Jon Nicolaisen: Can crises be curbed?
Speech by Mr Jon Nicolaisen, Deputy Governor of Norges Bank (Central Bank of Norway), at
the Norwegian Academy of Science and Letters, Oslo, 12 April 2016.
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Please note that the text below may differ slightly from the actual presentation.
Keynes versus Hayek
On 17 October 1932, a letter on the subject of public and private spending was published in
The Times newspaper. The letter was signed by several economists, one of whom was John
Maynard Keynes. In the letter, Keynes argues in favour of public spending:
"If the citizens of a town wish to build a swimming-bath or a library, or a museum,
they will not, by refraining from doing this, promote a wider national interest. [...]
Through their misdirected good will the mounting wave of unemployment will be
lifted still higher."
Two days later, on 19 October 1932, another letter was published in response. This letter
was also signed by several economists, among them Friedrich Hayek:
"... many of the troubles of the world at the present time are due to imprudent
borrowing and spending on the part of the public authorities. [...] the existence of
public debt [on a large scale] imposes frictions and obstacles to readjustment [...]
If the Government wish to help revival, the right way for them to proceed is, not to
revert to their old habits of lavish expenditure ... "
The debate between Keynes and Hayek took place at a time when millions of people were
out of work. Governments, firms and households were heavily in debt and many banks were
on their knees. In many countries, deflation made debt even heavier to bear. At the same
time, pessimism and caution put a damper on the willingness to spend. Deflation and
unemployment led to a low level of consumption, and investment that could have generated
jobs and growth was held back.
The question is, then, can the authorities curb a crisis by spending borrowed money?
According to Keynes, spending would not only prevent the economy from sinking even lower,
it would also reduce the extent of the crisis and bring the economy back into balance more
quickly. Or was Hayek right when he claimed that misjudged attempts to curb a crisis by
means of debt-financed spending can sow the seeds of a subsequent and even deeper
crisis?
According to Hayek, measures should be focused on the underlying challenges, such as
public debt, that had created the crisis. In Hayek's opinion, higher public debt would
inevitably end up funding unproductive investments and consumption in the public sector,
which would lead to low growth. Instead, government budgets should be brought into
balance and regulations hampering economic activity should be removed. In Hayek's view,
this would over time provide the basis for healthy, self-driven economic growth, even if the
measures taken might deepen the crisis in the short term.
Keynes won the public debate in the 1930s. His views influenced economic policy in the
West, particularly in the post-war years. However, Keynesian policies would later prove to
have their weaknesses too.
Deeper causes
Major crises are usually the result of a series of unfortunate events that occur in close
proximity in time. A triggering factor can often be identified. But there is often an equally
important and deeper underlying cause. If this is overlooked or not dealt with, the road out of
the crisis may be long. Let me give an example from Norwegian economic history:1
The oil price shock in 1973 and 1974 led to a recession in western economies - the worst
recession since the Second World War. The Norwegian economy was also affected. At the
same time, the Norwegian oil age had just begun. With prospects of high future income, the
authorities responded with an expansionary countercyclical policy with large fiscal deficits.
Targeted measures were also implemented to help manufacturing through the most difficult
period. Manufacturing firms operating at a loss received funding support to cover hourly
wage costs and support for production for inventory. The aim was to curb the crisis.
But the diagnosis was wrong. What was interpreted as a cyclical problem was fundamentally
a structural problem. There was a pressing need for restructuring. Norwegian industries -
shipping and wood processing, shipyards and steel works - had allowed themselves to
become dependent on high growth and cheap energy. High wage increases pushed up cost
levels in manufacturing, and inflation accelerated, amplifying imbalances instead of solving
problems and weakening international competitiveness even further. The current account
deficit was record-high.
A countercyclical policy that resulted in labour market pressures and that kept firms alive
artificially provided little help. It delayed restructuring, while inflation and fiscal deficits made
restructuring even more urgent. Economic structures were protected rather than being
reformed. Countercyclical policy became counterstructural policy.2
When economic policy changed course around 1980, the Norwegian economy started to get
back on its feet again, but Norway's growth potential was low and new imbalances were
building up. The fall in oil prices in 1986 sparked a new, and even deeper, crisis in the
Norwegian economy.
The economic policy conducted in the 1970s was intended to follow Keynes' advice.
Subsequent developments proved Hayek's point. To curb a crisis on a lasting basis, the
measures implemented must also address the deeper causes of the crisis.
