DABERIAM XCVII

13th April 2016

Nothing much, in reality, has changed since I put pen to paper in February, but the excuses have!  Only a month or so ago the world economic problems were blamed by politicians and economists on the banking crisis.  Central Banks were “riding to the rescue” by driving down interest rates and various forms of Quantitative Easing – printing money.  From the IMF downwards through Central Banks and regulatory bureaucracies, the group-think was the same.  We can handle this.  If, however, you are part of this bureaucratic machinery, you have to wonder why no one is asking if more of the same has not worked for eight years or so, why it would start to work now.

From the outside observer’s point of view, we can but observe that the policy of driving down interest rates and profligate expansion of the Central Bank balance sheet has not worked in twenty years in one of the world’s major economies – being Japan.

Japan’s problems and the failure of the authorities to solve them are not dissimilar to Europe.  Its stagnant economy was being held back by highly restrictive labour regulations and corporate regulations; government policy had the effect of concentrating power in large institutions whether they were financial or industrial.  This also propped up agricultural inefficiency and stifled smaller businesses and general innovative ideas in most areas.  Low interest rates also distorted investment decisions and penalised savers and pensioners.  The low interest rate trap allows banks and inefficient businesses to avoid the decisions needed to close companies, creating a world of so-called zombie institutions which help keep capital and people employed in inefficient and non-productive pursuits.

The banking crisis in the West caused a potential systemic breakdown of the whole financial system.   Comments like “too big to fail” are now banded around to appear to summarise the problem, when in reality the problem was complexity of the financial systems, which the regulators did not understand and nor, to a large extent, did the management of the financial institutions.  While the crisis started in the junk bond/debt area, it got serious with the failure of the relatively small bank, Lehman’s, which because of its relationships, effectively disconnected the financial institutions from each other.  Without going into the complexity, the point I make is that the immediate solution of the US Treasury and the Federal Reserve was to flood the markets with liquidity, so stabilising the individual banks without them having to have recourse to the interbank markets.   The Quantitative Easing worked and in the US the system stabilised and got reconnected.  In the aftermath, banks wrote-off huge amounts of bad debt and bad mortgage loans that were the primary cause of the crisis.

The collapse of the Mortgage market caused house prices to tumble and repossessions to take place. Corporate, as well as personal, bankruptcies are tragic; however, as so often experienced in the “last Century”, debt destruction leads to recovery, the inefficient and unlucky are cleared, as lessons are learned and resources are re-allocated.

In Europe, the debt destruction did not take place, banks did not write-off their bad debts, property prices by and large remained high and low interest rates have helped preserve inefficient businesses.  Europe looks very much the same as Japan, and economic stagnation has set in, while to some extent Britain has bucked the European trend, mainly because it has a less constrained and regulated labour market and it is not, thankfully, stuck in the straitjacket of the monetary union.

It is worth mentioning at this point that Britain also contributes very considerably to the European economy by running a large trade deficit with Europe and contributes quite a large percentage of the European government’s budget, very considerably more than it receives back from Europe.

The economic experiences of Japan and now Europe, with very low and even negative interest rates over what is now a very long period, beg the question of why this policy does not work!  From the IMF downwards and from many economists, one of the explanations is “…because people are saving too much and businesses are not investing”.  More recently, and more interestingly, the IMF has added its voice to the chorus that Britain’s possible exit from the European Union could destabilise the West’s economy!  I would accept that it might destabilise the European Union’s government’s budget, but the world?

Perhaps, as I mentioned earlier, this economic group-think seems to confuse coincidence with causation.  Is it possible that after experiencing an economic shock the “man in the street” is more likely to save than borrow and spend more?  It also must be likely that sensible people, trying to save for the future, will increase their savings rate if their returns are lower.  Certainly in Japan, the experience has been to save more in order to gain a comfortable retirement.  Lowering interest rates logically encourages savings and if people already have had an unpleasant experience from over-borrowing, they are unlikely to be influenced to increase their borrowing even by low interest rates.  If this causes a feeling of insecurity about the future in the general population, it would be hardly surprising if it did not have an effect on business attitudes to investment.

The attitude of the small and medium sized business community, particularly in the manufacturing sector which has to grapple with the difficulty of making investment decisions that take years to produce a benefit, is heavily influenced by any feeling of general uncertainty.