Any illusion that the end is in sight for the global economic crisis has now vanished. One cheerleader for world capitalism, Martin Wolf of the Financial Times, recently admitted, “It has, in all likelihood, not even passed the end of its beginning.”
Janet Yellen, a US central banker, describes the economy of the US as in the hands of the three witches in Macbeth: “Only here, the three troublemakers are the housing market, the financial markets and commodity prices.”
The housing market is where the crisis began, when the great bubble of speculation in housing loans to poor households (subprime mortgages) burst 18 months ago. In the US house prices are 19 percent below their peak, and are expected to bottom 30 percent down.
This hits the economy in two ways. First, families spend less, either because they can’t borrow against the rising value of their home or because they are forced to default on their mortgages.
Second, the banks find themselves stuck with bad loans and so stop lending to each other, industrial and commercial firms, and to consumers. The result is a positive feedback loop.
Banks lend less so more firms and households go bankrupt. These bankruptcies mean that banks are stuck with yet more bad loans. They cut their lending further, and this leads to even more bankruptcies, feeding a downward spiral.
Add to this the leap in the rate of inflation of 5 percent in June, the highest since 1991, bearing down on consumer spending.
US economic growth has nevertheless held up – 1 percent in the first quarter of 2008, possibly 2 to 2.5 percent in the second quarter. This is partly because the fall in the dollar’s exchange rate has made US exports cheaper and more competitive.
Moreover, consumer spending has been propped up by the $110 billion tax rebate voted by the US Congress. But its impact will fade in the second half of the year, while the worst of the credit tightening maybe yet to come.
As a result, according to the Financial Times, a growing number of economists are predicting a “W-shaped downturn, with some forecasting outright contraction around the turn of the year”. In other words, the higher growth of the past few months may prove to be merely an interlude.
The three witches also have Britain in their grip.The Financial Times said, “The UK is facing an extended period of weak growth as policymakers battle to control inflation and this week’s data releases will confirm that the risk of the economy sinking into recession has risen substantially.
“With house prices falling at the fastest pace since the 1930s and family budgets under pressure from rising petrol costs, utility bills and food prices, the outlook for consumer spending has clearly deteriorated.”
In the light of all this, the fuss about the Treasury’s admission that it is considering revising the “golden rules” devised by Gordon Brown when he was chancellor seems pretty silly.
Economic slowdowns always worsen government finances. Tax revenues fall because firms and households are doing badly, and, even now, the state has to spend more on benefits for the unemployed.
To finance this spending, the state has to borrow more. The budget deficit for the first three months of the financial year was a record £20.4 billion, up from £12.5 billion a year earlier. So the Treasury is saying that it may allow government borrowing to rise above the limit of 40 percent of national income set by Brown.
The alternative – to cut spending or raise taxes – would be economic madness.
One of the lessons of the Great Depression of the 1930s was that government spending can help to prop up a declining economy. So the decision is a perfectly sensible one – though it was idiotic of Brown to have tried to handcuff economic policy in the first place.
All the same, it will take more than government spending, either here or across the Atlantic, to stabilise an economic system in the grip of powerful contractionary forces. The three witches have plenty more damage to inflict.