Why the economy can’t get real

Markets, we are told, are rebelling against the government’s irresponsible fiscal policy, not least the now-abandoned plan to abolish the 45p tax rate. If that is what they are doing, it marks a sharp change in their behaviour. For most of the past decade they have whooped with delight whenever a fantastically expensive stimulus package has been announced and gone into a sulk whenever there have been rumours that the punch bowl is about to be withdrawn.

In this Alice in Wonderland world, good news became bad and bad news became good. Why? Because bad news means greater likelihood of a stimulus package; good news means stimulus is likely to be withdrawn. And of course, the extra billions pumped into the economy through stimulus – whether it be quantitative-easing or Joe Biden’s blatant helicopter money – had a tendency to be sucked into inflated asset prices.

Maybe like a reformed gambler, global markets have finally come to the realisation that this really can’t go on. You can’t go on creating money out of thin air forever after and expect it not to end up with serious inflation. They are giving the global bookmakers – i.e. central banks – a message: save us, before we all end up broke. If markets have told us anything over the past month it is: governments and central banks, get your fiscal and monetary houses in order.

Bank rates have been rising, of course. But if anyone seriously thinks we have reached the end of financial stimulus here are a few figures to consider. Global stock markets staged a brief rally last week, apparently on the back of expectations that interest rates might peak at a slightly lower level than previously feared. In Britain, market expectations are now that the Bank of England’s base rate will peak next year at around 5.5 per cent, rather than 6 per cent as previously.

Now let’s have a look at a bit of monetary history. The Retail Prices Index, RPI (now frowned upon by the government although for decades it was the country’s principal measure of inflation), currently stands at 12.3 per cent. The Bank of England’s base rate, by contrast, stands at 2.25 per cent, having been raised by 0.5 per cent in September. The RPI last reached current levels in January 1981, when it stood at 13.0 per cent. What was the Bank of England’s base rate at that point? The answer is 14 per cent. To put it another way, in the early 1980s, when Mrs Thatcher’s then newish government was being lambasted for its harsh ‘monetarist’ policies, real interest rates were one per cent. They are currently minus 10 per cent.

We keep hearing about central banks ‘tightening’ monetary policy, that they are ‘withdrawing stimulus’, or that they are determined to do ‘whatever it takes’ to fight inflation. Yet the reality is that monetary policy has not been looser in 40 years. Never mind quantitative easing, never mind the interest rate of 0.5 per cent set in the depths of the 2008/09 economic crisis, neither of those measures can match the power of real interest rates of minus 10 per cent. We are in the midst of the grand-daddy of all stimulus programmes – the most expansionist monetary policy dreamed up by central banks in modern times.

It is extraordinary that rates of 2.25 per cent are now considered to be high. Not in 315 years of the Bank of England’s base rate – from 1694 to January 2009 – had it ever fallen below two per cent. Yet it has taken just over a decade for rates very much below two per cent to be considered ‘normal’.

This is the fundamental problem for the economy at present: it has become so drunk on stimulus that it can no longer seem to function without it. Years of easy money created the expectation that it would last forever. Investors watched as central bankers bailed out investors trapped in falling markets and assumed that they would always come to their rescue. The seminal moment in all this was in 1998 when the then-Chairman of the US Federal Reserve stuffed a bung in the direction of a failing hedge fund, Long-Term Capital Management. A government rescue was justified, he argued, because failure to do so could result in serious collateral damage to the wider US economy.

But if it was true that a collapsing hedge fund could inflict such damage on the economy that it required a government bailout, why tolerate the activities of hedge funds in the first place? If government is going to intervene in the workings of capitalism surely it should do so before a hedge fund had the chance to take down the rest of us with it. But that is not how things panned out. Over the following decade, the bets placed by financial institutions got bigger and bigger and neither Greenspan nor other government officials thought it appropriate to intervene – until, that is, the financial system suffered an even bigger blow-out in 2008. At that point, we had even bigger intervention. Lehman Brothers was allowed to go to the wall, but other banks were bailed out.

The West no longer has a laissez-faire economy nor a socialist one but a bizarre lop-sided hybrid one characterised by laissez-faire on the way up – and intervention on the way down. Or, as some have put it, governments have nationalised profits and socialised losses.

