World leaders play war games as the next financial crisis looms
Global community can see dark forces gathering but lacks the weapons or the will to tackle them effectively, writes Larry Elliott
Larry Elliott, economics editor
Press the uniform. Check the battle plans. Call up the reservists. Arm the bombers and refuel the tanks. Field Marshal George Osborne is going on manoeuvres.
On Monday in Washington, the chancellor of the exchequer will see if Britain is ready for war. A financial war that is. Along with his allies from the United States, he will play out a war game designed to show whether lessons have been learned from the last show, the slump of 2008.
Like all commanding officers, Osborne thinks he is ready. He will have general Mark Carney at his side. He has studied the terrain. He has a plan that he insists will work.
Let’s hope so. Because the evidence from last week’s meeting of the International Monetary Fund in Washington was that it won’t be long before the real shooting starts. The Fund’s annual meeting was like a gathering of international diplomats at the League of Nations in the 1930s. Those attending were desperate to avoid another war but were unsure how to do so. They can see dark forces gathering but lack the weapons or the will to tackle them effectively. There is an uneasy, brooding peace as the world waits to see whether lessons really have been learnt or whether the central bankers, the finance ministers and the international bureaucrats are fighting the last war.
Here’s the situation. The years leading up to the start of the financial crisis in August 2007 were like the Edwardian summer in advance of the first world war. All seemed serene, but only because of an unsustainable build-up in debt. There was a structural shift in power and income share from labour to capital. Rising asset prices compensated for real income growth.
Then came the crisis, which was long and costly. Once it was over, there was a strong urge to return to the world as it was. Countries wanted to return to balanced budgets and normal levels of interest rates, just as they had once hankered after going back on the Gold Standard.
But that proved impossible. Six years after the global banking system had its near-death experience, interest rates are still at emergency levels. Even attaining the mediocre levels of activity expected by the IMF in the developed countries requires central banks to continue providing large amounts of stimulus. The hope has been that copious amounts of dirt-cheap money will find its way into productive uses, with private investment leading to stronger and better balanced growth.
It hasn’t happened like that. Instead, as the IMF rightly pointed out, the money has not gone into economic risk-taking but into financial risk-taking. Animal spirits of entrepreneurs have remained weak but asset prices have been strong. Tighter controls on banks have been accompanied by the emergence of a powerful and largely unchecked shadow banking system. Investors have been piling into all sorts of dodgy-looking schemes, just as they did pre-2007. Recovery, such as it is, is once again reliant on rising debt levels. Central bankers know this but also know that jacking up interest rates to would push their economies back into recession. They cross their fingers and hope for the best.
Meanwhile, the legacy of the slump has been high levels of unemployment and growing inequality. In those economies where jobs have been created, such as the UK, they have tended to be of the low pay, low skill and low productivity variety. Profits have recovered; real incomes have not.
Christine Lagarde, the IMF’s managing director, says inequality must be tackled. The Fund has produced papers showing that a more even distribution of income and wealth would be good for growth. The words “shared prosperity” were on everybody’s lips in Washington last week.
But as some sceptics pointed out, so far the fight against inequality is currently a phoney war. Lagarde talks a good game, but the advice her organisation dispenses to individual countries has not really changed. There were four things that ensured shared prosperity in the 1950s and 1960s: strong trade unions; redistribution through the tax system; higher public spending; and curbs on the financial system. Apart from suggesting that some countries, such as Germany, might care to spend a bit more on infrastructure, the Fund is not really in favour of any of them. The message, therefore, is clear enough. Lagarde et al are worried about inequality. But they are not yet worried enough to do much about it.
This is where the comparison with the 1920s and 1930s gets scary. The problems created by the first world war were never properly dealt with, and it was only after the Great Depression and a second conflict that policies changed and global institutions were made fit for purpose. There is a real danger of history repeating itself.
The Fund, for example, knows that something is going badly wrong in Europe but is powerless to do anything about it. In the rest of the world, IMF policy is normally governed by what the US Treasury wants. In the euro zone, it is governed by what Germany wants. And what Germany wants is to turn the euro into the modern equivalent of the Gold Standard, with every country running balanced budgets. What Germany is getting is a eurozone in semi-permanent recession. There are alternatives to the status quo: full political union; break-up; a German Marshall Plan for Europe; dumps of helicopter money. Eventually one of them will be tried.
Similarly, the IMF is alert to the threat of another financial crisis. It knows that much of the cash created by central banks has found its way, via the shadow banking system, into emerging markets and developing countries. It knows that investors are complacent about the risks. It knows that in a rush for the exit, many of these investors would be badly burned.
There is, though, no mechanism for regulating these financial flows, just as there is no mechanism for dealing with countries when they go bust. The vulture fund case against Argentina should be the trigger for a sovereign debt bankruptcy system. Instead, the global community is sleepwalking its way towards a developing country debt crisis.
But for the time being, it is easier to avoid doing anything. The rich can enjoy their Great Gatsby lifestyles. Multinational corporations can strip poor countries of their commodities and pay their taxes elsewhere, if at all. Living standards can continue to be squeezed. Debt levels can continue to rise.
Only a real scare, as with Ebola, will lead to meaningful action. Until then, though, the Fund can sit behind its Maginot Line and Field Marshal Osborne can play his war games. But be in no doubt: our chancellor is less Monty in the desert than Neville Chamberlain declaring peace in our time.