Strange, unsettled economic times

Economic history provides a context for both the "recession" and the "recovery", says Peter Lyons.

This is not a "normal" recovery because that was not a "normal" recession.

Retailers are lamenting the continued lack of sales.

The housing market is stagnant, with sales volumes plummeting. Business confidence is schizophrenic.

Our economic situation bears little resemblance to past recessions and recoveries. This time is very different.

There is little economic history taught in our universities these days.

A likely reason is that the pattern of economic booms and slumps called the business cycle was meant to be a thing of the past.

The Great Moderation of the 1990s and early 2000s was meant to herald a new era of continuous economic prosperity.

This prosperity would be overseen by wise central bankers.

These bankers could pull on the levers of monetary policy whenever an economy appeared to be overheating or heading for recession ...

This appears to have been an exercise in policy hubris which is now unravelling on a grand scale.

What was actually happening was a massive build-up in consumer debt levels and multiple asset bubbles created by easy credit.

These bubbles included emerging markets and tech stocks in the 1990s and housing in the 2000s.

Economic history provides a context for what is happening both here and abroad.

Following the Great Depression of the 1930s, most Western economies used Keynesian policies to manage their economies.

The overriding aim was to prevent a repeat of the large-scale unemployment of the 1930s.

If an economy was in recession, a government would increase demand in the economy, often by borrowing and spending.

By the 1970s, Keynesian policies appeared to be running into major problems.

Government debt levels had soared.

Borrow and spend policies by governments led to higher and higher rates of inflation and little or no economic growth. This came to be known as stagflation.

A new ideology of economic management was to emerge from the 1970s based around University of Chicago's Milton Friedman.

Monetarism is based on the use of interest rates, money supply and credit, particularly to control inflation.

President Jimmy Carter in the United States appointed Paul Volcker as chairman of the Federal Reserve.

Volcker promptly ramped up interest rates to smother inflation.

Unemployment rocketed.

New Zealand was to follow a similar process following the passing of the Reserve Bank Act in 1989.

The severe recession of the early 1990s was largely a result of high interest rates being used to squeeze inflation pressures out of the system.

Monetary policy had become the new holy grail of macro-economic management.

When inflation loomed, central banks would raise interest rates to kill off demand in the economy.

During a recession, central banks would slash interest rates to crank up borrowing and spending in the economy.

Major recessions in the West were averted in 1997 (Asian crisis) and 2000 (Tech stock crash) by flooding economies with easy credit.

Central bankers such as Alan Greenspan became superstars. The legacy of decades of monetary management is now apparent.

Keynesian policies led to massive government debts. Monetarism has led to massive private sector debts.

Unfortunately, the monetarist approach to averting recession is no longer effective.

There are simply not enough people left to lend to. They are either very shy of taking on debt or very unlikely to repay.

Businesses are also reluctant to borrow because there is little point in expanding when sales are plummeting.

Keynes called this situation a liquidity trap.

He likened using monetary policy in this situation to like "pushing a piece of string".

So where does that leave New Zealand? We may not be in a technical recession but this anaemic recovery appears a statistical occurrence rather than reality.

A sudden bounce-back will be very unlikely and the reason is the lack of demand in the economy.

People are desperately trying to pay down debt, hence the huge fall in consumer spending.

Firms are unwilling to invest in new plant and equipment because the demand for output is not there.

Government spending has attempted to fill some of the demand deficit but it is constrained by fear of mounting public debt.

The only other source of demand for our economy is export sales and problems are looming here.

The United States, Japan and the United Kingdom are abandoning monetarist orthodoxy.

Their central banks are pumping money into their economies with the aim of stimulating demand and driving down their exchange rates.

This aims to increase the competitiveness of their exports.

As the New Zealand dollar increases in value against these currencies it makes our exports less competitive on world markets.

Export-led growth was meant to be our saviour but this may be denied to us by the beggar-thy-neighbour polices of other countries.

Further decrease in effective demand in New Zealand will lead to rising unemployment which could spill over into the housing market.

If significant declines in house prices occur, this could create a negative wealth effect.

As people feel less wealthy they cut back spending, leading to a nasty deflationary spiral.

This is what other countries are desperately trying to avoid.

There are no easy answers but we need to look seriously at our use of monetarist policy through the Reserve Bank.

It is a debate that is long overdue. Our economy is not out of the woods by a long shot.

These are strange times as countries seek to extricate themselves from the debt quagmire left by decades of monetarism.

If other nations continue down the path of beggar thy neighbour policies such as currency depreciations, we will need to seriously reconsider our commitment to monetarism.

Peter Lyons teaches economics at St Peters College in Epsom and has written several economics texts.

 

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