LONDON – We all know how the global economic crisis began. The banks over-lent to the housing market. The subsequent burst of the housing bubble in the United States caused banks to fail, because banking had gone global and the big banks held one another’s bad loans. Banking failure caused a credit crunch. Lending dried up and economies started shrinking.
So governments bailed out banks and economies, producing a sovereign debt crisis. With everyone busy deleveraging, economies failed to recover. Much of the world, especially Europe, but also the slightly less sickly US, remains stuck in a semi-slump.
So how do we escape from this hole? The familiar debate is between austerity and stimulus. “Austerians” believe that only balancing government budgets and shrinking national debts will restore investor confidence. The Keynesians believe that without a large fiscal stimulus – a deliberate temporary increase of the deficit – the European and US economies will remain stuck in recession for years to come.
I am one of those who believe that recovery from the crisis requires fiscal stimulus. I don’t think monetary policy, even unorthodox monetary policy, can do the job. Confidence is too low for commercial banks to create credit on the scale needed to return to full employment and the pre-crisis growth trend, however many hundreds of billions of whatever cash central banks pour into them. We are learning all over again that the central bank cannot create whatever level of credit it wants!