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Identifying The Correct Recovery Paradigm

Pedestrians look at share prices on a board in Tokyo. Japan in the 1990s is an example of how "fiscal and monetary aspirin can kill the patient if used to treat a serious disease."
Pedestrians look at share prices on a board in Tokyo. Japan in the 1990s is an example of how "fiscal and monetary aspirin can kill the patient if used to treat a serious disease."
The potential swine-flu pandemic has emphasized once again the vulnerability of the global economy to unexpected events, not all of which are as obviously based in past economic policy as the U.S. housing-finance disaster.

Wars, epidemics, serious terrorist attacks, and doubtless, in the future, ecological crises are all capable of devastating the finely tuned modern economic system. The government panic and misguided activity of the last six months have, however, made one thing abundantly clear: the world urgently needs a better-designed paradigm for stimulating recovery.

Ordinary recessions, which are a product of a predictable business cycle, don't seem to be much of a problem, nor are stock market crashes, taken in isolation. Over the past 30 years there have been many such events, during which governments either did nothing, or confined themselves to moderate monetary and/or fiscal stimulus.

In 1987, for example, monetary authorities in both Britain and the United States loosened policy after a stock market crash, and thus prevented it from spreading. Likewise in 2001 both countries loosened monetary policy in the face of a stock market crash, although in that case U.S. policymakers kept rates too loose for too long.

The problem is that those remedies, both of which are generally popular with business and the public at large, are only effective when used in moderate doses against moderate, conventionally caused recessions.

In 1987, the stock market crash took prices down to reasonable levels, and policy prior to the boom had not been overexpansionary, so stimulus worked well. Likewise in 2001-03, the U.S. budget was close to balance, and so the moderate fiscal stimulus of the early Bush years proved effective, particularly as it was accompanied by a modest supply-side effect from the 2001 tax-rate cuts and a much larger one from the 2003 partial removal of dividend double taxation.

But loose monetary policy in the United States and Great Britain in 1970-73 led to much higher inflation without producing much economic recovery. Britain's mid-1970s fiscal stimulus under Harold Wilson similarly produced a sterling crisis, without helping the economy to recover.

The Bigger The Headache...

Fiscal and monetary stimuli are thus the equivalent of aspirin, effective in small doses against mild illnesses, but ineffectual against major maladies and dangerous if taken in excessive quantities. One need not be pessimistic about their efficacy in the current crisis; one need only look at the huge fiscal and monetary stimulus employed in 1990s Japan to realize that fiscal and monetary aspirin can kill the patient if used to treat a serious disease.

Policymakers therefore need a recipe to prevent serious economic traumas turning into something like the Great Depression or Japan's miserable post-1990 trajectory. It is reasonable to suppose that exogenous shocks to the economic system are more likely in a world of globalization, rapid communication, and high population density than in the slow-communications, lower-population, less integrated world of the 19th and early 20th centuries.

One way or another, we can confidently expect at least one major economic crisis per generation, generally from a cause that is either noneconomic or wholly unexpected beforehand. So we had better learn how to deal with them.

The first point to note in dealing with these serious crises is that the policy aspirins effective against lesser economic ills are harmful in these cases. This time round, the Bush "stimulus" of 2008 was not only ineffective, it dangerously increased the government's borrowing requirements, reducing financial flexibility and increasing the capital starvation caused by the flight to quality in late 2008. Monetary stimulus used after 2001 to counter the effects of the stock market downturn produced the much more dangerous and widespread housing bubble.

The huge additional monetary and fiscal stimuli implemented since September 2008 have not yet exacted their full toll, but may be beginning to do so. The first quarter gross domestic product (GDP) deflator came in contrary to expectations of deflation at a 2.9 percent rise, while 10-year Treasury bond yields have now risen decisively above 3 percent. Both inflation and interest rates can be expected to rise sharply in the months ahead.

