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Interest rates are a signalling mechanism. When the US Federal Reserve cut interest rates to 1% in 2003, and held it for a year, that was a signal for a boom. That became a massive bubble that is now at the centre of all the problems in the global economy. Getting interest rates down to those levels sends all the wrong signals.
The good news is that people are sick of the signals, and won't respond in the same way.
Second, getting interest rates down to zero is counter-productive. It takes away from the vast bulk of the population who actually save money. Meaningful interest rates have a compound effect on people's wealth, and the irony is that once you go to zero interest rate, people have to save more to compensate for the loss of the compounding effect.
The Japanese proved that over the past 20 years, a zero interest rate policy becomes counter-productive. You also signal to business that we are in deep, deep trouble. When you do that, businesses cut capital expenditure, cut expansion plans, stop doing things, and they save more.
The whole notion that zero interest rates get people to spend is not supported by evidence or theory. That's about the interest rates.
The second aspect of the policy response is the bailout of banks and insurers. Again, this is a wrong-headed approach. If the government bails out banks and then says that as the major shareholder, it will get the banks to lend, it sends a message to the other private banks that you have a massive state-owned competitor that you cannot compete with. 'We're going to going to lend, we don't care whether they are bad loans because the government (or the taxpayer) takes the hit, we can undercut you every turn of the way, because the government carries the can, we can take business away from you because we don't need to worry about profitability.'
This makes the rest of the banking system less profitable, which is terrible news when banks are in trouble. Secondly, if you are a shareholder in any bank in the private sector, you are an idiot because you are holding a company that can't compete with a giant competitor. So, share prices of banks fall, and the profitability of banks in the private sector falls. That's a terrible position that central banks and governments are taking right now.
When they nationalise a bank, they should stop it from being able to compete with other banks. All that banks should be able to do is take deposits and buy government treasuries. Actually, India did exactly that in the 1970s and 1980s.It effectively created narrow banks that were not allowed to compete with good banks. People have talked about the Swedish model, and various other things. The Indian model is just about as good as any other...
And then we have this stimulus package, which is all about spending. But what if the problem is too much spending?
But when spending falls off the cliff, is it wrong to lift it up in the short term so it falls gradually over the long term?
Sure, spending has fallen off sharply. The thing about gigantic booms is that they result in gigantic busts. We can understand why governments feel the need to soften the blow. The question is whether in softening the blow you prolong the pain. If the economy were allowed to take a massive hit in the first instance, it would be up and running quickly. The alternative is to take a series of hits over a series of years -- and see sub-trend growth for a long period.
That is the choice, and at the moment, the choice of the government is for sub-trend growth for a long period.
So, is the overall policy response doomed to fail?
I think it's been poor so far, and it's getting worse rather than better. It's not considered the done thing to criticise the new President who is in his honeymoon period and is a messiah. The fact is he is bringing back pretty extreme socialist policies in America.
The tax increase he has signalled is indicative. Effectively, for better-off Americans, the marginal tax rate on high levels if income will move from somewhere over 30% to over 60%
Corporate taxes will go up. The notion of a green cap-and-trade carbon revenue... is a cool word for taxation.
Americans are going to move towards a society that is much less vibrant and slower-growing than it has been for the past 50 years. Their entrepreneurs and wealth-creators will leave.
In the short term, can Americans spend their way out of this recession?
That's the great dilemma. Do we really want them to spend? What we want them to do is get back to comfortable household balance sheet levels so that their spending patterns, going forward, are sustainable. If we don't get that, we have just a continuation of the problem.
So, what's the best way to clear household balance sheets? A lot of the debt is going to be defaulted on, which is bad news for the banking system. But it will reduce debt levels.
The other way to reduce debt levels and repair balance sheets is to cut taxes as hard as you possibly can. Instead of spending all this time agreeing on a spending programme with 8,600 earmarks for spending by Congressmen on their pet projects, across-the-board tax cuts and simplification of the tax system would give people their own money back and allow them to repair their balance sheet and wealth much more quickly.
