There is a way out of this mess

Here is quick inventory of problems now facing the UK economy: falling output; a large external deficit; rising public sector indebtedness; unsustainable levels of household debt; a crashing housing market; quasi-insolvent banks; declining real incomes, and rising unemployment.

Did I leave anything out? Ah yes, Sterling, I forgot. The UK is on the slow side towards a currency crisis. With this nasty brew of tribulations before us, is there a way out?

As the problems have mounted, the Government and the Bank of England have cooked up a response to this crisis. The bare bones of the strategy are quite straightforward; cut the bank rate to the lowest rate in sixty years so that in real terms, rates are negative; nationalize the banks, and run up a series of massive fiscal deficits.

I hate to say this, but I do not think this approach is going to help much. However, a critique is easy, but what about some solutions? Here is what I think might resolve our economic difficulties over the medium term.

Don’t make things worse – no more debt

It is a simple point, but the government should stop making big problems even bigger. This economy already has a major problem with debt. Every major sector of the economy has too much; firms, households and the government.

Trying to encourage people to hold more debt will not restore a degree of sustainability to sectoral balance sheets. It follows, therefore, that the government should not force banks to lend more. It should forget those fantasies about reviving the credit fueled housing bubble. It should encourage people to pay off their debts rather than accumulate new ones. Above all, it should set its own house in order and put a brake on its own unsustainable borrowing plans.

Build a platform of stability

The economy needs stability and fiscal policy is the weightiest anchor available. Darling’s plan to ratchet up the deficit creates huge uncertainty about where the UK economy will be in a year or so. Will a future government have to increase taxes? Will long term interest rates have to rise as government borrowing increases? What is the probability of a fiscal crisis, where the government actually runs out of money? And before you ask, yes, governments can run out of money, just ask the Argentinians or the Icelanders.

This uncertainty feeds into the present. In the absence of any clear idea about the future taxation, firms will defer investment plans. This leads to slower growth, and lower living standards.

Although firms no longer know what the tax system will look like in two years time, they know that taxes will have to go up and that will lead to a future contraction of output. Darling “spend now, tax later” plan will lead to a recession now, and more recession later.

At a minimum, the government should restrict the growth of the public sector and balance its books. Forget this rubbish about spending your way out of recession. It has been tried many times before. It only leads to a bloated public sector that squeezes out private enterprise. Government debt grows remorselessly, leading to higher interest rates. In short, it is a recipe for failure.

Fix interest rates

No economy can prosper with negative real interest rates. When the deposit rate is lower than the inflation rate, people no longer have an incentive to save. It also affects the incentive to work. There is no point putting in a few extra hours of overtime, perhaps to save something for retirement or finance the kid’s education, when it will disappear in withholding tax and inflation.

Negative interest rates also threaten to prolong our banking difficulties. Currently, there is a huge gap between total bank loans and total deposits. Banks need depositors more than ever, but with such low rates, savers have no incentive to put money into banks. In the interim, banks are forced to depend on the Bank of England for liquidity. Banks can not prosper if they waiting cap in hand for financial assistance from the state.

Deposit rates have to increase and exceed the inflation rate. The Bank of England need to push rates upwards, and only reduce them as inflation falls. But what about the real economy? Won’t higher rates lead to recession?

Negative rates will do nothing to prevent a recession. In America, the Fed pushed interest rates below the inflation rate almost a year ago. Since then, the US economy has lost jobs remorselessly. Why? Negative rates are always associated with unstable failing economies, where savings, investment and work are all discouraged.

Tell the truth

The government needs to tell people that we are about to enter a prolonged period of economic decline. As the economy contracts, it will crush all our illusions about asset prices. The housing market is not going to provide anyone with a pension. Likewise the equity market will not generate sufficient capital gains so that we can save nothing and consume as much as we earn. Utimatelely, it is a simple message, we need to know that we must save more, work harder and expect less.

At the same time, the government must tell us that it will not run up huge deficits, and therefore it won’t need to play around with taxes in the future. At the same time, the MPC must also tell us that it will establish a monetary framework that provides price stability and incentives for people to save and work.

In the short run, there will be pain. We are in a right mess, and a recession is unavoidable. However, high deficits and negative real interest rates will guarantee years of instability and uncertainty. But there is a better way; create stability, minimize financial chaos, and create the right incentives; a strategy that requires lower government deficits and higher interest rates.