From Notting Hill Editions
Tom Kremer, the founder of Notting Hill Editions, says that the way we define the success of the economy is fundamentally flawed. Until we improve our definitions, we won't properly understand how and when things go wrong.
Language informs content and content shapes language. The discussion of the present crisis creates terms and conjures up images that have a bearing on our thinking, and therefore on our actions.
One of the most widespread expressions employed in the debate runs along the lines of 'we must do x, y or z in order to jump-start (or kick start) the economy'. The implied image is a well-oiled, perfectly functioning machine or vehicle, temporarily stalled with a flat battery, easily restarted with an externally-provided electric charge. The electric charge invariably takes the form of a sudden infusion of money.
The other consensual feeling is that we should not dig too deeply for the causes of an unprecedented, unforeseeable crisis. The matter is of such urgency, goes the argument, that we need to act at once to save the world from economic meltdown. We have time enough to assess what went wrong at leisure and put in place such reforms as may be necessary in the more distant future. Delay could have fatal consequences.
The assumption that national economies in their global totality were sound, moving under a benign sky towards ever-accelerating growth, is extremely arrogant. Even in profitable companies, cashflow problems seldom appear out of the blue and are almost invariably related to more fundamental weaknesses. Not that economies throughout the world, taken as a whole, are profitable.
These two presumptions - that the economy is basically sound and that you do not need to understand the root causes of the crisis - apart from being facile, have this in common: they shield the principal architects of the failure from blame and attempt to separate the inseparable. The financial sector, and what is lazily termed the 'real economy', are deeply interwoven. The health of any economy is determined by its profit and loss account, its balance sheet, its borrowing, capitalisation and cash flow. The finance industry, in its turn, rides the waves of the 'real economy'; the pattern of crests and troughs mirror each other, albeit with some time lag.
It is astonishing that governments are taking all kinds of actions, with co-ordinated haste, to stimulate economies in response to diverse episodic and local eruptions of the crisis, without an all-embracing comprehensive idea of the crisis itself. You may well ask how this is possible.
After all, we have a far greater wealth of economic and financial data than at any time in history. The International Monetary Fund and OECD report on the state of the global economy, past, present and future, at quarterly intervals. A significant number of highly respected academic institutions produce a stream of well-researched papers, explaining the past and forecasting the future. The 24-hour global stock market records millions of transactions, having every asset in the world priced on a continuous basis. Traders and analysts, with eyes glued on multiple screens, try to interpret every scrap of information rather like African witch doctors interpret the dried bones of sacrificial fowl. And yet we can neither explain nor anticipate events that vitally affect all our lives.
What about economic theories - Adam Smith, John Stuart Mill, Hayek and the Austrian school, Keynes, Friedman and the monetarists of the Thatcher era. Economics has become a highly-respected academic discipline with a fair number of Nobel Prizes awarded to its more distinguished exponents. After all, no bank, no financial institution, no government department, would permit itself to function without the advice and guiding hand of senior economists.
I am a rank outsider. Untutored in the historical sequence of economic theory, I am not competent to explore a minefield of conflicting ideas and academic debates that are unlikely to be resolved in the foreseeable future. From the little I know, the major theoreticians of the subject have developed profound ideas and bequeathed valuable insights to our own academic generation. Accordingly, I will restrict myself to a few comments on past theories only insofar as they touch on our present predicament.
There is much talk, naturally, of deflation and inflation, free market and regulation, productivity, growth and contraction, government intervention and money supply, free trade and protectionism, recession and depression. Bits and pieces of various well-known economic theories are quoted in support of arguments, or as justification for proposed measures to alleviate the crisis.
These abstractions and extractions, piecemeal as they are, do not form a coherent theoretical base for a satisfactory explanation of our predicament. The terms employed seem to be taken for granted, as if their meaning was clear and, even more questionably, as if they were sufficient to carry the whole burden of the discussion itself.
