Tuesday, January 20, 2009

Why Bitter Medicines Need to Be Swallowed

It was Keynes who noted the Paradox of thrift. In troubled times, people took a seemingly rational step to save more. From a personal perspective this decision to save more in a recession makes sense - savings can help to compensate for loss of your job.

The problem is that if consumers save more, it leads to a decline in consumer demand and output. The rise in savings causes a decline in spending and the recession is made worse.

Keynes theory is that the government should borrow to offset (at least some) of the rise in private sector saving. This government borrowing will not 'crowd out' the private sector it will just mop up some of their excess savings in the private sector. Therefore the economy will recover quicker and as the economy recovers tax receipts will rise to reduce the borrowing.

But wasn't it Borrowing and a lack of saving that got us into this problem in the First place?

Many times, I read comments from people who say something along the lines of - This mess was cause by excess borrowing - so why are we trying to borrow more to get out of the mess? Furthermore, the banks don't deserve help. If anyone deserves help it is long suffering virtuous savers.

In the boom years, private sector borrowing did increase to excess levels. In the summer of 2008, the UK savings rate fell to less than 1%. This is indicative of an unbalanced economy. Many problems would have been avoided if savings had been higher and borrowing lower. The credit bubble has proved very damaging. However, the past is gone and we can't change it. The question is what do we want to happen now?

In the medium to long term, a rise in the savings ratio is desirable. Less reliance on borrowing and consumer led growth would be beneficial for the economy.

The thing is we do want an increase in savings, but not just at the moment; a drastic rise in savings (and hence fall in spending) would be very damaging with the present state of the economy. In a recession, a sharp fall in spending and decline in investment could make a recession very deep. The saving ratio will rise in the recession, but we don't want it to rise too fast too soon.

In other words higher savings would be beneficial, but, we don't want to go from one extreme to the other. If we went from a very low saving ratio to a very high ratio it would be damaging to the economy. The government and MPC are trying to moderate the fall in consumer spending. There is logic behind the policies even if it rather galling that we appear to be helping people who don't 'deserve' it.

Why Should the taxpayer guarantee bank loans. Surely the banks don't deserve more taxpayer guarantees?

The banks probably don't 'deserve' loan guarantees. Their business and financial acumen has shown to be quite poor in the past few years. But, we don't want to see to small firms go out business just because they can't get access to short term lending.

It is more important to do the right thing for the economy rather than taking delight from a collapse in the financial sector which would hurt everyone much more.

In other words low interest rates, loan guarantees and tax cuts may prove the least unpalatable medicine. That is not to say there aren't risks such as moral hazard, subsidising inefficient firms. But, problems have to be put into perspective.

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