivate more saving should be seen in this light. Just as opposition to more borrowing means opposition to more spending, so support for more saving means support for less spending. Which means even less economic activity. This might be a decent policy for a few years from now – other things being equal, I have nothing against more saving – but in the middle of a recession it’s only going to make things worse.

He might do well to remember what Keynes had to say on the ‘paradox of thrift’, back in 1931:

For take the extreme case: suppose we were to stop spending incomes, and were to save the lot. Why, everyone would be out of work. And before long we should have no incomes to spend and the end would be that we should all starve to death.

Or from a more contemporary observer, Carl Emerson of the Institute for Fiscal Studies:

The issue is that the Conservatives are proposing taking money that definitely would have been spent in the economy on public services and putting it in people's pockets. To the extent that those people save that money, it will be taken away from the economy next year.

This is a terrible policy. I almost can’t believe that it’s actually intended to be implemented; rather, it’s a proposal spewed out to create a certain impression of the Tories (saving good, debt crisis bad) – the details to be swiftly forgotten.

One of the tactical advantages of being in opposition is that you can produce new policies more quickly than the governing party, safe in the knowledge that they’ll get less forensic scrutiny – and it makes you look like you’re ‘leading the debate’. However, when events change quickly, this approach can make you look like you’re all over the place. And so it is.

Compare this new policy with Cameron’s urging, back in November, that lower interest rates – not tax cuts, not public spending – should be the tool to fight the recession. But rate cuts are exactly what hurt the savers that he now seeks to reward.

And what happened to the six-month cut in NI contributions for small employers that they were proposing back in the autumn? That at least had the merit of being likelier to protect some jobs, even if only on a piddling scale.

That the Tories’ policies (at least, today’s) are bad is clearly the more important point; that their strategy has degenerated into sub-Blair ‘initiativitis’ plus moralising is perhaps more interesting.

8 comments:

Anonymous said...

"We're in this mess because of the sudden, massive fall in the availability of debt."

Then again, falling credit supply was itself caused by a collapse in an asset price bubble, leaving banks undercapitalised. That bubble was caused at least in part by reckless lending and borrowing (Ninja mortgage, guvnor? 115% LTV, anybody?). I don't think that these are controversial statements, and in that sense, Caron's got a point that "we're in this mess because of too much debt," although perhaps it's an oversimplifying, politician's way of telling the story.

"The normal operation of a market economy requires a regular flow of borrowing... It's not an evil. And, given the current drought, increasing it back nearer towards normal (rather than superabundant) levels is a precondition of recovery."

First, the problem here is the difference between 'normal' and 'superabundant'. The likelihood is that 'normal' is a lot lower than the 'superabundant' flow of borrowing we've been used to these past years, and on the basis of which assets have been priced. So, inasmuch as lending might be sub-optimal now, it won't be recovering to that level. Attempting to hold it up to that level would be disastrous.

Second, the flow of borrowing goes one way, but only if the flow of lending goes another. Following currency depreciation, borrowing from abroad is a lot more expensive; and we're already massively dependent upon it. But our current problem is that, through our banks, we have borrowed more than we have lent. The banks need to recapitalise (i.e. build reserve capital) before they can return us to 'normal' levels of credit supply. They can either do this by selling more deposits, or they can do this by shrinking their loan books, which is what they are doing.

Third, picking up from the first point, that 'normal' is lower than what we thought - the reality is that spending needs to fall, because we were spending before on the basis that incomes and wealth were rising more quickly than has turned out to be the case. It falls today, or it falls tomorrow - but it is going to fall. No politician can say this without being pilloried, but it is true.

But here's the upside: the sooner we adapt to the fallen level, and costs, employment and output adjust, the sooner people will spot investment opportunities which can be invested in.

Keynes' extreme case is wonderfully put, and only slightly let down by the fact that if we were all to stop spending our incomes we'd starve to death anyway (no consumption=no food and shelter).

Re "Cameron's urging, back in November, that lower interest rates... should be the tool to fight the recession. But rate cuts are exactly what hurt the savers that he now seeks to reward."

Or, he could argue that that's precisely why we should take the microeconomic action: to mitigate the losses sustained by some in helping others.

snowflake5 said...

If people want to save, they can already do so tax-free via the cash ISA. Sadly most people don't. Cameron's policies are for those who have money over and above the ISA allowance - say bankers wishing to deposit their redundancy cheques, or people like himself.

Andreas Paterson said...

Anonymous - I'm under the impression that our national debt is denominated in pounds, locational mismatch is not really a problem. The real danger from currency devaluation would be a lack of confidence in the currency leading to lenders refusing to buy government bonds.

