James Worron

7th Aug 2011

As the world economy faces a possible double dip we should take a moment to work out how we got in this mess. We seem to have taken the ideas of the liberal Keynesians, of the right-wing free-market neo-liberals and of left-wing social democrats and combined them in such a way as to build the worst of all possible economic systems.

Keynes thought economic growth depended upon increasing demand, created by low interest rates and cheap money, together with low savings. We have duly obliged. However, Keynes also thought there should be restrictions on financial markets, particularly internationally, to prevent the “animal spirits” of speculation and excessive debt getting out of hand.

The neo-liberals on the other hand believe that capital should flow freely across the world, and that we should be free to borrow and lend it as we please. And to an extent we have allowed this. But they also have a caveat: money must be sound and interest rates should reflect the true cost of borrowing, encouraging saving and making people cautious lenders and investors.

We have created open capital markets and poured cheap money into them. We have combined each system in a way that rips the safety valves off each one. The result – massive and spiralling debt, followed by economic stagnation.

We then compounded and reinforced this with big government: industry competes globally but is ever more regulated. Meanwhile, the government itself becomes more bloated and wasteful, but this is superficially affordable because of a growing private sector – and a deficit funded by cheap credit from all over the world.

Why did we do this? Greed, selfishness short-termism: we wanted to spend, not save, we wanted our share of public spending and we wanted consumer goods. But these are constants. We did this because we were able to. The Asian economies have been amassing savings for which they needed a safe home. Up till now the West has provided that home, and so this have-your-cake-and-eat-it system has continued for year after year. The details differ between theUS,UKand Euro-land, but the broad story is the same.

What can we do about it? Whilst the mistakes have come from both philosophies in moving forward it is Keynesian theory that looks increasingly irrelevant:

• The genie is out of the bottle: international capital markets are surely here to stay, if only thanks to technology
• The spike in gold prices suggests that new money is not going to be turned into demand, but go into this static asset
• The evidence suggests that more deficit spending won’t work – we are beyond the point of diminishing returns (see the Economist here for the debate.)

 The alternative is what you have read a hundred times elsewhere: de-regulated, cut spending and taxes and move resources into the private sector.Asiastill wishes to lend us money (for now), if we invest that into productive economic activity we will be able to pay them back. Government must soak up less of the capital. The only “demand” we seem to have created by stimulus is for more Asian imports. Instead we need private sector investment. That needs de-regulation to make it economic, profitable and sustainable. We might need government guarantees to make business investment happen – so be it.

We still have access to that cheap easy money: we won’t for much longer. In the time we have remaining we must use it for the one thing it is genuinely good for: business investment.