Over the past 7 years we have had three huge boosts administered to the economy. The first of these is interest rates, which have been kept exceptionally low in every single developed economy across the world. According to the vast majority of standard economic theory negative or very low real interest rates for this long should have resulted in a rapid return to expansion in the economy long ago. It isn't supposed to take 7 years of virtually free money for growth to emerge and for it then to look weak and insecure.
This is even more true of the second major counter cyclical measure adopted by many countries. Money has been printed on a scale that is unprecedented in history. The UK has done this to the tune of £375 billion, the US by around $4,500 billion and, after a lot of dragging of feet even the EU has adopted the policy and is in the process of printing 1,100 billion euros. Theory states that printing money out of thin air on this scale should lead to runaway inflation. Instead the UK is experiencing deflation and with every passing month the US government decides that inflationary threats are not emerging as rapidly as they feared, or indeed at all.
Finally there is the stimulus of what is called the automatic stabiliser. When economies slow the government collects less revenue and pays out more in benefits and this means it injects a huge stimulus into the system in a way that should help to counteract the slowdown. After 7 years of running a deficit budget the UK government is still doing this to the tune of some £70 billion a year. By now the economy ought to be bouncing back really strongly. Instead it feels more like a temporary pre election boom is starting to run out of steam.
The explanation for the failure of these stimulus measures to work effectively is, I believe simple. You can't achieve anything by pushing on a piece of string. You can make money as cheap as you like but you can't force people to be confident enough to borrow it and to invest. You can print money and use it to buy dodgy bonds from banks in the hope that this will provide them with lots of liquid assets. But you can't make them lend those liquid assets out at reasonable rates to companies who want to expand. If the banks choose to then they can take every penny you give them and use it to rebuild their balance sheets and to lend to people who will buy shares in existing companies driving up the stock market or buy houses at sky-high prices but be very reluctant to take risks on new business ventures. Finally you can hold off from cutting benefits or raising taxes before an election because you know that it would cause a dramatic economic slowdown that would see you out of power but you can't stop ordinary people deciding that now is a risky time to buy a new telly because their job is at risk or they are working part time on minimum wage zero hours contracts for two different employers neither of which they can rely on.
Confidence has gone and when people feel insecure about the future they change their patterns of behaviour. In good times a lot of business people are desperate to get access to cash and to invest it in developing new products and bringing them to the market. When they are worried they tend to keep hold of their cash and build up their reserves.
As with so much of modern economics the behaviour of banks is critical in this. If they decide to keep very low margins of liquid cash and to lend out as much as they can then not only do they make spectacular profits but they create a huge amount of new economic activity. The people they lend the money to spend that money and it ends up back in a bank who then proceeds to lend it out again as quickly as they can. Effectively banks create money and keep people in work.
When the process goes into reverse it has some horrible side effects. If banks keep as much money as they can in their tills and only lend out cash reluctantly and slowly then this is one of the major triggers of recession. The move from bank profligacy to bank penny pinching is, in my view, the main mechanism which moves an economy from growth to recession.
In these circumstances it is extremely hard for any amount of stimulus from the government or the central bank to achieve a strong impact on the real economy. They can pump money in but the banking system and the private sector will simply absorb it and squirrel it away. Without confidence stimulus results in boom in share prices and house prices and very little change in the rate of investment. (For economists what I am arguing is that MV=PT and what has happened is that governments are increasing M only to find that V has slowed dramatically).
What is required in times like this is for the government to start investing directly in long term sustainable projects instead of hoping that the free market will sort everything out by some magical mystical process that doesn't exist outside of the blind faith of extreme zealots. For example, if there is a problem over house building happening far too slowly and the wrong type of houses being built then the government needs to invest directly in a major programme of building affordable homes. If there is a problem over some of our industries losing money, laying off workers and closing down then the government needs to invest directly in helping to create new jobs and new industries. Like solar energy, health technology, new products based on discoveries like graphene and a strong programme of scientific investigation and of development of science into successful new technology. If there is an imbalance between opportunities in the north and the south then invest directly in major infrastructure projects in the north. Create a northern powerhouse by seriously equalising investment per head between London and the rest of the country rather than via talking a lot and spending very little.
The money to achieve this is actually very easy to find. When interest rates are near zero the national government can borrow money for a genuine long term investment very cheaply. Provided they pick something which actually helps the economy long term such borrowing is perfectly sound and can easily be paid back. It is also relatively easy to use quantitative easing for direct investment instead of for buying dodgy assets off banks. Whilst we have very low or negative inflation governments can safely continue to print money and invest it wisely, provided of course that they stop injecting extra investment when signs emerge that inflation is returning.
Unfortunately the government is incapable of doing any of the necessary things because of a naive belief that government spending is always and at every time a bad thing that must be stopped. Instead of using the power of government to get the economy moving in the right direction of sustainable low energy growth it is doing almost the exact opposite. It is launching a new range of cuts to government expenditure onto an economy which can't take them. They are about to follow up on their attempts to cut tax credits drastically and clumsily with an attempt to slash government expenditure in unprotected departments by around 20%.
We do not know yet where those cuts will fall. We do know that they will deliver a downwards push to an economy which has reacted remarkably sluggishly to all attempts to make it grow and is still very fragile. Economic and political prediction is always a dangerous business but I think this means that three predictions can safely be made.
1. The UK's economic recovery will come to a halt when the next round of cuts start to bite unless there is a very dramatic improvement in the neighbouring economies.
2. As the economy falters and those cuts are implemented the UK's government is about to become one of the most unpopular in its history
3. These changes will bring to a close the intellectual dominance of a blind faith in the power of the free markets
The next year or so is going to be interesting!