Playing the contagion blame game

This is my latest column for Fund Strategy

It is another one of those conjurer’s tricks so beloved of politicians. This one could be called the “contagion evasion”. Point furiously to the danger of financial contagion coming from other countries as a way of drawing attention from economic problems at home.

All of Britain’s main political parties are guilty of playing. When it suits them they are quick to blame others, particularly foreigners, for Britain’s economic woes. Indeed, the habit of criticising international bankers for the country’s economic problems, which I have written about several times before, can be seen as a variation on the theme.

David Cameron recently played the contagion game to great effect in a supercilious speech on the eurozone’s troubles. The aim was not only to make him sound like a statesman but also to suggest that the region’s troubles were substantially responsible for Britain’s economic weakness.

“The eurozone is at a crossroads. It either has to make-up or it is looking at a potential break-up,” he said.

“Either Europe has a committed, stable, successful eurozone with an effective firewall, well capitalised and regulated banks, a system of fiscal burden sharing and supportive monetary policy across the eurozone. Or we are in un­charted territory which carries huge risks for everybody.”

Labour, of course, was happy to play the contagion evasion card when it was in charge. Essentially its argument was that it had put the economy in a strong position to avoid “boom and bust”, only for foreigners to derail its clever plans. Alistair Darling, then Chancellor of the Exchequer, put it this way at the Labour party conference in 2009: “In the face of such unprecedented global turmoil, no one government could hold back this economic tidal wave.”

Of course, there is always an element of truth in such arguments. Substantial economic troubles outside Britain are likely to have some impact on the domestic economy. But the politicians’ trick is to shift most of the blame abroad, ignoring the fact that if Britain’s economy were stronger, it would be more resilient in the face of external trouble.

Even the headline figures for GDP growth call the attempt to blame outsiders into question. According to data from the IMF, the British economy has performed worse than the global economy and even the eurozone as a whole in recent years (see graph).

The discussion of contagion goes back at least as far as the Asian financial crisis of 1997-98. Back then, Thailand was hit by a run on the baht followed by market panic in Indonesia, Malaysia, the Philippines and South Korea.

Talk then, both in the media and by western politicians, was of “Asian contagion” or the “Asian flu”. The idea was that trouble in relatively small Asian markets and economies could somehow damage the West. Newspapers and television programmes carried lurid graphics showing the “infection” spreading from the East.

Few pointed out that the panic in Asia was itself largely an expression of economic weakness in the developed world. Western capital had poured into Asia in a desperate attempt to take advance of eastern dynamism, only to withdraw in a panic at the first sign of trouble.

Fortunately, some experts took a sceptical view of claims of contagion. Michael Bordo, an economic historian at Rutgers university in New Jersey, made an important distinction between transmission and contagion. He argued that transmission was possible when two neighbours or trading partners shared similar weaknesses.

But he rejected the idea of ’pure’ contagion: “There is little evidence for such a phenomenon, although it has been given as a key reason for massive international rescue operations.” (“Currency Crises (and Banking Crises) in Historical Perspective”, Research Report No 10, 1998, Stockholm School of Economics.)

Although the circumstances today are a little different from those of the late 1990s, the same general scepticism should apply. Even if economies suffer an external shock, there is almost invariably a strong domestic element to the troubles they face. In Britain’s case, there are several factors to bear in mind.

• A low level of capital investment by firms. For example, Chris Dillow, a former City economist, recently used official figures to show that capital spending by non-financial firms was at its lowest share ever – just 65.7% of retained profits. Since capital spending is the motor of future growth, the lack of such investment is a key weakness.

• A low level of research and development. Closely related to capital investment. Britain was slightly below the European Union average and well below America, according to the latest figures from the Organisation for Economic Cooperation and Development.

• A particularly high dependence on financial services. Clearly, income from the financial sector can be lucrative but it can also be volatile and vulnerable to competition. As late as 2007 the then chancellor, Gordon Brown, said in his Mansion House speech that the City had created “an era that history will record as the beginning of a new golden age for the City of London”. By the following year it was in the midst of a crisis from which it has yet to fully recover

• A technocratic system of economic management. An economy where many key decisions are made by technocrats, such as the Bank of England’s monetary policy committee, with little scope for democratic involvement. As I have argued previously, such a system makes the economy more rigid than it would otherwise be – although admittedly, Britain’s system of technocratic rules is not quite as rigid as those for the eurozone.

Rather than whinge about “contagion”, it would be far better if Britain’s politicians created a framework to tackle economic challenges at home.