As far as this comment goes:

But here's the upside: the sooner we adapt to the fallen level, and costs, employment and output adjust, the sooner people will spot investment opportunities which can be invested in

I'm think that's an area for debate but I'm pretty sure there are historic examples where this kind of recovery didn't happen.

Anonymous said...

"I'm under the impression that our national debt is denominated in pounds, locational mismatch is not really a problem. The real danger from currency devaluation would be a lack of confidence in the currency leading to lenders refusing to buy government bonds."

Fine - but I wasn't talking about the national debt as such; nor do I think the currency depreciation is necessarily a problem or a bad thing overall. The UK runs a large current account deficit, and has for a long time. Not necessarily a bad thing, but it does require a balancing sale of sterling assets to finance it. Those assets are now depreciated; future investors are paying less for a given sterling return - and will probably price in an exchange risk premium, especially as the UK is relatively more exposed to further financial shocks and without a reserve currency, and so may inflate its way out of a potential default. If we are to maintain domestic spending, it will keep the current account deficit high, requiring more such borrowings.

In re "I'm think that's an area for debate but I'm pretty sure there are historic examples where this kind of recovery didn't happen."

You're "pretty sure", eh? Tell me about them. Don't try the US in 1929-31 - Hoover explicitly promoted maintaining wage rates (amid falling prices) in an attempt to maintain spending; and that's leaving aside output-limiting policies like the Smoot-Hawley tariff.

With the caveat of maintaining the price level by ensuring there's enough of a supply of sterling liquidity to meet increased demand for it (which can be achieved by printing money if all else fails), eventually increased savings will create capital looking for investment. The sooner we have potentially profitable opportunities - created by undervalued resources - the sooner demand can start to increase sustainably.

But either way - is your belief that if we sustain spending for long enough, that it will all go away? That the economy will recover to its previous trend? If no, then why is it better to delay the hit we're going to take? Just like Japan - see how that worked out for them...

Tom Freeman said...

"'normal' is a lot lower than the 'superabundant' flow of borrowing we've been used to these past year"

Absolutely. But 'normal' is a good deal higher than the sudden drought that's now been forced upon us. The talk about 'returning lending to 2007 levels' is ridiculous, but luckily it's just talk.

Booms overshoot. But busts undershoot. The time when a soft landing to the household debt boom might have been possible is long past, but a slightly less hard landing now would be nice.

Of course the banks want capital, but getting smaller personal savers to stick a bit more in their accounts isn't really going to do the job. (Despite my criticisms, I think the actual effect of the new Tory idea would in fact be very small - it's only worth about £4bn in all, and not having to pay 20% tax on savings at current tiny interest rates isn't going to give anyone that much of a boost.)

"the sooner we adapt to the fallen level... the sooner people will spot investment opportunities"

I'll be putting my money where my mouth is on that one. I had the excellent good fortune of failing in my attempts to buy my first flat in late 07 and early 08. I'm thinking the middle of this year will probably be a good time to pounce...

Anonymous said...

Just one minor point. You agree that banks need capital (=saving), and I agree, this tax change is unlikely to have a big impact on meeting this need. But your original post criticised the move because it would raise saving, which was bad.

I'm not trying to wind you up here, just trying to get you to see that the problem here is precisely one of different parts of the economy pulling in different directions - on the one hand, we need to save more to replenish the financial system; on the other hand, if consumption falls, we worry about the real economy. My feeling - and I think the Tories' premise, although they're not very good at articulating it - is that tackling the first problem is the primary step if we are to prepare the ground for long run growth.

The truest criticism of the Tory proposal is that it's a programmed appeal to their own core vote; older people and wealthier people. But then the same applies to most recent noises emanating from Downing Street, appealing to public sector job creation. Unfortunately, politicians' willingness to use crises as justification for pleasing preferred factions is very much a cross-party phenomenon.

Good luck with the flat-buying.

Tom Freeman said...

I quite accept that these tensions are pulling in different ways; my own feeling, though, is that the least bad area for taking the strain is on the government side. I don’t exactly relish the thought of all the public debt we’re taking on, nor the various degrees of risk with the recapitalisation scheme (plus any successor/bad bank/loan guarantees that may get offered) – but it’s the only way of getting credit going again without having to drain money out of the rest of the economy. At least, not yet.

The extra public liabilities will mean tighter fiscal policy in years to come, along with a slower recovery. I’d take that as the price of softening the recession, though.

(Also, to the extent that the banks don’t pass on the rate cuts to borrowers, that helps their balance sheets. The base rate cuts are as much a boost to them as they are to consumer spending.)

Dr. Car Buyer said...

the world is out of wack, I wish I could produce instead of consume... I'd farm the rest of my life...