Following 2008/09 we briefly went through a period in which it seemed that government would not tolerate another collapse. But promised legislation either never happened or it was imposed then whittled away on the basis that it was holding back the economy. The ban on bankers’ bonuses is a prime example. Recently lifted by Kwasi Kwarteng, it is now damned as a piece of EU meddling which has held back the banking sector. It seems rather forgotten why it was imposed in the first place: to try to reduce the incentive for bankers to take excessive risks. True, it might not have been effective, and banks simply upped salaries instead. But doesn’t it deserve even to be acknowledged why it was introduced and questions asked as to what other means might be employed to prevent financial gambles bringing down the economic system in future?

It isn’t just banks and stock markets which became caught up in the bailout culture. Housing markets became swept up in it, too. The 2008/09 crisis had property loans at its heart. Banks had been advancing long-term loans funded by short-term borrowing. When the short-term finance dried up, the loans were doomed. Not only that, ‘secured’ loans equivalent to 95 or 100 per cent of the value of a property rapidly became unsecured as soon as property values fell. Come the crash, and banks didn’t want to advance such high loan-to-value mortgages. So what did George Osborne do when he felt like giving the housing market a boost in 2013? He got the taxpayer to underwrite 95 per cent home loans instead, under his Help to Buy scheme. If property values fell and loans went bad, the taxpayer would suffer the first 20 per cent loss of value, and the bank only lose if values plunged by more than that.

Help to Buy did more than expose taxpayers to potential losses; it seeded in the minds of property investors the idea that government would always bail them out, always intervene to prevent a slide in house prices. The result was an immediate resurgence of house price inflation, thanks not just to first time buyers (whom Help to Buy was designed to help) but to renewed interest from buy-to-let investors, too, who calculated theirs was an investment which couldn’t go wrong. First time buyers who got in early were able to afford properties they might not otherwise have been able to afford, but this came only at the cost of making life even more difficult for future buyers.

That is the world of perpetual stimulus that we have been living in for the past quarter century. But is it really coming to an end as some seem to think? Hardly. The bailouts just keep getting bigger and bigger. Here’s a remarkable fact from the first year of Covid, 2020. It turned out to have the lowest number of corporate failures in Britain for 30 years – in spite of the economy collapsing by nearly a fifth in the second quarter. Why? Because government emergency schemes – loans, handouts, the furlough scheme -- didn’t just save businesses which had been undermined by Covid and lockdowns; they helped keep afloat businesses which would have been doomed to go bust in a covid-free 2020.

But the £70 billion furlough scheme now looks small beer. The Bank of England had to offer to spend almost as much last week – £65 billion – to buy up long-dated government bonds to save pension funds massive losses as interest rates rose. Liz Truss – who on paper is the most free-market Prime Minister we have had in three decades – has just unleashed the biggest bailout package of them all: a plan to subsidise all domestic energy bills for the next 18 months, at a cost which could exceed £100 billion. Markets, interestingly, didn’t seem to have a great problem with this, unless they were too distracted by the Queen’s death – the scheme was announced by the Prime Minister in the Commons on 8 September, 15 days before the mini-Budget. Yet they did seem to be unnerved by the idea of tax cuts.

It isn’t hard to wonder whether stock markets – supposedly the expression of red-blooded capitalism – are not actually a little afraid of a smaller state. Shrink the state and we might enter a world where governments do not react by trying to bailout falling markets. Buying shares might become a whole lot riskier; the rewards might become lower if central banks stopped pumping up asset values by printing money. Property-owners may have to face the prospect that the value of their home might actually be allowed to suffer a prolonged fall.

Governments, central banks and speculators are engaged in a kind of unspoken conspiracy in which the state uses its might to temper the risks of the market and indeed to boost returns. The price, though, is inflation and soaraway public debt. The losers are those who do not have assets and who lack the means to acquire them.

We would have healthier corporations and public finances in the long run if capitalism were allowed to run its course, if lousy businesses were allowed to go bust and their employees and assets reallocated to more productive businesses. We would have better-financed public services, too, if taxpayers weren’t forced to service the debts of free-spending governments of the past. In 2022/23 debt interest will cost UK taxpayers £83 billion – more than half the NHS budget.

How would we get there? Trouble is that there is always some short-term justification for intervention in the markets. There are jobs to be saved. Subsidising our energy bills will help bring down the inflation rate. Helicopter money will help avoid recession. Buying up bonds will help to save pension funds from going bust. In the longer term, government-underwritten capitalism threatens to turn us all into paupers – ever more dependent on the state, while the state itself becomes ever more burdened by debt.