On Monday, I attended a fascinating debate on the Economics of Deficit Reduction at the House of Commons (audio link in this post). Essentially the debate was about the pros and cons of fiscal austerity versus stimulus. On the "stimulus" side were Prof. Paul Krugman and Jonathan Portes of NIESR: on the "austerity" side were Bridget Rosewell of Volterra Consulting and Stephen King, Chief Economist of HSBC.
The definitions of both "austerity" and "stimulus" were somewhat unclear. As far as I could tell none of the four were remotely in favour of the severe austerity measures being imposed on some members of the European Union. Furthermore, none of the four were in favour of extensive cuts to capital investment such as the current Coalition government and its Labour predecessor have already undertaken (and more are planned). In fact Rosewell, supposedly anti-stimulus, actually said she was in favour of increased government borrowing for capital investment projects. In her eyes, the debate was really about whether continued support for current consumption was an appropriate course of action at the present time, given the levels of public debt and the fact that the UK is running a significant fiscal deficit.
Except that it wasn't. The debate was about whether the government should continue its austerity programme (Rosewell and King) or change to a debt-financed stimulus programme to encourage growth (Krugman and Portes). Internally rebalancing the current austerity programme towards capital investment and away from supporting consumption wasn't discussed. Nor was the IMF's advice, which is to allow automatic stabilisers to operate freely but refrain from explicit debt-financed fiscal stimulus measures. There was also no discussion of the sort of balanced-budget stimulus measures suggested by Simon Wren-Lewis: this is something of a pity, because it means that the debate tended to become a discussion about whether or not the UK government could afford to borrow the extra money required, which isn't really the issue (as I shall explain later). It all made for great debate, but sadly no practical solutions to a difficult situation.
Krugman delivered a consistent and well-thought-through message, well-supported by Portes, who actually gave a figure (2-3% of GDP) for the amount of stimulus he thought the economy needed. But I was disappointed with Rosewell's presentation. My notes taken at the time comment on the inconsistency of her message, which appeared to be driven largely by her fear of a return to the financial markets' dislocation of 2008.
The trouble with fear is that it inhibits both thinking and action. As the Bene Gesserit in Frank Herbert's Dune have it, "Fear is the mind-killer". Fear is one of the biggest issues I deal with in my work. Once someone gives in to fear, they stop thinking, and something that they actually are perfectly capable of doing becomes an impossible task. (As an aside - perhaps my own difficulty with maths is because I fear it?) The Hitchhiker's Guide to the Galaxy famously had "Don't Panic" in large, friendly letters on its cover. I, too, have "Don't Panic" written in large (and I hope friendly) letters at the top of sight-reading exercises for my students.
Fear also inhibits appropriate action. People who are afraid may do nothing, like the rabbit caught in the headlights which stands and waits to be hit instead of legging it at top speed - or like a student who suddenly becomes incapable of singing a single note. Or they may do stupid things. My sight-reading students have a distressing tendency to invent the music instead of reading what is on the page. They are perfectly capable of reading the music when they aren't panicking, but when they are, they are incapable of reading the music at all, so they make it up.
I think fear is the cause of a large part of what is wrong with the world at the moment. People are either doing nothing, or they are doing stupid things - such as imposing severe austerity on fragile economies in the mistaken belief that sharply cutting public expenditure will somehow magically bring about economic recovery. And people who believe that it is only going to get worse are adjusting their behaviour in the expectation of future losses. Ordinary people are paying off debt and saving like crazy because they fear cuts in their real income shortly. Businesses are not investing because they see no prospects for an improvement in customer demand. Investors are prepared to accept gradual erosion of capital through negative real interest rates because they are terrified that default and/or hyperinflation will wipe them out. So I am concerned that the thinking of an influential economist such as Rosewell is so influenced by fear.
