Dealing with a different sort of recession

Political debate usually generates more heat than light. That is one of the basic rules of life and the political debate over policy to deal with the recession illustrates this well. So we have to try and look through the politics of the latest announcement.

The last recession was caused by a collapse in financial markets which, by various means, led to a collapse in Aggregate Demand. A prudent response by most governments was to pursue an expansionary fiscal and monetary policy. This was to deal with the immediate effects of the crisis.

The debate now rages on how to continue to cope with the crisis, especially now that a 'double-dip' recession seems a possibility. Sadly at least one group in this debate have missed the point.

The Keynesians have, as usual, crawled out from under their stones and claimed they have the answer. 'Boost Aggregate Demand by the government spending more money', which they borrow. But Keynes was talking about a recession caused by a failure in the goods market in the General Theory, not one caused in the financial markets. (Read the General Theory if you like, it's pretty obvious. There is a copy at the back of Mr Lewis's room and online).

The time for old fashioned demand management has passed. It is necessary to deal with the financial market problems, such as the European Debt Crisis and Bank re-capitalisation. But this has led to a drying up of funds available for lending to businesses and this is preventing a timely recovery in the private sector.

Despite encouragement banks find they cannot both re-capitalise their balance sheets (so they can survive a second GFC or major default by Euro area countries) and lend to small and medium size businesses. This prevents those businesses expanding and reducing the unemployment problem.

Small and medium size businesses basically have two sources of capital, loans and retained profit. Unlike in the USA (where such bonds are a major source of funding) they cannot easily issue 'corporate bonds' as there is no established market for them.

So now the Chancellor is proposing to help develop this additional source of funding by offering to buy bonds issued by smaller firms. It is an unusual, and potentially far sighted, move to help recovery. It is, however, fraught with difficulties.

As the market for small firm bonds is currently tiny it is likely the costs of operating in this market will be high. It will also take time to establish and the firms that can benefit will find it is some time before they are ready to issue bonds. However they now have a guaranteed buyer in the government and so they can raise money with certainty and, presumably, at a lower cost than any alternative. The government hopes it will allow the development of a small/medium firm bond market that will persist in the future.

The measure is being called a credit easing plan. It directly addresses an issue caused by a financial market induced recession and so should be applauded. I would call it a 'supply side' measure as it is trying to help a market work, is specifically targeted at an issue, will allow the expansion of productive capacity and will take a long time to work.

Time will tell how effective it is.

The Guardian reports the measure here