No Easy Remedy

To determine the most appropriate policy response to a serious economic crisis, it is first necessary to consider what you are attempting to achieve: an economy in rapid recovery, generating large numbers of jobs at good pay rates, with capital formation and entrepreneurship active, inflation low or even negative, and government reined in, so that the budget is either in balance or moving rapidly back toward it.

The best recoveries from economic catastrophe have all taken this form -- consider the British 1820s recovery from the Napoleonic Wars and postwar depression, the U.S. 1920s recovery from World War I and postwar depression, the U.S. 1945-60 recovery from the Great Depression, the German and Japanese 1950s recoveries from World War II, and many others. Even during the Great Depression, Britain, which followed these policies, fared much better than the United States and Germany, which did not.

Alternative approaches to recovery have not worked. The German money printing of 1919-23 led to the Weimar hyperinflation and the impoverishment of the middle class. The British attempt to recover from World War II through Keynesian government spending and economic planning never got off the ground and lagged behind similar efforts in France and Germany, let alone Japan. Notoriously, Japan's attempt to achieve prosperity through public-sector infrastructure in the 1990s didn't work. Russia's attempt in the 1990s to achieve prosperity through dodgy privatization and cheap money failed catastrophically.

In each of these cases, other excuses can be made for failure, but the overall picture is clear: only the hard-money, high-savings, balanced-budget approach can be relied upon to produce recovery from a real crisis.

Recipe For Recovery

These policies have succeeded in past centuries in the wake of wars and major economic collapse, but there is no reason to believe they will not work against other types of catastrophe, such as major epidemics or ecological disaster (which does not include only global warming; economic catastrophe could also result from uncontrollable pollution or a "nuclear winter" period of famine and disruption resulting from volcanic activity.)

In each case, there would be special factors to be dealt with, such as a catastrophic loss of population, the abandonment of some central economic activity that had caused the pollution problem, or relocation of much of the planet's agriculture or industry to take account of new conditions. Nevertheless, there is no reason why the same central economic objectives should not hold true, whatever the cause of the initial disaster.

  • If a high-saving, low-inflation, reined-in-government environment is the necessary state for economic recovery from disaster, the correct policies to pursue become obvious.
  • Interest rates should be increased to provide adequate returns for savers and rebuild the capital stock.
  • Public spending should be reined in sharply in order to get closer to budget balance without having to increase taxes, which inevitably dampens activity.
  • Economic losers should be starved of capital and liquidated, in order to free up resources for new industries that need to develop.
  • Inflation should be treated as a leper because of its erosion of savings, while a moderate amount of deflation should be welcomed, as it will increase the value of capital and thereby produce more and better new businesses.
  • Trade should be freed up, in order that new business opportunities appear and Joseph Schumpeter's "creative destruction" can work its magic.
  • Labor laws should be eliminated as far as possible so that wages and employment can readjust to market levels, while labor mobility within the domestic economy should be encouraged. However international labor mobility in a recession depresses living standards in the higher-wage economy, allowing unscrupulous employers to drive wages down to Malthusian levels.

Against a major economic collapse, only these policies will work. They were employed by Lord Liverpool in 1815-25 in Britain; by Andrew Mellon in the 1920s in the United States; by Dwight Eisenhower and William McChesney Martin in the United States after 1951-52 (when the U.S. savings rate was over 10 percent, far higher than today); by Konrad Adenauer and Ludwig Erhard in Germany from 1948 through 1963; by Shigeru Yoshida and Hayato Ikeda in Japan from 1949 through 1964; and by Neville Chamberlain in Britain in 1931-37.

Maynard Keynes would grind his teeth in thwarted academic fury at the policies proposed. He disliked Chamberlain, disdained Mellon and Liverpool, and would have hated the others. Yet they, not he, were true architects of economic recoveries, and it is their policies, not his failed nostrums, that should be adopted today.

Martin Hutchinson is the author of "Great Conservatives" (Academica Press, 2005). An earlier version of this commentary was published on the Prudent Bear website. The views expressed in this commentary are the author's own, and do not necessarily reflect those of RFE/RL