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William Keegan: We're all aboard the American loco, hoping it's on the right track

Guardian Economics 3rd May 2009

What gives me hope is that so many financiers and entrepreneurs seem to be more worried about inflation than depression. There is no serious danger of inflation. Political commentators tell us that New Labour and Thatcherism are dead. But it is my firm belief that one survivor of the past 20 years is going to be the all-party political commitment to the fight against inflation.

However, the mere existence, indeed proliferation, of fears that current fiscal actions will stoke the dying embers of the inflation stove is a sign that, for all their complaints about fiscal stimulus, people believe in their guts that it is going to work - eventually, that is.

I make no apology for having raised, some months ago, the spectre of depression. However, the policy response to the crisis has been such that there is a reasonable chance that we shall limit the damage, although more damage there will most certainly be. The dramatic collapse in gross domestic product and world trade during the fourth quarter of last year and the first quarter of this year guarantees rising unemployment and social misery for the rest of 2009. But, as those Nobel prize-winning US economists Robert Solow and Paul Krugman have both indicated, the size of the US fiscal stimulus, mind-blowing though it is, is not nearly mind-blowing enough to fill the gap in effective demand in the US. And since, for all the wishes to the contrary, the US is still the world's most powerful economic locomotive, this has implications for others, as well as the US economy.

An all-too-predictable aspect of the debate about fiscal policy and massive central bank open-market operations is that many beneficiaries of what they call "lax policies" are the very people who got us into this mess. For example, as the UK budget report makes clear, a significant contribution to the formidable expansion of the British government's borrowing requirement is being made by the cost of the bank bailout. This does not inhibit a failed financial sector from castigating the government for its debt levels, or moaning about the loss of its bonuses.

Professor Solow, writing in the latest New York Review of Books, states: "No one can possibly know how long the current recession will last or how deep it will go." As he points out, the recession and the financial breakdown are each "both cause and effect of the other". Reviewing A Failure of Capitalism: The Crisis of '08 and the Descent into Depression by Richard A Posner, Solow has fun with some of Posner's economic misconceptions (Posner is a prominent right-wing US judge) but concludes with apparent approval: "As Posner sees it, talk about greed and foolhardiness is comforting but not useful. Greed and foolhardiness were not invented just recently. The problem is rather that Panglossian ideas about 'free markets' encouraged, on the one hand, lax regulation or no regulation, of a potentially unstable financial apparatus and, on the other, the elaboration of compensation mechanisms that positively encouraged risk-taking and short-term opportunism." I quote this because I think it a classic example of Alexander Pope's "what oft was thought but ne'er so well expressed".

Many people are bored by seemingly endless backward looks at the origin of the downturn, but such examination is relevant to policies for emergence from this crisis and the avoidance (or mitigation) of future ones.

John Llewellyn, in a sequel to his paper "Lessons from the Financial Crisis" (john.llewellyn@llewellyn-consulting.com) notes that respondents tend to put more emphasis on the financial implosion and less on global imbalances (such as US and UK trade deficits, or Chinese and German surpluses) as causes of the crisis. But this does not mean that those global imbalances have gone away. Indeed, one of the obstacles facing the recovery that ought to come from the "kitchen sink approach" - they have thrown everything but the kitchen sink at it, as demonstrated by the subsequent fiscal caution manifested at the recent G20 summit in London - is still-inadequate global demand. Japan and Germany, those exporters par excellence, are in even deeper trouble than us. There is a limit to export possibilities in the markets of Mars and Venus. And I note that although the UK should eventually benefit from the enormous devaluation of the pound (doesn't the exchange rate hurt in France ... ) the volume of our own exports of goods and services is forecast to fall by some 9% this year, the real benefit from the devaluation being expected in 2010 and 2011.

Assuming that all goes well - or less badly - on the bank rescue front, the fiscal and monetary stimulus should show results next year and the year after. Whether the sight of green shoots next year would be in time, or sufficient, to rescue this tired and beleaguered government is another matter.

Meanwhile, the Conservatives are licking their lips at the prospect of office. It would be deeply ironic if the left's opposition to the identity card scheme and the renewal of Trident were finally to be listened to, not by a New Labour government, but by the newly austere Conservative party, and on grounds of cost.

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