Policy Research in Macroeconomics

Without a U-turn, there is much worse to come.

By Ann Pettifor & Douglas Coe

The IMF’s World Economic Outlook this week expressed optimism that OECD economies are recovering, and that emerging markets are doing better than ever. However, while UK unemployment numbers fell, Britain’s first full National Accounts for 2010 are a reminder of the severity and fragility of the UK’s present economic position.

Media coverage has focussed on the fall in households’ real income, the first decline since 1976.  This is of great concern, with austerity and threats of interest rate rises. But the same dataset enables a fuller assessment of the financial position of UK households and firms.

The recession that began in 2008 is widely accepted to be the result of the excessive indebtedness of private sector firms and households, not of government. Private debt has risen relentlessly since the early 1980s. Most commentators focus on the extent of household debt, which rose from around 40 per cent of GDP before the 1980s to a peak of 110 per cent in 2009.  But corporate debt is even more elevated, rising from 50-60 per cent to a peak of 130 per cent in 2009. The latest National Accounts show that both measures fell back in 2010, but only by a very small margin: households to 105 per cent of GDP and corporates to 125 per cent.

Many economists privately rely on ‘rebalancing’ to ensure debts fall back to more ‘normal’ levels – neglecting to define ‘normal’. But if so, then the ‘Great Recession’ that we are currently living through, might scarcely have begun, in spite of any preventative action.   Irving Fisher’s celebrated 1933 paper, ‘The debt deflation theory of the great depression’ described how elevated levels of debt unravelled during the Great Depression, leading to unemployment rates of over 30%.

The manner of the unwinding depends on policies adopted by governments and central banks. As a matter of arithmetic, the debt to income ratio can be reduced either by paying down/writing off debt or increasing income. So far policymakers have adopted strategies that result in the opposite:  increased debt and reduced income.

In 2007/2008, firms and households began ‘de-leveraging’.  The process was triggered by the long-overdue recognition in financial markets that a large proportion of private debt was unlikely to be repaid. On ‘Debtonation day’ – 9 August 2007 – inter-bank lending seized up, and the ECB was forced to intervene.  Soon after, firms and households confronted the realities of balance sheet positions. Firms went bankrupt, made redundancies and cut wages. Economies were plunged into recession: households confronted unemployment and reduced incomes that are now compounded by cost of living rises and hence the fall in real gross disposable income.

The 2007 debt deflation was quickly arrested by decisive interventions by financial authorities around the world. But these interventions served only to increase the aggregate debt. Debts were transferred from the financial sector to government and taxpayers, and quantitative easing increased overall aggregate indebtedness.

In their report, ‘Where did our money go?’, economists at PRIME and nef (links) argued that when these interventions are unwound over 2011-12 another financial crisis is inevitable. This because the bankruptcy of borrowers can only be delayed by the lending of more money.  The debt deflation has merely been postponed.

In the meantime, policymakers across the world – but especially in Europe – have abruptly turned the strategy of interventionism on its head. Austerity policies – government spending cuts, benefit cuts and tax rises – are imposed. Governor Trichet of the ECB justified this approach on the grounds that cuts would mobilise resources for further financial interventions. But this is misguided: for, as we have repeatedly predicted, and as is now evident in the latest OBR forecast, austerity leads to higher public debt and reduced national income. This is the very opposite of what is required to deflate private debt, which will rise not fall.

Policymakers must turn to alternative strategies to deflate household and corporate debt as a share of income. Without action, matters will eventually unwind of their own accord, potentially as brutally as they did in the Great Depression.

The first step is a large-scale exercise in the writing off and/or renegotiation of unpayable household and corporate debt.

The second step is to adopt measures to increase national income. As we at PRIME have consistently argued, the most direct way of generating income for both firms and households is through investment in public works. Under present conditions public schemes are essential to private sector income.

The third step is large-scale reform of the financial sector to a) revive lending to the productive sector, and b) to make such lending affordable and sustainable.

The debt data in the National Accounts are a stark warning that perceptions of recovery are delusional. What signs there are, are temporary and have been bought at great cost by interventions and stimulus packages now withdrawn. While symptoms have been treated, the disease is still raging and the patient is gravely ill. A cure is possible but requires a radical change of treatment.

The remedies currently being dispensed are likely to be lethal.

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