A tide in the affairs of men

Over the last 100 years there have been two turning points in the evolution of the main economic philosophy that have supported economic policy in the UK and the US – the third such turning point appears to be now in progress.

In 1936 Keynes published his General Theory of Employment, Interest and Money in which he demonstrated that the economy could be in a state of equilibrium but with very high levels of unemployment. His policy prescription that the government make up for insufficient private sector demand by borrowing to fund public sector investment spending was the first time that an economist had argued that there was a key role for government within economic policy. This prescription was adopted in both the UK and the US (Roosevelt’s New Deal) in the next few years to deal with the Great Depression of the 1930s. The post-war economic policy conventional wisdom was that governments had a legitimate and necessary role to play by intervening in the economy in order to boost growth.

In 1976, the UK was forced by the weakness of its economy, to go and borrow money from the IMF and put in placer what would now be called policies of austerity. Most famously, the then Prime Minister, James Callaghan said “We used to think that you could spend your way out of a recession and increase employment by cutting taxes and boosting government spending. I tell you in all candour that that option no longer exists …”. This was also the year that Milton Friedman received the Nobel Prize for his work on the importance of the money supply in generating inflation and marked a key change in mainstream economic orthodoxy which led to the rise of Thatcher and Reagan who looked to roll back the influence of government in the economy and re-focussed the target of central banks’ policy on containing inflation rather than supporting growth. Terms such as economic liberalism and free market capitalism also reflect the same direction of economic thought and in particular the deregulation of the financial sector that has marked economic policy in both the UK and the US from that point. Globally, free trade was a concept that dominated international policy-making as it was seen as both containing inflation and boosting growth.

In 2016, it appears that the tide of economic ideas is once again turning, and once more it is led by the UK and the US (with the UK again just a little ahead). The motto of the Brexit Leave campaign to “take back control” and of Donald Trump’s campaign to “make America great again”, are both calls to move away from the economics of free markets and the philosophy of free trade.

As in the 1930s, this follows a period in which a laissez-faire philosophy has not delivered improved living standards for the average person, but instead seen the share of wealth amongst the very richest in society rise sharply, boosting inequality. Interestingly is the right-wing of political thought that have understood and sought to exploit this. Trump’s calls to fight immigration and renege on trade deals have strong appeal to the (white) working classes who have suffered most the globalisation of the world economy. Even in the UK, the words of the incoming prime minister have pointed to the need for business to work for all sections of society, rather than the elites. Central banks around the world have for a few years now quietly been pursuing policies designed to increase inflation rather than contain it, though without success to date.

We have passed the point of “peak free markets”, and changes in the direction of the dominant economic meme tend to be long-lasting (40 years going by recent experience). We should expect governments to become increasingly involved in the affairs of men.

For investors, the key correlation to note at these tide-turning points is for interest rates and bond yields. The history of greater government action in economies is marked by rising interest rates and inflation, with real returns from government bonds the key outcome. These were disastrously poor from 1936 to 1976 but have fabulous from 1976 to 2016. A long period of very poor real returns from government bonds is now at hand.

Situation Vacant – one new genius economist

There is an old joke that if you laid down all the economists in the world from end to end, you still wouldn’t reach a conclusion. It is certainly a tragedy that as the western world finds itself in the biggest economic mess since the 1930s, the economics profession is unable to articulate clear policies to resolve the problems.

Up until the 1930s, politicians did not see themselves as particularly responsible for the economy. The government’s finances were managed in the same way as any other family unit, in that you made sure that spending did not exceed income, and borrowing was only acceptable to cover the cost of emergencies like wars. Foreign exchange rates were all fixed by adherence to the gold standard and it was considered a shameful act to devalue.

This went wrong in the 1930s when the 1920s financial boom led to a banking crisis the following decade. As the banking system sought to deleverage its balance sheet, asset prices fell and unemployment soared. Wages fell but economic recovery did not come because the economy was in a Depression and companies and individuals did not have the confidence to spend. It took the economic genius, John Maynard Keynes to show how capitalism could get stuck in this Depression mindset with low growth and low interest rates. His solution was that governments should take advantage of their high credit status to borrow the excess savings that were being created by the lack of confidence and go out and spend them to kick-start an economic recovery. He always expected however that once recovery had returned, then governments would seek to run budget surpluses so that the extra borrowing was repaid and hence temporary.

Post-war politicians however focussed on the ideas that (i) budget deficits were now good for the economy and (ii) they had the power to manage the economy to deliver full employment, and ignored the idea of running budget surpluses in the good times to offset the deficits that should be run when bad times hit. As the decades wore on, the politicians promised their people more goodies from public spending, budgets only got balanced in economic boom conditions and the size of the governments’ debts relative to the size of their economies rose steadily.

Recent academic work (Rheinhart & Rogoff) has shown that as the Debt to GDP ratio nears 90%, the capacity for economic growth diminishes markedly. The Western world is at or past these limits and finds itself there just as the next 1930s style banking crisis has hit it. The standard Keynesian response of government borrowing and spending is now either not available since markets are unwilling to lend to some governments because they have lost their strong credit status, or not palatable since it is likely to damage longer term economic growth prospects.

In general the right-of-centre politicians (Merkel, Cameron, Romney) stress the need to get government deficits and debt under control, so as to retain the long term confidence of financial markets. This austerity agenda does nothing for short term economic relief however. The left-of-centre politicians (Hollande, Milliband, Obama) stress the standard, Keynesian policies of spending in the short term to enable recovery to occur. The problem here is that financial markets might only provide the funds at an unacceptably high interest rate, and trigger a wider debt crisis.

The positions of both sides contain important truths, but the arguments display the divisions between economists. Japan, over the last 20 years, can be used as an example to prove each is wrong. The Keynesian response of government borrowing and spending has not led to sustainable economic recovery but has led to a Debt to GDP ratio now of over 200%. However this massive debt burden has also not led to a financial market crisis (yet), as Japanese savers have been happy to lend to their government for miniscule returns.

A Nobel Prize, a place in history and the gratitude of the world surely await the economist who can untangle all this and provide the solution to our current problems.