Why it’s hurting but not working


The reason why European economies are stuck in the trenches is actually quite simple. Our governments have shot themselves in the foot.

One of our favourite economists at English Economic (yes, one or two are all right) is Oxford University’s Simon Wren-Lewis. Simon has been one of the most trenchant critics of Britain’s Tory government within mainstream economics, and his clear and straightforward arguments generally go unanswered by government supporters. Simon is also one of the few academic economists to make a concerted effort to reach out to non-economists, both through his Mainly Macro blog (which caters for both economists and the rest of us) and his campaign against “media macro” – the distortion and misinformation in the mainstream media which does so much to promote right-wing economic ideas and always seems to favour the interests of the rich and powerful.

One of the most important questions Simon has been tackling recently is why all the extraordinary measures taken in the UK and the Eurozone in recent years have failed to get the economy moving. Put very simply, there are two ways for the authorities to stimulate the economy quickly (in what economists call the “short-run”), so we can see some economic growth and start getting pay rises again. The government can either spend money itself or it can encourage other people to spend money. Either way, someone somewhere has to start putting some money down.

The Government can invest in roads and railways, pay its staff more, build schools and hospitals and so on. This stimulates the economy by creating jobs and raising wages and profits. Or it can put money directly into people’s pockets by cutting taxes or increasing welfare benefits. This is “fiscal policy” and it was the preferred method of reviving a stagnant economy until the late 1970s.

The alternative is for the government to encourage other people to spend money, usually by reducing interest rates or loosening restrictions on credit. This is “monetary policy” and it works by encouraging businesses and households to borrow more, either to invest in plant and machinery or to spend on things like new cars, holidays and home improvements. This has been most governments’ preferred tool for the last 35 years.

One explanation could be that trying to restart a stalled economy by cutting interest rates is like “pushing on a string”

But since the crisis of 2008-9, monetary policy simply hasn’t worked very well. Interest rates have been close to zero in both the UK and the eurozone for years, but the economy is still stuck in (at best) second gear. We don’t know for certain why monetary policy failed. One explanation could be the one attributed to the great British economist John Maynard Keynes: that trying to restart a stalled economy by cutting interest rates is like “pushing on a string”. You can make more credit available but you can’t force people to borrow. If they think they won’t be able to pay it back or that the investment will go sour, people won’t borrow at any interest rate. And even when they do, you have no control over how they spend the borrowed money. They might invest it abroad or spend it on holidays in the Caribbean – which won’t create many jobs at home.

But Simon’s main argument is that monetary policy is useless at what economists call the “zero lower bound” (from what I can see this basically means “zero or nearly zero”). In the Eurozone rates are already zero, so can’t really be cut any further (you can have negative rates, but that has all sorts of strange consequences (£) which we won’t go into here). In the UK, rates have fallen from around 5% to 0.5% with little effect. What difference is cutting them a further 0.25% or 0.5% likely to have? If the policy is exhausted, it’s time to try something else.

When interest rates failed, the Bank of England and the European Central Bank (ECB) resorted to “unconventional” monetary policy. They have been trying various forms of “quantitive easing”, in which the central bank creates electronic money and deposits it with commercial banks (usually in exchange for government bonds) in the hope that they’ll lend it out. That isn’t working well either. Rather than lend the money for consumers to spend and businesses to invest, banks have stashed it in shares and property, which pushes up stock markets and house prices but doesn’t do much to stimulate the economy. Unconventional monetary policy hasn’t been much more effective than the conventional variety.

Oh, yes, what about the government’s other tool – fiscal policy? Surely that must be worth a go? Apparently not. Rather than spend or invest more, governments have been cutting back, quite savagely in the case of the UK. The policy of cutting spending regardless of the economic circumstances – what we call now call “austerity” – just means monetary policy has to be even more effective to compensate. But monetary policy isn’t working.

Why is the government doing this? At least in the case of the UK, the reasons seem to be ideological. “The antagonism to public investment seems to lack any deep historical explanation, and may just reflect stupidity or an ideology imported from the US,” says Simon. The ideological obsession in the Tory party with reducing the size of the state, whatever the consequences, effectively rules out using fiscal policy as a tool of economic management.

The reason we’re still deep in the hole we fell into during the financial crisis of 2008-9 is therefore quite simple. The government had two tools to help get us out. One isn’t working very well and it has used the other to dig us deeper into the ground.