Sometimes I think economic policy making can be best explained through stories, with ogres, giants and other mythical figures from folk tales wreaking havoc on the economy. Contemporary policy makers are obsessed with the ogre of inflation, although that particular ogre was slain years ago.
The events of the 1970s traumatised the political classes in the West. There are two explanations of the inflation of the 1970s, one is that the world economic system became increasingly dysfunctional in response to political crises such as the Vietnam war and the actions of OPEC in raising oil prices to cripplingly high levels. However that explanation became disregarded and instead policy makers focused on what they termed cost push inflation. Workers by pushing for above inflation pay increases were causing inflation to spiral out of control. This inflationary spiral was given further impetus by excessive government spending, this spending increased faster than the capacity of the economy to increase output of goods and services and in consequence prices rose (demand pull inflation).
Rather than accepting the inflation of the 1970s was due to a series of one off events, they believed that the cause was a malfunctioning economic system. Inflation had to be squeezed out of the system through controlling wages and reducing government spending. This caused in Britain the recession of 1981 in which it lost 20% of it’s manufacturing capacity and a massive increase in unemployment. This policy was counted a success as inflation was reduced to historically low levels. The policy of limiting the increase in incomes has been so successful that in the USA the incomes of the majority have remained unchanged since 2003 and in Britain since 2008.
However the economic is a dynamic creature and cannot be constrained within policy straight jacket. Businesses that have successfully limited the incomes of their employees to keep down costs are now faced a new problem. People on low or stagnant incomes don’t buy lots of goods and there was a danger than stocks on unsaid manufacturing goods would build up. Mountains of unsold goods would diminish the profitability of these businesses.This certainly seemed to be true of the motor industry, where for year on year output of cars exceeded demand for them. There was some reduction in capacity, the closure of much British owned car manufacturing. However a dynamic economy will soon go into reverse if demand for goods is not maintained.
If rising demand could not be financed from ever increasing incomes, an alternative had to be found. The alternative was to be consumer credit. At first the credit came from the ever increasing use of credit cards and from loans raised on the security of ever increasing house prices. Growth was driven by the ever greater use of credit. Banks cooperated by making increasing amounts of money available on ever more generous terms to finance house purchases. All this extra money in the housing market pushed up house prices, which in term increased the value of assets (houses) on which loans could be raised. Any economy whose growth is dependent on ever increasing levels of consumer debt is inherently unstable. Debt financed trade is particularly vulnerable to adverse changes in the economy. A rise in interest rates can lead to a crash in demand as people can no longer afford to borrow at the new higher rates. This happened in 1990, 1999 and 2008.
The unvirtuous circle
When economic growth is dependent on ever increasing levels of consumer credit, extraordinary steps have to be taken to keep consumer credit growing. In the years immediately preceding 2008 banks and other financial providers took increasingly less prudential steps to keep the level of consumer credit growing. Applicants for mortgages if self employed could self certify their income, mortgages were increased to 125% of the value of a property and to make possible the purchase of increasingly expensive properties the time over which a mortgage could be repaid was extended from twenty five to forty years. The whole financial sector was gambling that house prices would increase at an ever increasing into for the indefinite future. This could not continue forever and inevitably the whole system came tumbling down in 2008, resulting in the greatest recession since the great recession of the 1930s.
Rather than taking the difficult step of rebuilding the economy on sounder lines, the government took extraordinary steps to stoke up the credit bubble. Interest rates were reduced to record lows, so people could continue in their risky habits of funding expenditure from credit. The government poured record amounts of money into the banking sector to keep rates low and to ensure that the banks had plenty of cash to lend for the various speculative activities that would fund the demand for goods and services that would keep economic growth going. Strangely enough they were abetted in this by the employers who would keep wages low as possible, but who would instead give those same employees whose income they froze, access to the most generous of terms for credit. Since the crash there has been a rapid growth in what is called shadow banking, a system where the manufacturers rather than the banks provide credit. One such example is the credit hire or leasing system for the purchase of cars. A system whereby the buyer leases a car for a period of say three years and then returns the car to the dealer and then takes out another car on a lease. While car leasing is not unsound, it becomes unsound when it becomes part of an ever increasing credit bubl. Leasing as with another system of credit is particularly vulnerable to any adverse change in the economy.
One such event was last Friday when the result of the referendum was announced. A debt driven economy will be easily upset by such an event. There has been since Friday a rapid collapse in the share prices of banks and other financial institutions, as any adverse change in the economy makes it more likely that there will be an increase in the rate of default and the profits of the banks will be particularly badly hit.
The great mystery is why conservative businessmen who will use any method to keep down or reduce the wages of their employee’s down and yet will throw increasing amounts of cash to enable the same employees and those of other businesses to buy goods on credit. To this particular economist this is the riskiest of economic strategies, yet governments encourage such practices. The only conclusion that I can arrive at is that rather than these businessmen being the great leaders they are lemmings that follow the worst instincts of the herd.