The facts are stark and brutal. Property prices are sharply down and continue to fall. Equities, across virtually all sectors and nearly all markets, have lost more than a third of their value and no one seems to know when they will hit rock bottom. Jobs are being shed at an alarming rate and businesses fold all over the place. Private, corporate and national debt, already vast, is growing out of all proportion. There is insufficient liquid money to meet debts. The world is quietly drifting towards insolvency. How does economic theory explain this state of affairs?
Classical economists talked in terms of supply and demand. At its simplest, if demand exceeds supply, prices go up and, as a result, demand drops. If there is oversupply, prices drop and demand rises. Thus, while there are bound to be temporary fluctuations, markets always come back into balance. Such a basic model would suggest that we have simply produced too much in relation to existing demand and, as the price drops, human appetite will grow to absorb the supply. Markets then will once more come into a customary equilibrium.
Such a model seems to work for specific components of an economy; copper, soy beans and oil for example. The model fails when the whole economy goes into reverse so precipitously and on a global scale. It fails for multiple reasons: the economy is too complex, the free market is never absolutely free and demand, being subject to the whims of human beings, is not wholly subject to variations of supply.
The theory advanced by Adam Smith in his The Wealth of Nations, although still serving as an inspiration for all free marketers, cannot in itself cope with our present predicament, for some of the same reasons. Free trade, like free markets, is an ideal worth striving for but, in a world constrained by political pressures and diverse national governance, it is unachievable. The imbalances between producing and consuming economies may be a contributing factor to the crisis but the malaise is too deep and too general to be healed by only dealing with these imbalances.
The historical parallel drawn between our situation and the prelude to the depression of the thirties, and the oft-quoted Keynesian remedies, does little to explain the nature of our present experience. The narrative for what happened in the thirties runs like this: excessive borrowing and wild speculation created a massive stock exchange bubble; the bursting of the bubble plunged the American economy into a grave recession; the Federal government responded by adopting protectionist measures that damaged international trade; as a consequence the grave recession turned into a world wide depression. President Roosevelt' New Deal reversed the policy, injecting large government funds into the economy and reviving international trade; as a result, America and the rest of the world gradually recovered from the depression. With the benefit of hindsight, Keynes formulated his salient economic principle of corrective government intervention in periods of deflation and inflation.
As we are on the brink, if not already in the midst, of deflation, governments, following both the Monetarists and Keynes, are inundating contracting economies with money. They increase the money supply and dispense fiscal stimulus via government expenditure. But both doctrines are, at best, questionable and, at worst, dangerously flawed.
The narrative implies a few yawning assumptions: of a perfectly well-balanced economy collapsing under the weight of a market downturn; that the New Deal would have had the same impact at the beginning of the depression, not after three years of economic contraction; that total debt, building up throughout the twenties, was in balance with total assets at the time of the crash; that, without government intervention, the consequences of the downturn would have been even worse than six years of general misery.
Economists from the monetarist persuasion, dominant in the Thatcher and Blair/ Brown era, accept the notion that controlling the money supply could, on its own, enable governments to determine suitable levels of inflation in line with overall economic growth. The simplicity of the idea, as well as its mathematical mechanics, is most seductive.
In practice, however, the approach has serious weaknesses. To begin with, it is reactive - it responds to trends once they have started to materialise. Also, managing the money supply has a track record of fostering bubbles. But perhaps most gravely, there is no reliable benchmark as to what, at any given moment, the overall money supply ought to be.
The only theoretical formula for quantifying money creation, the Quantity Theory of Money (GDP = Velocity x Money Supply) suffers from several grave deficiencies. As Velocity is assumed to be constant in 'normal' economic conditions, the Money Supply factor was used to keep growth of the economy within desirable limits. In a credit crunch, with the velocity of money nearing zero, increasing money supply is supposed to protect the economy from crashing. So the central banks are now in the business of generating a near-endless supply of money in the belief that economies all over the world will resume their customary growth.
The trouble with this formula is that with weak Velocity you have to print a hell of a lot of money to make any difference to GDP. This is exactly what is happening today: instead of extending a helping hand to borrowers, banks have become reluctant lenders. All they care about is their own financial viability, no matter how much money is made available.
