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Time to end the age of malinvestment

19 June 2012

3:45 PM

19 June 2012

3:45 PM

Chancellor George Osborne’s latest idea to stimulate the economy is to offer the banks money (£140bn) to lend to firms and households. The idea is that families will borrow more and spend the extra cash on goods and services, while firms will borrow more to invest in providing these goods and services. With one bound, the economy is free? Not quite.
 
Interest rates are already at rock bottom, where they have been for almost two years. Larger firms are actually sitting on mountains of cash that they are reluctant to invest because they do not see any sign of life coming back to the economy any time soon. Small investors and pension funds have plenty of money that they could lend to businesses if they chose to. Households have been scaling down their borrowing or adding to the piles of money under the mattress, fearful that they might be hit by unemployment or an unexpected bill. Even the banks have been ‘strengthening their balance sheet’ — that is, keeping more safe assets, including cash, to hand. They were burnt by the 2007/08 debacle just like the rest of us. And all that new money generated by the Bank of England through successive waves of quantitative easing has to be floating round the economy somewhere.
 
So the problem is not that the UK is short of cash to spend and invest, but people’s willingness to spend and invest it. Small businesses complain that what is putting them off borrowing and investing more is the high cost of loans — and the more onerous conditions that the banks are imposing in order to make sure they are lending to people who can actually repay them. With the prospects for growth so poor across the world, and the strong possibility of complete turmoil from a disintegrating eurozone, it is perfectly sensible for people to be cautious. If there is anything at fault here, it is the fact that there is far too little competition in banking. Indeed, even less than there was before the crisis, thanks to Gordon Brown pressing Lloyds to merge with HBOS and the integration or closure of several of the old building societies. Britain’s banks operate like a cartel and it is no wonder that they charge high prices, pay themselves well and give customers a poor service.
 
But there is another reason why we should be sceptical of the chancellor’s stimulus plan. The root of the financial crisis was cheap and easy credit. The American government, wanting even the poorest to be homeowners, pressured the banks into handing out sub-prime mortgages. Federal Reserve Chairman Alan Greenspan, who wanted to leave office on a high note, kept interest rates down and created more new money. The Bank of England followed suit. Gordon Brown congratulated himself on engineering a boom — but it was a boom built on artificially cheap credit. 
 
Such fake booms cannot last, of course. Eventually reality reasserts itself and the boom turns to bust. The trouble is that people have spent years buying, and investing in, luxuries that nobody can now afford. All those big houses have to be sold at a loss (as people in Ireland and Spain know to their cost), cars go unsold, holiday companies go bust. After the party of the last decade and a half, it all feels like a bad hangover.
 
You can try to lift your spirits with the hair of the dog. This is UK and US government policy. Make credit even cheaper and more plentiful, print as much money as you can, raise public borrowing to record levels, and hope that things will revive. The trouble is that this policy simply prolongs the recession. Productive resources are in the wrong places, producing the wrong goods — goods that people were happy to buy when things were booming, but which they cannot afford (or are reluctant to commit to buying) today. Artificially cheap credit perpetuates this.
 

The painful truth, as economists of the Austrian School will tell you, is that the cure is the problem. The problem was cheap credit that caused massive malinvestment that went on year after year after year. Frankly, those bad investments have to be written off, so that the money tied up in them can be released in order to be invested in things that we and our international customers might actually want to buy these days. Easier credit that makes it possible for firms to borrow more or roll over their debts will simply prompt them to continue investing poorly. And where does that get us? A hair of the dog does not actually cure the hangover.


Eamonn Butler is Director of the Adam Smith Institute.


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