Having said that, rather than dismissing her fears, we should consider whether they are justified. Like pain, fear is a warning: if we are afraid, we should examine that fear and consider whether it is rational, and if it is, what an appropriate rational response should be. Is there REALLY a risk that financial markets would seize up again? Rosewell correctly notes that we don't actually know what causes financial markets to freeze, and she appeals for the economics profession to develop models that better explain and predict the behaviour of the financial system. I absolutely endorse her remarks. Classical economic models have excluded the financial sector, effectively treating it as passively reactive to real economic forces. We now know that nothing could be further from the truth - it is clearly an active driver of economic change, and not always for the better. But we don't know enough about what does drive market behaviour. So further research is needed.
So yes, there is a risk that financial markets might freeze again. But Rosewell then goes on to make a priori judgements about what would cause that to happen. In effect she suggests that the UK government borrowing another 2-3% of GDP for capital investment and perhaps private debt relief or tax cuts might cause the sort of market panic we saw in 2008. I really can't follow her logic here. In what way would a responsible government borrowing a small percentage of its GDP to invest in the future of its economy equate to a catastrophe of the same order as the failure of Lehman Brothers? Krugman dismissed Rosewell's fears about the financial markets as "fantasy", and to be honest I am inclined to agree. I can't see that she is comparing like with like.
Having said that, the financial markets do seem to be behaving irrationally - if fear is irrational. It seems to me that fear is the principal driver behind most investment decisions at the moment: fear of default, fear of inflation, fear of collapse, fear of loss.......fear of the unknown. As Christopher Cole of Artemis Consulting puts it, we have a "bull market in fear". So I suppose that it is entirely possible that financial markets might respond very negatively indeed to an already-indebted government borrowing a bit more. The likely effect would be a significant increase in the yields on government debt and perhaps a cut in its credit rating (not that anyone takes much notice of credit ratings any more). But yields on government debt are currently well below inflation and being pushed down by QE. There is room for quite a considerable rise in yields without causing financial distress to the UK sovereign.
But even if the UK borrowing more did cause financial markets to reject its debt, the UK has other weapons up its sleeve, like forcing pension funds and banks to buy its debt - it has already done this to some extent - or even, as a last resort, monetizing the debt at the Bank of England. The UK is not going to suffer a debt crisis of the same order as Greece. It has a sovereign government and a central bank. Greece has neither.
What the UK could suffer as a consequence of increased borrowing, or rather monetization of increased borrowing, is currency collapse. I find it extraordinary that despite all her fears of financial market dislocation, Rosewell ignored this risk. Markets know that sovereign governments with central banks can always pay their debts. So if they don't like the behaviour of the government they reject the currency in which the debt would be paid, not the debt itself. The last time this happened in the UK was in 1976, when the government was forced to seek assistance from the IMF to choke off a run on sterling arising from loose fiscal and monetary policy.
But again, let's consider the risk. Is the UK government borrowing an additional 2% of GDP for investment in a stagnant economy really likely to cause a run on sterling? I doubt it. Financial markets may be irrational, but surely not that irrational. The inflation risk from that amount of borrowing in a stagnant economy is tiny. Implosion of the Eurozone and collapse of the Euro is a much bigger risk. Even if the UK Government borrowed more, I think investors would still see it as a safe haven from the Eurostorm.
So broadly, I don't think Rosewell's fear-driven analysis stacks up. And I am particularly concerned by the illogicality of her conclusion, which is that the Coalition government is "getting things about right". Even from her own analysis, it is getting things very wrong. She is in favour of borrowing for capital investment, whereas the Coalition government is cutting capital investment to the bone. Furthermore, she has not explained why she regards reducing public borrowing as more important than allowing the private sector to reduce its debt burden. Non-financial corporate and household debt of over 170% of GDP is surely a much larger brake on growth than public debt of under 80% of GDP. And as Krugman explained in his opening remarks, it isn't possible for both to deleverage at the same time without provoking what he calls "a depression, properly understood".
The trouble is, there are an awful lot of people who think like Rosewell. The world is on an austerity drive, with crippling effect on the real lives of ordinary people and businesses. And perhaps more importantly, in the UK (and I suspect other countries such as France) where there hasn't yet been much real austerity, the FEAR of austerity is driving people into self-protective behaviour that seriously reduces economic activity. We are frightening ourselves into a completely unnecessary depression.