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It's an emergency. Long-term cures must wait
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The world economy is suffering from two quite separate problems. Unfortunately they need contradictory solutions

Unemployment is soaring. Property and share prices are collapsing. Gordon Brown's borrowing plans are accused of driving Britain towards bankruptcy. Mervyn King, the Governor of the Bank of England, says that it is impossible to predict when the recession will be over and is pilloried for “losing touch with reality”. What is to be done?

When a patient is seriously sick - as the British and world economies clearly are at present - it is wise to make a careful diagnosis before prescribing the cure. The first step in this, as the Bank of England prepares for its next interest-rate cut and Mr Brown flies off to Washington for the global economic summit this weekend, is to decide who is qualified to make the diagnosis and who isn't.

Should we disqualify all those who failed to foresee the gravity of this crisis - a group that includes Mr King, Mr Brown, Alistair Darling, Alan Greenspan and almost every leading economist and financier in the world with the partial exceptions of Warren Buffett and George Soros? Speaking as a junior member of this confederacy of dunces, my answer is, not surprisingly, an emphatic “no”.

The reason for continuing to take seriously the views of the many so-called experts wrong-footed by this crisis is, however, more complex, and more enlightening, than the self-justification offered yesterday by Mr King. The Governor excused the Bank's past misjudgments on the grounds that economic performance is inherently unpredictable and “the world changed completely” in mid-September after the Lehman Brothers collapse. This is perfectly true, but not very helpful. The question raised by Mr King's refrain that “the world changed in September” is why this happened and whether this sudden transformation was inevitable.

The answer, to return to my medical analogy, is that the world was suddenly hit by a second, more dangerous disease in mid-September that was quite distinct from the chronic, but manageable, illness from which it had been suffering for the previous year. Correctly diagnosing these two separate ailments is absolutely crucial because they require different, and to some extent contradictory, cures.

The slow-moving cancer that the world economy was suffering until August was caused by excessive borrowing, property speculation and reckless and dishonest banking practices. A still-deeper cause of this credit cancer was the global imbalance between exuberant consumption and house-price speculation in America, Britain, Spain, Scandinavia and Eastern Europe, on one hand, and excessive saving and austerity, on the other, in China, Germany and Japan.

Dealing with this cancer required bankers to be disciplined, borrowing to be restrained and property prices to be gradually deflated to reasonable levels. Dealing with the deeper problem of global imbalances required consumers in the US and Britain to spend and borrow less, while the surplus countries invested and spent more. This cancer of globally unbalanced credit growth was not, however, immediately life-threatening to the world economy and the cures - tighter bank regulation and a gradual, orderly reduction in lending - could be administered relatively slowly over a long period. This is what the Bank of England and other central banks and governments around the world were trying, with moderate success, to do until early September.

The sudden collapse of the global banking system that followed the bankruptcy of Lehman - described by Mr King yesterday as probably the worst financial crisis in recorded history - was a separate affliction. Like a heart attack in a patient previously weakened by chemotherapy, it required a different clinical response.

Rather than a heart attack, the global banking collapse could perhaps be described as a bullet in the head, since its proximate cause was a conscious decision by the US Treasury to jeopardise the stability of the world economy in pursuit of an essentially political objective - to show that the Bush Administration was willing to act ruthlessly against at least one big Wall Street investment bank. Until that point, savers and investors around the world had assumed that financial institutions such as Lehman were “too big to fail” and would always be supported by their governments.

By shattering this belief Henry Paulson triggered a run on every important bank in the world and caused the sudden implosion of consumer and business confidence seen in the past two months.

Unfortunately, the cure for the post-Lehman collapse is totally different from the prescription for the credit and property boom. Instead of restraining lending, punishing banks and encouraging saving, policymakers have to do the opposite. They must support - and if necessary - subsidise banks, to create conditions for easier lending and borrowing terms and to do their utmost to encourage consumption.

The obvious ways to do this are to slash interest rates and taxes, especially taxes on consumption and on lower income households, who are most likely to spend rather than save any extra money that they are allowed by governments to keep.

To avoid a deep and prolonged depression, policymakers all over the world must be willing to cut interest rates to levels never before imagined - if necessary all the way to zero, as Mr King hinted yesterday - and to increase their budget deficits without any regard to the old rules of fiscal restraint. They must also be willing to let their exchange rates float without worrying about inflation - another controversial policy that Mr King rightly endorsed yesterday.

Luckily, the post-Lehman recession has made this possible by transforming the inflation outlook: oil and commodity prices have halved in just over two months.

If governments around the world are willing to pull out all the expansionary stops - and especially if they do this with some degree of co-ordination - then the risk of a prolonged global slump will be much smaller than generally believed. With interest rates near zero and big tax cuts made across the world, a robust recovery would probably begin by the middle of next year, starting in America and China, spreading to Britain and eventually reaching continental Europe in 2010.

But what of the pre-Lehman problems? Credit will have to be controlled in the long run through better regulation and tougher capital requirements; saving will have to be encouraged, especially in America and Britain, by higher interest rates; and consumption will have to be restrained with higher taxes. These higher taxes, in turn, will eventually narrow the government deficits that must be temporarily swollen to offset the post-Lehman slump. Any such long-term measures to restore global balance and encourage savings must, however, wait until the world economy has returned to robust growth.

There is no point in offering chemotherapy to a patient whose heart has stopped.

by Anatole Kaletsky

Source > 
TIMES online | nov 13

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