I wish to talk about the dangers of our current economic circumstances, which have been exacerbated over the past five years of a Conservative Administration. I believe that we are heading for a crisis that will impoverish the nation, and from which it will take a long time to recover. I should like to examine this situation in the context of competing economic theories.
In the years following the end of the Second World War, until the 1970s, Keynesian macroeconomic theory held an unassailable position. Keynesian theory placed its emphasis on the supply side of the economy and on the role of central government in regulating economic demand through fiscal controls. It gave little recognition to the monetary and financial aspects of the economy. The theory had shown how an economy could be lifted out of a recession, but the problem in the UK in those post-war years was with an overheating economy.
A monetary aspect of Keynesian theory to which little attention was paid in the early post-war years concerned a theoretical curiosity described as the liquidity trap. The liquidity trap denotes a situation in which injections of cash by the central bank into commercial banks fail to decrease already low interest rates. Therefore, an expansionary monetary policy becomes ineffective. I shall return later to this matter, because it fits our present economic circumstances.
In the 1970s, economists began to espouse monetarist doctrines that were utterly at variance with the Keynesian nostrums. The doctrines were accompanied by a free-market ideology that advocated a widespread deregulation of economic and financial activities. Markets were deemed to be rational and self-regulating. These ideas, which were readily adopted on the right wing of British politics, had an appealing simplicity.
One of the simplifications of the monetarist theory was the assumption that the rate at which the stock of money circulates throughout the economy could be regarded as constant. In that case, since it was geared to the circulation of money, economic activity could be regulated by controlling the available quantity of money. The theory took little account of the towering edifice of credit and of derived money that can be generated by the financial sector on the basis of the so-called high-powered money provided by the Treasury and the central bank. In the latter years of the Thatcher Administration, the nostrums of the monetarists were utterly negated by the growth of this edifice. This was the result of the financial innovations that the Conservatives’ deregulation of the banking system encouraged. It was the unstable nature of this vastly inflated financial structure that caused the crisis that occurred in 2007 and 2008, during the subsequent Labour Administration, the effects of which continue to afflict us.
One of the myths perpetrated by the Conservatives during the recent electoral campaign is that the financial collapse was Labour’s responsibility rather than theirs. The blame that falls on a Labour Administration is a failure to recognise the extent to which the hypertrophy of Britain’s financial sector was endangering the nation. The blame must rest squarely on the Conservatives for having unleashed the malign forces in the first place. Thereafter, over the past five years, they may be blamed for having done next to nothing to diminish the dangers posed by our financial sector.
It is important to understand the manner in which the activities of Britain’s financial sector are serving to perpetuate the pathologies of our economy. These activities have succeeded in averting a balance of payments crisis that would otherwise have overtaken us long ago. In the process, they have created the circumstances that will eventually give rise to much greater difficulties.
The UK’s current account—which captures the value of flows of income and goods between the UK and the rest of the world—has now reached a record deficit of 6% of gross domestic product. The overall balance of payments has been maintained, as it must be inevitably, by adjustments on the capital account. These consist of the sales to foreigners of purely financial assets, of residential properties and of the public utilities and manufacturing enterprises that remain in British hands.
The result of this process has been the maintenance of a high value of the pound versus other currencies. The overvalued pound makes it generally difficult and often impossible for British companies to export their manufactured products. The reductions in the value of the pound that occurred between 2008 and 2010 have not materially altered this circumstance.
The prolonged overvaluation of the pound has left Britain with a severely diminished industrial sector, which satisfies an ever-decreasing proportion of our own domestic demand. A major crisis will arise when the supply of assets for sale overseas has been depleted and when the remnant of our industrial sector will be too small to engage in any effective import substitution. I believe that the crisis will be upon us sooner than most of us are liable to expect.
I now wish to return to the matter of the Keynesian liquidity trap. This was little more than a theoretical curiosity in the early post-war economic environment but it now has a very tangible embodiment. It is represented by our commercial banks, which have benefited from large injections of money from the central bank via operations that are nowadays described as quantitative easing. The banks had been expected to supply some of the money to industrial enterprises for the purpose of investment but they have not done so. Instead, they have retained most of the money, albeit that some of it has already found its way into financial assets.
The existence of the liquidity trap has some disconcerting implications. The abundant surplus of money, if it is not to be deployed in stimulating an investment boom, will surely be available for fuelling a further boom in financial and capital assets. Such a boom will favour those who are in possession of such assets, and they are the richer members of our society. What we will see is a worsening of the already sickening inequalities of our society.
To avert an impending economic crisis, or, at least, to reduce its severity, we need to reduce the value of the pound, and we must cease to sell our assets overseas. We need to ensure that the money that has been pumped into the economy finds its way into industrial investment. In short, we should observe the nostrums of Keynesian economics.