Back to news

The Telegraph - Too much stimulus could spell disaster for Dr Darling’s ailing patient

Back to news
I have little doubt that there will be much talk about the stimulus that he is delivering to the UK economy in line with his G20 colleagues (expect much grandstanding about this) but also how fiscal prudence will be retained by a combination of lower public spending targets over the medium term (not now of course).

But what is the real background? Darling will be taking to his feet after a warning from Mervyn King, the Governor of the Bank of England, that the UK's public finances cannot stand any further increase in deficit spending.

The theories of the economist John Maynard Keynes are often cited to bless the stimuli which are being shovelled out by governments. Unfortunately, there is one part of Keynesian economics which they have conveniently forgotten: Keynes prescribed building up reserves during boom periods in order to fund deficit spending when this was necessary to provide such a stimulus. This part of Keynesian economics has clearly been observed mainly in the breach in the UK and the USA in particular.

As a result, there will be a severe constraint on the stimulus which Alistair Darling can deliver. The reality is that the UK is heading for a budget deficit which may hit 15pc of GDP and will make the so-called PIGS (Portugal, Ireland, Greece and Spain) look like models of budgetary rectitude. The reality is that the UK requires and will get a severe cutback in social services. The unmentionable will happen. At some point someone is going to have to confess that the NHS can only deal with items such as A&E, pregnancy and cancer. Everything else will have to be privately insured. Those who are government employees will have to lose their jobs and/or take pay cuts (not to mention pension cuts). But I doubt Chancellor Darling will be telling us this on Wednesday.

If Darling does not show such restraint there must be every likelihood that the international investment community will refuse to fund his plans by buying gilts, and the UK's lack of creditworthiness will be felt through further depreciation of sterling.

But what of that other item which has been deployed from the Chancellor's emergency toolkit for warding off depressions: Quantitative easing? The purchasing of assets (mainly government and corporate debt) with money "printed" by the central bank. It is the most extreme form of expansionary monetary policy. There has been much talk of "green shoots" and other signs of recovery, including the sharp equity market rally. But the analogy with the stimulus packages and quantitative easing is that the economy is like a patient in the emergency room who has suffered a heart attack. He has just been given the largest dose of adrenalin and the largest shock from the defibrillator in medical history. If there aren't a few flutters from the heart after that, be very afraid.

To take the analogy further, this patient had previously appeared fit but only because he had been taking steroids (i.e. the growth fuelled by the credit bubble). The chances of a patient in this condition making a full recovery would seem to me to be slim.

The application of these massive stimulus packages and quantitative easing is also analogous to trying to cure alcoholism by going binge drinking. Economies are suffering a hangover from the largest credit fuelled consumption binge in history. It will be rather extraordinary if this is cured by encouraging renewed borrowing and spending.

There are other problems with quantitative easing, even leaving aside the rather large issues of inflation and the potential effect on the currencies. The US is committed to buying large quantities of its own government debt using funds supplied by the Federal Reserve Bank. Coincidentally, the largest external holder of that debt in China has already expressed misgivings about the US dollar as a reserve currency. It would more than blunt the impact of quantitative easing if the Chinese supplied most of the bonds which the Fed buys.

In contrast, the Shadow Chancellor , George Osborne, should have a good day on Wednesday. He has started to show some form with his recent speech calling for a larger role in managing stability for the Bank of England, and smaller banks so that we can afford to let some fail, and pointing out that it's hard to see how you can borrow your way out of debt. He needs to press this last point home.

And finally, where does this potential policy disarray leave the recent market rally? I suspect the closest parallel is with 1931 when similar stories about recovery appeared, just prior to the second and most damaging leg of the Great Depression. But as ever, I'd be happy to be wrong.

Click here to view the article on

Terry Smith 

The Telegraph