Thursday, October 30, 2008

Will interest rate cuts and Keynesian spend haul back Western Economies from recession?

John Maynard Keynes was in vogue almost 100 yrs during the Great Depression when he suggested that because the equation for investment was private + public, if private investment fell, it was incumbent on the government to fill the gap. Later last century, guys like Milton Friedman, Phelps trashed his theory arguing that a market could perform efficiently if rational man was left to hid devices. Now with the banking system in ICU, he is back in vogue again and govts as varied as US, UK, Japan and Germany are looking to spend their way out of the looming deep recession.

But will this do as hoped and prevent these economies from a deep recession. Not if history is anything to go by. In the late 80s, the Nikkei was at around 40,000 (contrast with today's close of 9,000), real estate prices were stratospheric (average house prices in Tokyo were $2m). With such over-heating and everybody putting pressure on Japan to cool its economy, interest rates (that underpinned much of the bubble like today) were raised. And the wheels came off the economy and the Nikkei. The bear lasted almost 14years. This was despite interest rates being cut to and remaining at zero for years; massive gova spending in all kinds of fancy schemes.
The main problem was that low interest rates couldn't be passed onto consumers because the banking system was broken with banks saddled with bad debts, undercapitalised due to the same as well as decimated shareholding portfolios. 2ndly, up until this bear, Japan had been a job for life type of economy. Job insecurity made consumers save more despite zero interest rates!

Today in the West, the economies are in the main driven by consumer spending. Consumer spending has been financed by cheaply available credit (in form of credit cards and overdrafts) and home equity financing. Both have now dried up as banks seek to aggressively reduce their balance sheets. Home equity apart from being a source financing, has been a source of security in the same way job security was in Japan. Therefore this is where Western economies must concentrate their firepower.

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