As a new global crisis looms, and political paralysis worsens, genuinely bold solutions are required to overcome the malaise
There was fear this week – real fear. There was fear eliminating $2.5tn from the value of global shares in a mere five days. There was fear provoking the dumping of Italian government bonds at rock-bottom prices. And there was fear taking the yield on short-dated US treasury bills to below zero: investors were so anxious to park their cash somewhere safe that they were, in effect, paying the US government money to steward their savings – something not seen since the second world war.
Yet the credit ratings agency Standard & Poor's ended the week by casting a shadow over the creditworthiness of American government debt, unprecedentedly downgrading it from its AAA status, a monumental blow to the standing of the richest country on Earth and its political system. S&P's held its ground despite intense lobbying from the US treasury. Without tax increases, it said, the US could never recover its fiscal position – but tax increases, given the implacable opposition of congressional Republicans, have become impossible. The markets lurched downward.
Meanwhile in Europe, France's president, Nicolas Sarkozy, chair of the G20, finally managed to disturb German chancellor Angela Merkel's holiday and, with Spain's prime minister José Zapatero, discussed in a conference call how best to react. It was long overdue. Even the president of the European Commission, José Manuel Barroso, described a week in which individual governors of the European Central Bank, and the German government, were openly saying different things about whether the ECB would support the Italian and Spanish stricken bond markets as "undisciplined communication". The ECB said it was "constructive ambiguity". To panicking markets, it looked what it was: hesitation and indecision that could only fan the flames.
What we have witnessed is a mass global flight from risk and an accompanying hoarding of cash on a huge scale. It was the worst week in the financial markets since the dark days of autumn 2008 at the height of the implosion of the western banking system – itself one of the worst periods since the early 1930s. But in important respects this week was worse. At least in 2008, governments could put their national balance sheets behind their respective banking systems to restore confidence. Now the fears are more deep-seated and far harder to counter.
The markets have lost confidence that western governments can successfully manage the legacy of vast private debt and broken-backed banks without imposing huge and nameless costs. They don't know what the costs will be – perhaps a series of chain defaults on government debt starting in Europe, perhaps worldwide debt deflation, or even helplessly printing money to pay off public and private debts, so generating unmanaged and volatile inflation. But they know the costs will be huge. And unpredictable.
After all, Greece's eurozone creditors, who were part of the EU deal two weeks ago, accepted that Greece might not be able to pay its public debts in full. What about other countries in the eurozone, such as Italy and Spain, with even bigger public debts? Will their creditors be similarly hammered if the contagion spreads? And if individuals, companies and governments have collectively got too much debt that they cannot repay, whether inside or outside the euro, what prospects for the banks – and indeed any of their creditors – who lent the money? What is the extent of their writedowns or even potential bankruptcy?
The markets have known these truths for some months but have trusted that policymakers in Europe and the US also knew the risks and also how to respond. In any case, it was hoped, global growth and the steady rebuilding of western banks' balance sheets would gradually allow the world to lower its massive debts and banks to remain solvent. But events of the past few weeks have shaken that faith to the core.
The scale of the economic challenges that the western industrialised countries now confront may be impossible to handle. The markets' judgments are brutal. For example, this week yields on American 10-year treasury bonds fell to levels – 2.2% – that only make sense in a world close to falling prices and economic stagnation. Meanwhile, the yield on Italian government debt rose at one time on Friday to 6.4%, meaning that the government would have to plan for vast and deflationary budget surpluses for years just to service its debts worth more than 120% of its GDP.
On Friday evening, prime minister Silvio Berlusconi bowed to the inevitable and promised to balance the Italian budget a year earlier than his government had planned only a fortnight ago.
"No major advanced economy is doing anything to promote growth and jobs," says George Magnus, a senior policy adviser to investment bank UBS. He is right. Wherever you look, it is an economic horror story. Put bluntly, too many key countries – the UK in the forefront, with private debt an amazing three and half times its GDP, but followed by Japan, Spain, France, Italy, the US and even supposedly saint-like Germany – have accumulated too much private debt that cannot be repaid unless there is exceptional global growth.
