Edward Hadas

On September 15, 2008 Lehman Brothers collapsed in a heap, a bankruptcy that was followed by a recession in most rich countries. As time goes on, the severity of the disruption becomes both more apparent and more puzzling.

When Lehman failed, it was reasonable to expect the pain to be brief and concentrated. While too many houses had been built in the United States, most of the world’s real economy (comprising factories, offices, retail outlets, construction projects) was doing well. The global financial sector was more distorted, even before investors took fright at the decision to let Lehman go under. But by the middle of 2009, governments and central bankers had agreed to provide bankers and brokers with anything needed to keep them healthy.

Optimism was not justified. Although the countermeasures stopped the deterioration, the rich world now seems stuck in a Lesser Depression – many years of poor economic results and a series of financial crises. In the United States, the euro zone, Japan and the UK, real GDP per person is still lower now than it was four years ago. In all of them, GDP growth is currently either slow or non-existent.

The consumption setback shouldn’t cause too much concern – it wasn’t so bad five or six years ago, when real GDP was last at today’s level. But the enduring recession in the labour market is another matter.

In April 2008 the unemployment rates in the United States, euro zone and UK were respectively 5, 7.3 and 5.3 percent. In April 2012, the corresponding percentages were 8.1, 10.9 and 8.4. More refined indicators – youth unemployment, involuntary part time work and disaffected ex-workers – are even more discouraging. The post-Lehman economy is failing a significant number of people in a fundamental way.

Some economists argue that this real suffering is the necessary price to pay to bring order to the financial world. That’s a dubious argument, since people are more important than money and credit. But the ethical debate isn’t necessary. Despite the real economic pain and the official aid, the financial world looks as ill as ever. On the monetary side, policy remains in shock territory – buyers of safe government debt receive negative real returns. Fiscal positions are equally alarming. Deficits everywhere remain at levels more suitable for wartime mobilisation than for a sputtering economy.

The puzzle is why a relatively small problem in the real economy has led to this Lesser Depression, especially when the authorities have followed expert advice throughout. Surely, if the counsel were sound, the depression would have lifted by now.

The experts offer several excuses. One is that the euro zone’s special problems have delayed recovery. That’s probably true, but European politicians and central bankers are following the best advice on how to compensate. Another is that the authorities should have been even more aggressive in their support for the financial system. Maybe, but even larger fiscal deficits and even easier money would create other distortions. Yet another claim is that governments should have cut back their spending faster. Possibly, but that would hit consumption harder and further increased unemployment.

The problem is actually the experts. Recent history provides a good reason to doubt their competence. Five years ago, economic gurus saw no end to the pre-Lehman “Great Moderation” – steady GDP growth, shrinking unemployment and rising asset prices. They were wrong about that, and they are still making two basic mistakes.

The first concerns the real economy, in particular the highly productive modern economy. Economists underestimate the difficulty of keeping unemployment down. It is much easier to destroy jobs, with labour-saving devices and more efficient procedures, than to create them by starting up enterprises, finding customers for new services or creating new bureaucracies. The employment asymmetry accounts for the persistent pain in the labour market. The jobs shed at the beginning of the Lesser Depression are not easily replaced, nor are the jobs currently being cut by governments searching for austerity.

The second mistake is financial. Economists underestimate the danger of debt. Whether the money is owed by companies, households or governments, the disadvantages of debt financing increase as the ratio of liabilities to income rises. Heavily indebted borrowers are less eager to take economic risks and more likely to default. In a highly leveraged and financially interconnected economy, one default often leads to other bigger collapses. In short, massive debts almost invite economic paralysis. It’s hardly surprising that the increase of debt-financed government spending has done so little good.

So what should be done? New ideas are required – and I’ll offer my contributions over the next few weeks. Without a fundamental change in the thinking, the global economy won’t reach its goal of steady growth and low unemployment.

Once upon a time there were 11 prosperous merchants who lived in a land of peace and plenty. They decided to form a league that would work together for everyone’s greater good. But then a charming man in a fine suit came around with a tempting speech: “I love your project and trust your businesses. I will lend you money at a very attractive interest rate”. How nice, thought the merchants. Our customers will love us if we use the money we borrow to give them better deals.

All went so well that six other merchants were proud to join the league. Mr. Fine Suit seemed pleased. He reduced the already low interest rate on the loans. The merchants all planned to repay, but today was never quite right. Today, in fact, was always a good day to borrow more, while tomorrow always looked like a better day to raise prices.

Then one day Mr. Fine Suit changed his tune. “You know, you have a mighty nice little enterprise going here. But business is business, my friends. Interest rates are going to rise for some of you.” The merchants were angry, but what could they do? They promised to be more frugal, but still had to pay up. As the months went by, Mr. Fine Suit became more hostile. Just last week he came to the G-store, the most prosperous and prudent of all the merchants, with a really nasty threat. “You know, between us, I’ve never liked your stupid league. You’re much smarter than the rest. Leave the league and I’ll keep on lending you money at a low rate. If not, well, here’s a little reminder of what I can do.” He increased the interest rate by two notches before leaving the room with a menacing smirk.

The story is a parable of the euro zone debt crisis. The merchants are the member governments, the customers are the taxpayers and Mr. Fine Suit represents the banks, fund managers and individuals who lend to governments. These investors in government debt tend to think and act alike; just about two years ago their message to the euro zone changed from “We’re behind you all the way” to “Nice little monetary system you have here. It would really be a shame if something happened to it”.

The euro zone’s weaker members and the EU as a whole have responded to the threat with tougher budgets than were ever contemplated while investors were still friendly. But the investors have started to behave like an extortionist, demanding ever higher interest rates and threatening to withdraw funding totally. Even fiscally healthy Germany (the G-store) is now under threat. Of course, investors do not think of themselves as extortionists or even as malicious. They think of themselves as merely law-abiding professionals trying to protect the value of their investments, either by making sure the governments will be able to pay up or by selling before the governments default. But many sensible individual fears — “I don’t want to be caught out” — can add up to group menace– “You must meet our ever harsher demands – or else”.

The fable of Mr. Fine Suit could be elaborated to include the European Central Bank as policeman, but the addition would not change the moral: the mix of governments and financiers can easily become toxic. It has always been thus, at least as far back as the English King Edward III’s 1343 default bankrupted the lenders of Florence. The political-economic logic behind these recurrent crises is straightforward. On the one hand, governments which are too weak to cover current expenses with tax revenues are bad credit risks. On the other hand, when previously supportive lenders suddenly turn against profligate governments, they look arbitrary and rapacious.

In recent years, these basic truths have been obscured by the widespread acceptance of a principle associated with the British economist John Maynard Keynes — governments should sometimes spend a little more than they take in to keep the real economy humming along. Even if the Keynesian principle is right, it justifies neither the imprudent deficits which Greece ran up after it entered the euro zone nor the ease with which it was able to borrow to fund those deficits.

In the euro zone, Mr. Fine Suit is now on the rampage. In the United States, he is still very friendly. But the stubbornly large American deficits – currently more than twice as high as the euro zone’s as a share of GDP – are a sign of political inadequacy. Like Edward III and the government of Greece, the U.S. government has consistently decided to spend significantly more money than it is willing to demand from taxpayers. Unless Congress finds a way to balance revenues and expenditures, sooner or later America’s Mr. Fine Suit will be coming around with a baseball bat.

Photo: An employee at the National Bank of Belgium holds a new 500 Belgian Franc note (front) and two small reproductions of paintings by Belgian famous surrealist Rene Magritte. REUTERS/Nathalie Koulischer