Economic dominoes are still falling

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It is often said by wiseacres that we cannot spend more than we earn. That is, of course, true enough of the individual but it is exceedingly misleading if it is applied to the community as a whole ... It would be much truer to say that we cannot earn more than we spend.

J.M. Keynes, quoted in The Manchester Guardian, July 20 1932

One of the supposed justifications of the Vietnam war was the domino theory. This alleged that if Vietnam fell to the communist insurgence neighbouring countries would fall too. And the neighbours of the neighbours would succumb too in a sinister sequence. This theory was disproved at the cost of millions of casualties.

But what is untrue for geopolitics may well be true for economies in a severe slump. One organisation goes to the wall taking with it creditors and workers who in turn have less to spend. A multiplier effect arises when workers who lose their jobs, or fear they will do so, slash their spending and an “accelerator” comes into effect when businesses start cancelling investment projects because of the depressed outlook. The whole process generates endless pessimistic news.

Surely, however, governmental authorities have an obligation to try to reverse the process long before the natural bottom of a depression. Unfortunately, even among those enlightened enough to see the need for a powerful stimulus, there are internal disagreements between those who emphasise the monetary and financial side and those who emphasise fiscal policy. And there are divisions within divisions. There are divisions between those who emphasise interest rate cuts followed by so-called quantitative easing and those who call for a reconstruction of the banking system. Among those who favour a fiscal stimulus there are divisions between those who urge more public spending and those favouring tax cuts. Some of these divisions are obviously partisan. But some reflect professional bias. Politicians and those who write about them are happier discussing government budgets, while those from the financial side are more at home in the minutiae of bank regulation.

It is not hard to list the qualities of an ideal stimulus. It should be quick acting, easily reversible and compatible with long-term economic and social aims. Obviously President Barack Obama’s fiscal package contains many favourite Democrat pork barrel projects, together with some questionable tax cuts to reduce Republican hostility. But a non-ideal stimulus is better than nothing.

Less obvious is the need to combine fiscal and monetary policy. The one sentence justification for operational central bank independence is that it offsets tendencies for governments to give the economy an inflationary boost for electoral reasons. But that is hardly an issue now when the need is to expand demand, irrespective of the political timetable. The one way citizens can spend more without increasing their debt is through tax cuts or social payments in cash. It is true that a fiscal stimulus financed purely by bonds risks raising long-term interest rates when we least need it. There is also always the danger that fears of a subsequent tax increase will dilute the effect of any fiscal giveaway. The British government has unnecessarily pandered to these fears by publishing a not very credible projection of cyclical recovery starting next year accompanied by budgetary tightening.

A monetary stimulus on its own, however, runs up against the zero interest rate bound. At long last the Bank of England is contemplating increasing the money supply by direct financing of part of the government’s deficit – and please do not recoil from “printing money”. Monetary authorities do this all the time. Zimbabwe may print too much while other countries may print too little. The Bank of England’s Inflation Report discloses that the adjusted annual rise in broad money and credit diminished from a trend rate of 8 per cent to less than 4 per cent at the end of 2008, while nominal gross domestic product has actually been falling.

Is there any limit to desirable budget deficits in a slump? In abstract terms it is when they provoke a currency depreciation so severe that the loss on the terms of trade offsets any gain output and jobs from an official stimulus. Meanwhile, as Martin Wolf has pointed out, staying out of the eurozone has given the UK a chance to explore the matter.

What difference does it make that this particular slump originates in the banking sector? It means that even where a business sees demand for its product or an investment opportunity it may be inhibited because working capital is only available on prohibitive terms, or not at all. If lending can be restored it does not matter if top bankers receive custodial sentences or earldoms. Revenge can wait, although it is a bit odd that the main advisers to the British government on the banking crisis have been ex-bankers themselves. And if the measures so far taken do not restore normal lending I cannot see any objection to governments using their recently established emergency financing facilities for ordinary banking operations. This would be far better than spending yet more in bailing out banks or industries that come to the government with their begging bowls.

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