LONDON News that Britain's economy contracted 0.7 percent in the second quarter, as bad weather and the impact of extra public holidays compounded the drag from the government's austerity programme and the euro zone debt crisis, has underscored the abysmal performance of the United Kingdom and most other G7 economies since 2007.
Many explanations have been offered. But the core of the problem is straightforward. Businesses and households have refused to invest in long-lived and illiquid assets in the face of extreme uncertainty about the outlook, preferring to accumulate short-term, liquid but low-yielding and unproductive assets such as cash and high-rated government bonds.
Fear of impending disaster has encouraged businesses and households to stockpile liquid assets, even though the real rate of return on bank deposits and short to medium term government bonds issued by the United States, Germany, the United Kingdom and other major sovereigns has been persistently negative.
The phenomenon of extreme risk aversion has been examined at length in a pair of pieces this week in the Financial Times by Gillian Tett ("We have entered the world of disaster economics" July 23) and Gavyn Davies ("Bond yields and disaster risk premia" July 22).
In effect, households and firms prefer incurring small losses every day as inflation gradually erodes the real value of their portfolio, rather than risk waking up one morning to find they have suffered a large loss or even been wiped out as a result of a bank failure, bankruptcy, devaluation or an abrupt move in asset prices.
Whether this extreme risk aversion is rational is not clear. Citing a study by Fulcrum Asset Management, founded by Davies and Andrew Stevens, Tett makes a case that investing in short-term liquid assets to avoid the risk of disastrous losses could be sensible.
The Fulcrum study shows there were 58 economic disasters in the 20th century (defined as a decline of at least 10 percent of GDP) but only two of them in the second half. "Most modern investors built their careers in a world without disaster risk," Tett writes.
But the world has changed, resulting in a profound shift in investor behavior. The potential for economic disasters and large losses now looms much larger in investors' minds.
"The key point about investing," according to Tett, "is that assets have two functions. They can produce returns, but they also offer protection. When disaster risk is low, investors stress the former; when the risk rises they focus on the latter."
"If this disaster theory has a grain of truth - as I suspect it does ... it implies that the investor grab for safe assets may not be a short-term phenomenon; disaster risk could influence asset prices for a long time" she concludes.
On the other hand, extreme risk aversion could be irrational if investors are over-estimating the prospect of future disasters, acquiescing in the gradual inflationary confiscation of their wealth to avoid even a very small chance of making large losses. I have argued elsewhere that the strong preference for liquid assets with negative real yields may simply be the latest bubble ("The bubble in fear" July 10).
Whether or not the preference for liquid assets is rational, characterizing the problem this way helps explain why ultra-low interest rates, repeated quantitative easing, and other monetary policy gimmicks have failed to jump-start the economies of the United States, Western Europe and Japan.
The Fed and other central banks have done their best to push investors into taking more risks by driving nominal returns on bank deposits as well as short and now medium-term government paper close to zero, ensuring that real yields are negative.
But the fear of impending disaster is so strong that investors seem content to accept negative real returns in the meantime to avoid it. It is not clear if central banks can raise the cost of risk aversion and holding liquid assets high enough to offset the (irrational) estimates of disaster risk.
Only by generating and sustaining prodigious rates of inflation (5 percent or more) could the major central banks shock investors out of their current preference for liquidity.
Monetary policymakers may not be able to produce this sort of inflation deliberately. Even if they could, they might not survive the resulting political backlash.
RE-ENTER FISCAL POLICY
The only solution to the problem is for the government to step in and underwrite investment in long-lived, illiquid assets that businesses and households are unwilling to do themselves (either by commissioning and paying for investment directly, or by guaranteeing returns for households and firms).
In his landmark "General Theory of Employment, Interest and Money," John Maynard Keynes explained that household and corporate savings would not automatically translate into productive investment, growth and employment if risk aversion causes savings to pile up in cash and other short-term liquid assets.
If businesses and households refuse to invest because of their extreme uncertainty, the government should step in and invest for them; not because it has superior knowledge about the future, but because it has a stronger balance sheet and greater tolerance for risk and negative outcomes.
In the post-war years, as economics came to be dominated by the conflict between capitalism and communism, the original and disturbing radicalism of Keynes' insights was toned down. The idea that in some circumstances the government might have to circumvent normal market mechanisms became anathema.
Instead, Keynesians and neo-Keynesians recast intervention in terms of limited changes to interest rates, and adjustments in tax and spending policies, designed to stimulate private sector agents to do the spending and investment the government deemed necessary to achieve full employment.
But even a quick analysis shows why this is likely to be inadequate in the face of a genuine depression. If risk aversion is sufficient to cause households to ignore the negative returns on deposits and bonds, it is unlikely that small, conventional changes in government spending or tax policy will be sufficient to induce them to take more investment risks.
Even in the 1930s, Keynes' insights proved too radical to be put into practice. President Franklin Roosevelt was no Keynesian. Before the onset of war, his administration only ever ran a large budget deficit in 1936, and even that was accidental. Taxes were quickly increased in 1937 and 1938.
Under political pressure from balanced budget conservatives, and divided over its own strategy, the administration never embraced deficit finance in peacetime.
The federal government only embarked on a massive increase in spending and deficit-financing when the outbreak of war quelled the political debate between left and right over the appropriate role of the government in the economy.
In fact, Keynes' radical insights have only ever really been tried when a massive increase in spending and deficits has been justified by non-economic factors. The Cold War conflicts (Korea, Vietnam), the Reagan defense build-up, and the space race are all classic examples of heavy government investment with strong stimulus properties that were justified by non-economic arguments.
Commentators such as Paul Krugman in the New York Times lament the inability of policymakers to transcend a fixation with balanced budgets and learn lessons from the past. But history suggests it has never been possible to reach such an agreement based on economic arguments alone. The philosophical differences between left and right over the appropriate role of government are too deep.
Some commentators suggest military conflicts provide a stimulus because they eliminate excess capacity. But excess capacity has never really been a problem.
In practice, conflicts, arms races and other "national projects" such as the space race provide stimulus and are capable of overcoming a depression because they enable the political system to transcend the normal divisions limiting public investment at a time when uncertainty and excessive pessimism have paralyzed risk-taking by the private sector.
At the moment, the United States and the countries of Western Europe are still struggling to define a national project that would justify large-scale public investment programmes. There is no convenient enemy to justify a big defense build up, and talk of investing in the clean economy to avert global warming has not achieved sufficient traction.
But in the absence of a unifying national project to justify more government-led or guaranteed investment, and with private investors sidelined by fear, the depression will continue until investors realize that holding liquid assets at negative yields is stealthily imposing far bigger losses than the potential catastrophes they fear.