Sunday 7 August 2011

What's gone wrong with the economy

The simple answers, along the lines of "the bankers did it" are wrong.  The highly technical answers are confusing at best.  So here's my attempt at making sense of it.

1) The global economy is in an unstable state.  Firstly because the USA has been running a large negative trade balance since the late 90s (so has the UK).  Obviously this can't go on forever, and the longer it runs for the more strained the system becomes.  And secondly because the concept have having independent countries sharing a currency - the Euro - can work only if there's a sufficient degree of economic convergence between them.  The Maastricht Criteria were designed to ensure that would be the case, but they haven't proved sufficient, even for countries which, unlike Greece, didn't lie about having met them.

2) The USA (and UK) enjoyed strong growth for ten years up to the banking crisis (with a blip when the internet bubble burst).  This growth was fuelled by a credit boom - bankers found new ways, such as mortgage-backed bonds, to recirculate money.  Under some measures, this was an increase in the money supply, under others it was an increase in the velocity of circulation of money, but either way it gave us more money to spend.  Monetarists, looking at the Equation of Exchange, will tell you that that will encourage inflation, but instead the Chinese (and others) kept prices down by selling us more stuff cheaper.  See (1).

3) The banking crisis brought the credit boom to an abrupt halt.  Governments could compensate for it by increasing the money supply - Quantitative Easing - but they haven't done it on anything like the scale that would be necessary.  It takes courage they haven't got to take such unprecedented steps, but it took none to sit back smugly while the credit boom raged and the good times rolled.

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