There is a more serious problem with the monetarist approach, one that is shared by other respectable economic theories. The problem lies with the essence of GDP. This ubiquitous term is used as a comparative measure to judge economies in relation to each other, as well as in relation to their own historic performances. In general, for political and commercial purposes, the performance of any given country depends on how fast, or how slowly, its GDP is growing. The most common statistic used to measure the gravity of our crisis, is the alarming rate of global GDP decline.
Being such a crucial term in the language of economics, you would naturally expect that its meaning is crystal clear to everyone, from the exalted circles of government and the City to financial journalists and the readers of their newspapers throughout the land. And in one sense this is true. The meaning of the term is taken for granted. We all understand that the Gross Domestic Product is a measure of scale; it tells us the size of an economy.
But pause and think for a moment. Apart from social transfer payments and financial transactions, such as the sale of stocks and bonds, GDP includes any and every item and service sold within the economy. The sale of every can of beer, loaf of bread and bottle of shampoo produced locally in a given year counts. So does every operation performed privately or by the NHS; every court case with the attendant legal fees; the cost of building an educational establishment, its staffing and running costs; every bit of military hardware and the personnel manning the army, navy and air force; the activities of all banks and insurance companies; the legislative process and the enforcement of the myriad of regulations it produces. The periodically published GDP figures measure the total monetary value of virtually all economic activity except, of course, the black economy which ought to add another 10%-20% to the official figure.
It is a comprehensive account of quantity without - and this is most significant - telling us anything about quality.
Every household, every business, every national economy produces revenue and generates expense. Working members of a family earn money, which is then saved or spent by, and on behalf of, all the family. If expenses exceed income, money has to be borrowed. The annual account of every business fundamentally has two columns, income and expenditure. The balance between the two totals determines the profit on which taxes have to be paid or the losses, which diminish the value of the business. The same, of course, applies to the ingredients of government activity as expressed, more or less accurately, by the Chancellor's annual budget. What is significant about GDP is that it measures total economic turnover without regard to the quality, profitability, viability, health, balance and future prospect of the economy it portrays.
Size matters. In judo, between two fighters of equal skill, victory is expected to go to the heavier one. On the other hand, history abounds with examples where numerically inferior armies, better equipped, motivated and led, defeat vastly greater forces. In economic terms, an estate centred on an antiquated mansion, that requires huge resources in staff and maintenance, is at a far greater risk than a modest town house inhabited by a couple of high earners. Similarly, companies with a relatively low turnover and high profitability are a better bet than companies with large turnover and low profit margins. Certainly, even in an age characterised by expansion through acquisition and merger, no one would dream of assessing a company just by its size. Yet such an assessment of national economies, using GDP, is not only practised but has become a matter of routine. Economists, in their theoretical mode, would naturally object to such an oversimplification.
The breadth of the economic base, natural and human resources, infrastructure and many other factors would all form part of the criteria used in an overall assessment. But, in practical and political terms, GDP as a simple figure plays a central, and often a crucial, role.
There is nothing wrong with measuring the GDP of a national economy. If you want to transport oil, it is useful to know the capacity of the ship that will carry it. But it would be sensible to ask what the ship is made of, how well it is constructed, what navigational instruments it has, and how competent the captain and crew are. If we need to assess any economy, to ascertain its strength, health and stability, in order to determine what volume of money represents its realistic worth, GDP is not only insufficient but, as currently used, highly misleading.
In trying to understand the crisis, to map its origins, we need to find a way to determine how much of the total GDP constitutes a contribution to the asset base of our economy and how much of it is a burden. We need a model for the national economy that reflects the income and expense columns of a household budget and that of the profit and loss account of any reputable company.
A national economy is hugely more complex than a household or business one and therefore creating an appropriate terminology will not be easy. But without such a critical distinction we cannot even start a meaningful discussion.
So, instead of criticising and fiddling with the existing language of discourse, I find it easier to start from scratch and try building a new conceptual architecture. Such a framework will need criteria to distinguish between sheer economic volume and the enlargement of its hard asset base. It will also have to take account of the much neglected human factor which is, in the final analysis, at the base of all material transactions.