That looks ever more improbable. Yet without growth there are only three ways out. The first is to increase public borrowing to compensate for the collapse of private borrowing. Private spending is bound to be depressed as individuals and companies lower their borrowing – so for a time exports (as long as other countries are buying) and growing public debts are the only reliable avenue to promote economic growth. But now there is a veto on growing public debt – due to the Tea Party movement in the US, the collapse in confidence in the euro and Britain's conservative government – and export demand from Asia is slowing.
The lessons from history are clear. Without publicly or privately generated growth there are only two other ways forward to pay down private debt after credit crunches: default or inflation, either containably managed or dangerously unmanaged.
What has unnerved the financial markets is that if the world cannot grow we are moving ineluctably towards these options. In the US, where the recent downward revisions to its economic growth statistics show how alarmingly weak its recovery has become, there has already been $300bn (£183bn) of private debt write-offs, according to McKinsey Global Institute's research. Now the Tea Party movement has vetoed any creative action by the federal government to stimulate growth, the pace of writing off consumer and mortgage debt can only accelerate. The impact on the American banking system, house prices and consumer confidence is bound to be serious.
In Europe the interconnectedness of public and private choices over debt is even more obvious – and being made more invidious with every hesitation by the EU's leaders about how to restore confidence in the euro. In July, the EU at last seemed to have come up with an effective response, proposing a nascent European Monetary Fund to police the economic policies of euro members and which could, alongside the European Central Bank, lend to governments and banks in trouble.
But having risen to the occasion, which heartened me, Europe is now moving at stately pace. To be told by the EU commissioner for monetary affairs, Olli Rehn (who at least broke off his holidays to engage with the crisis), that the technical work would start in September while the German government simultaneously insisted that no more need be done, reassured nobody. There is no political leadership, and worse, a paucity of original ideas about what to do even if there were.
The markets' reaction is made worse by herd effects – magnified by the many instruments, so-called financial derivatives, that have been invented supposedly to hedge and lower risks but which in truth are little more than casino chips. Long-term saving institutions such as insurance companies and pension funds now routinely lend their shares – for a fee – to anybody who wants to use them for speculative purposes. The financial system has become a madhouse – a mechanism to maximise volatility, fear and uncertainty. There is nobody at the wheel. Adult supervision is conspicuous by its absence.
What is required is a paradigm shift in the way we think and act. The idea transfixing the west is that governments get in the way of otherwise perfectly functioning markets and that the best capitalism – and financial system – is that best left to its own devices. Governments must balance their books, guarantee price stability and otherwise do nothing.
This is the international common sense, but has been proved wrong in both theory and in practice. Financial markets need governments to provide adult supervision. Good capitalism needs to be fashioned and designed. Financial orthodoxy can sometimes, especially after credit crunches, be entirely wrong. Once that Rubicon has been crossed, a new policy agenda opens up. The markets need the prospect of sustainable growth, along with sustainable private and public debt.
As the IMF's chief economist, Olivier Blanchard, has suggested, if the options are public and private default, continuing bank weakness, economic stagnation (perhaps depression), or inflation, then the least bad option is to accept inflation, but to manage it within bounds.
Since inflation will happen anyway as governments seek the least bad way out, the choice in reality is whether to accept and manage it or not. Once debt is at a sustainable level and growth has resumed, then the world's financial system can be redesigned to avoid a repeat, and price stability restored.
This is the truth that cannot speak its name: as a senior financial policy official told me, even to raise it at home or abroad merely as an issue for debate is to invite universal disapproval. But truth must be faced. Britain should provide a lead – both for its own economic fortunes and to set the new international standard. As a minimum it should announce a new programme of quantitative easing, in effect printing money; insist the Bank of England uses the money it prints to buy the broadest range of private debt; and immediately replace the 2% inflation target with a target for the growth of money GDP – so getting Britain off the hook of its unpayable private debts.
The markets have issued a stark warning. The old common sense is killing the western economy and Britain's with it. We must now act to save ourselves.
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