January 2, 2012
Did your mother ever tell you to be afraid of umbrellas because theyÂ could take your eye out? When I was a child, the humble umbrellaÂ transformed itself into a weapon of mass destruction in our houseÂ capable of all classes of contortions, which would lead directly toÂ poking some misfortunate’s eye out. I have no idea where the fear ofÂ the upturned umbrella came from, but someone, somewhere must have seenÂ an eye poked out by the sharp end of a brolly rib – maybe it was myÂ own mother or my granny. But the upshot was excessive caution around
Now, obviously, the umbrella anxiety is run-of-the-mill, but there areÂ many real examples where some truly traumatic experience changes theÂ way people behave for years.
For example, my mother lost her brother to meningitis in the 1940sÂ when he was only eight years old. This led to her subsequently havingÂ excessive anxiety about any pains her own children might have in theirÂ necks and the base of their skulls. So when I was a kid, a stiff neck,Â headaches or any rashes prompted all sorts of fears and dire diagnosesÂ around the kitchen table. In psychology this reaction is called “fearÂ conditioning”. Unlike phobias, it is actually quite logical. ExcessiveÂ anxiety is not that abnormal, because these deep personal experiencesÂ stay with us and change the way we see the world.
Imagine if the economy worked the same way. Or more accurately that weÂ behaved the same way when it came to money. Studies have shown thatÂ the generation which lived through the Great Depression in the USÂ remained excessively cautious and frugal throughout the rest of theirÂ lives because of the searing experience of the Depression.
Could this happen here? Has the traumatic effect of the collapse inÂ property values, the explosion of debt and the realisation that manyÂ tens of thousands are broke and will never be able to get out of debt,Â led to excessive nervousness about debt and spending? Like my motherÂ and meningitis, has the crash resulted in excessive caution which willÂ affect how we behave in the future? If so, we might be in what couldÂ be called an “anxiety recession”.
An anxiety recession is very different from the “normal” recession weÂ experienced in the 1980s.
Look at the chart (taken from a paper written by Japanese economistÂ Richard Koo*). It shows anxiety recession in Ireland in the past fewÂ years and how it materialises. Ordinary Irish people began to save andÂ pay back debt in l ate 2006 when they realised that the housing market
had peaked. Since then, we have been saving enormous amounts of ourÂ income. Irish firms took a while to cop on that the economy had turnedÂ but, since 2008, firms have been saving and paying down debt as fastÂ as they can. Irish households were borrowing 10 per cent of GDP inÂ 2006; now we are saving just under 5 per cent of GDP. This is anÂ extraordinary turnaround.
If we add together the change in spending and saving behaviour ofÂ families and firms, we see that 21.55 per cent of GDP which was beingÂ spent is now being saved. Therefore, 21.55 per cent of GDP has beenÂ taken out of the economy. Of the firms, the most essential sector inÂ this analysis are the banks because they are paying down their debts,Â shrinking lending and trying to suck in deposits. All this isÂ reinforcing the debt anxiety of the already-indebted population.
We can also see that, as we stopped spending, the government startedÂ spending to offset this. One way of looking at government spending isÂ that, without the government running huge deficits, the fall in GDPÂ and rise in unemployment would have been much sharper.
The anxiety recession is different to the typical recession in oneÂ crucial aspect: people are so indebted that they don’t want to borrow,and banks are so indebted that they don’t want to lend, no matter howÂ low the interest rate.Â In a traditional recession, the economy slows down, people get laidÂ off and interest rates fall. This fall in interest rates promptsÂ people to invest and spend, and the banks start to lend because that’sÂ how they make money. In time, demand comes back and monetary policyÂ works as normal.
But in an anxiety recession, people want to pay down their debtsÂ because they have been traumatised by too much debt. This is whatÂ Keynes described as a “liquidity trap” in the 1930s. It was also whatÂ happened in Japan and what led to the 20-year post-crash slump inÂ Japan. The economy didn’t recover because of the anxiety aboutÂ spending and the excessive caution of the average Japanese who hadÂ lived through the 1980s boom and had seen their assets collapse in
If people remain excessively anxious, then the recovery can’t happen.Â Many economists argue – not necessarily in Ireland, but elsewhere -Â that the answer to an anxiety recession is for someone or someÂ institution to break that anxiety by spending and keeping demand inÂ the economy from collapsing totally. The implication of this is thatÂ the Irish government should continue to run deficits and continueÂ spending, rather than cutting back.
But what if the state is also bankrupt? What happens if the financialÂ markets don’t want to lend to you – as is the case in Ireland?
One obvious solution is to impose capital controls and force – or atÂ least incentivise – Irish savers to finance the government. Thus theÂ government recycles the savings of the anxious savers, thereby
propping up demand, and eventually allowing the broken balance sheetsÂ of the Irish people to be repaired. Once the balance sheet isÂ repaired, normal economics will resume once again.
But this could take time, and the government’s debt-to-GDP ratio wouldÂ rise to possibly 200 per cent – where Japan’s is now. Doing somethingÂ like this would require the state to leave the euro, impose capitalÂ controls and issue its own currency all in one weekend. Even if youÂ thought it was the right thing to do, it might be a tall order toÂ execute. Plan B perhaps?
The other way out is to have a massive programme of debt reliefÂ because without the debt, people’s anxiety lifts. This would meanÂ defaulting on huge amounts of debts and stiffing the ECB in the
process, because the only way Irish banks could absorb all thisÂ domestic debt relief would be if they defaulted on their mainÂ creditor, the ECB. This must still be part of plan A.Â If neither of these choices is being entertained, then the anxietyÂ recession looks likely to condemn this country to possibly a decade ofÂ stagnation. It is hard to see – with the huge debt we are carrying,Â and the trauma associated with the crash – how the economy can performÂ otherwise. If this excessive caution proves to be enduring, ratherÂ than temporary, the economy will not rebound for years. If you doubtÂ that this can happen and can go on for years, consider that the NikkeiÂ Index, Japan’s stock market, ended 2011 at a 19-year low.
Happy New Year – and be careful of that umbrella in the hall.