When everyone in the world stops partying at once

by John Rapley

Save in good times, spend in bad. That was the basic advice given by John Maynard Keynes to governments. Use fiscal policy to smooth over business cycles. Drain money from an overheating economy with spending cuts, then pour it back in when a recession loomed.

Keynes' advice was practically dogma back in the 1950s and '60s. Not only most governments, but indeed most economists, swore by Keynesian techniques then. But sadly, politicians ended up implementing only one part of the equation. They spent in bad times. Then they spent in good times. By the 1970s, excess demand caused high inflation. When recession hit the industrial economies during the two oil shocks, they faced a problem Keynes had not reckoned with: stagflation - rising prices amid declining demand.

There was no obvious solution. Then along came the monetarists, led by Milton Friedman. They said Keynes had got it all wrong. Monetary policy, not fiscal policy, was the most important lever available to government. And they maintained that inflation, not unemployment, was the principal threat to market stability.

The basic purpose of policy was the same: to smooth over the business cycle. But the toolkit was new. When inflation was high because demand was excessive, the central bank would lower demand by raising interest rates, drawing money from spending to saving. When inflation was low because demand was deficient, it would then release money from savings by dropping interest rates. Central banks were to be independent, and governments were to get out of the economy.

Bitter medicine

The medicine was bitter. The Reaganite and Thatcherite revolutions continued a trend that had already started in some developing countries, of austerity during a recession. But it worked: prices came back down, economies stabilised, and people slowly got back to work.

Then, sadly, it was the turn of the monetarists to stop taking their own advice. In the '90s and 'noughties', asset prices began going through the roof. But central bankers, especially in the US, ignoring the exceptional cyclical features that were keeping consumer prices low (in particular the imported 'disinflation' of China), maintained it wasn't a problem in the 'real' economy. Interest prices remained low. Bubbles started inflating and they looked the other way.

By then, the public debt of the developed countries was on a secular upward path. The boom years had brought relief to some countries, but the underlying trends pointed towards long-term debt accumulation. So when the bubbles began bursting and crises hit the world economy, governments rushed back into the arms of Keynesianism. But very quickly, their debt loads shot to record levels. They grew as nervous as a rock climber who looks down.

Recession fears

So here we are. Europe is sinking back into recession, America is slowing. Consumer demand is low since everyone is rushing to pay off debts. Because demand is low, nobody is investing. Interest rates are at record lows. Governments should take advantage of them to borrow cheaply, and restore demand.

But either because they have too much debt already and can't, or because they want to gain a march on their rivals and export their way to growth by cutting costs, everyone is cutting back. From London to Washington to Berlin, governments most everywhere in the developed world are determined to get their deficits under control. But as their economies sink further into recession, they will have to cut further yet, and demand will only worsen.

During the boom years, some developing countries, especially in Latin America and Africa (let's not discuss the Caribbean, shall we?), had got their budgets back into balance. They can now borrow. But it is a bit much to hope that they can plug the gap vacated in the developed economies. They can stay afloat, but they may not be able to do much for the rest of us.

I don't envy Peter Phillips his job. His kitty is empty but the need is huge, and he can't look abroad for much help. The best support everyone can give him is to listen carefully to his concerns, because he'll need all the help he can get.

John Rapley is a research associate at the International Growth Centre, London School of Economics and Political Science. Email feedback to columns@gleanerjm.com and rapley.john@gmail.com.