Crisis has laid bare economic weakness

In: Uncategorized

18 May 2009

The following comment by me appeared in the latest Fund Strategy (18 May).

A fundamental problem with economic discussion is its naturalism. It wrongly assumes that the human world works in a similar way to the natural one.

This error is apparent in the discussion of ­pending economic recovery or, to use the awful phrase, “green shoots”. It assumes that the economic cycle moves like that of a pendulum. All that needs to be done is track the path of the pendulum and it is possible to work out where the economy will move next.

Therefore, a slowdown in the rate of decline of GDP is seen to signal that a start to the upward section of the cycle is imminent.

But in the real world the economy does not follow the simple harmonic pattern of a moving pendulum. Economic cycles can be short or drawn out. Declines can be moderate or severe. Numerous factors can influence the way in which the economy develops.

In recent years the economic cycle seems to have become more muted. This is what was meant by phrases such as “the great moderation”, as used by Ben Bernanke, the chairman of America’s Federal Reserve.

Although such talk has gone out of fashion with the global downturn, it still has some merit. It looks as though the underlying rate of growth of the developed economies has been slow in recent years and is likely to remain so in the future.

With the benefit of hindsight, it is clear that a huge surge of credit artificially bolstered economic growth rates in the years running up to the crisis. The underlying rate of growth was much slower than the headline figures suggested.

Similarly, the future rate of growth in America and Britain is also likely to remain slow. From this perspective the financial crisis can be seen as a mechanism for bringing the underlying rate of growth and the headline rate closer to together. Once the credit bubble burst, the weakness of the real economy was brutally exposed.

It is not that America and Britain are inevitably destined to suffer low growth for ever more. But until they tackle their problems of a chronic lack of innovation and investment they are likely to remain caught in the atrophy trap.

Despite the hype about America’s “new economy” in the 1990s, these problems remain a long-term weakness that needs to be addressed. In Britain the problem is even more severe.

Short-run sets of data reveal little about the character of the economy. Many factors need to be taken into account to work out its likely trajectory – including the impact of human intervention. But it is the long-term trends that are important to identify, rather than small variations in data that is inevitably imprecise or ephemeral.