The global financial crisis was triggered by the Lehman Brothers bankruptcy on
15 September 2008. The crisis has been attributed to a number of factors. One important
event was China's accession to the World Trade Organization (WTO) on 11 December 2001,
almost seven years earlier. With China now a member of the WTO, the global labour force
expanded considerably. Low wages and cheap goods from China exerted downward
pressure on goods prices. As China's substantial savings surplus continued to grow, large
amounts of savings were exported to the West. Inflation slowed in the decade following the
turn of the millennium, in spite of high growth and falling unemployment. Combined with
China's savings surplus, this resulted in persistently low interest rates.
Low interest rates coincided with weaker regulation of the banking and financial sectors,
particularly in the US, but also in Europe. That proved to be a dangerous cocktail. Banks took
more risk and levels of equity capital were too low. Household debt rose substantially. In
many European countries, government debt ballooned in the shadow of low interest rates.
When the crisis erupted in 2008, many were ill-prepared.
Two aftershocks - China and Europe
The global economy is still struggling with the repercussions of the crisis, with record-low
interest rates and overcapacity. Growth is low. In the past couple of years, growth has also
slowed in Latin America and Asia. The number of unemployed in the EU has reached around
22 million. This is equivalent to the combined populations of Norway, Sweden and Denmark.
Instead of being gainfully employed, workers are idle and their skills are eroding.
Unemployment is a waste of resources and a tragedy for the individual. A generation of
young people are suffering the consequences, particularly in southern Europe.
Government debt is still high in European countries, and in many of them debt burdens have
risen further. Government budgets are still showing sizeable deficits. Several countries have
also experienced economic decline and deflation.
Overcapacity is high in China, particularly in heavy industry. Some manufacturing segments
in other parts of the world are also facing excess production capacity, and profitability is low.
Overcapacity and lower prices for manufactured goods are adding to global deflationary
pressures.
Around half of China's steelworks are operating at a loss, and debt is rising.3 China lacks
efficient bankruptcy procedures, and as enterprises in heavy industry are mostly
stateowned, the industry can be run at a loss. This makes it difficult to effect change. The US has
imposed a penalty tariff on Chinese steel imports, and steel works in Europe are closing
down.
If he was to comment on China's current situation, Hayek would have stated the following:
Debt in the steel industry and other heavy industry must be restructured. Industrial
enterprises that are running at a loss should be closed down. Chinese authorities now
appear to be doing just that.
In the 1930s, many countries resorted to devaluations, tariff barriers and regulation of
crossborder capital movements to protect their own manufacturing industry. But this was the
wrong medicine. World trade fell, and the international division of labour went into reverse.
This led to lower income for everyone. In his letter to The Times, Hayek made the following
comment:
".... the right way [...] to proceed is [...] to abolish those restrictions on trade and
the free movement of capital which are at the present impeding even the
beginning of recovery."
Today, the global system of trade and cross-border investment is again under pressure. In
both Europe and the US, influential groups have argued in favour of erecting new walls and
barriers to the international exchange of goods. This is a recipe for yet another downturn.
Norway is a small open economy with substantial wealth invested abroad. As a nation, we
are completely dependent on a functioning international system of free trade and investment.
In the short term, major economies have less to lose from closing themselves off. We trust
that they will not, after all, abandon the global economic system that has been built up over
the past 70 years.
Hayek or Keynes?
The current situation on our continent - Europe - has much in common with the 1930s.
Unemployment is high, while there is a need for investment in infrastructure, new technology
and education. There are also many advocates of investing in a "green" shift towards
sustainable growth.
But investment is not forthcoming. In the light of the pessimism now holding sway in Europe,
this is perhaps not surprising. As Keynes wrote in his letter in 1932:
".... the [released] real resources do not find a new home waiting for them. In
present conditions their entry into investment is blocked by lack of confidence."
Keynes would have said that this is the time to deploy public investment to create jobs for
idle labour. The cost to society would be low. Wages would replace expenditure on benefits
and social security. Value-added would be generated, unemployment would decrease and
employment would rise. This solution seems obvious. But it is not happening.
In southern European countries in particular, government debt is high and growth is low.
Future public funding is tied up in servicing debt and funding public services and pensions.
Public administrations are cumbersome, inefficient and often over-staffed. The willingness
and ability of governments to increase taxes, and perhaps the public's confidence in the
authorities, is low.
The trap many European countries fell into was accumulating debt and spending borrowed
money in good times, leaving them without the fiscal muscle to pursue a rational
countercyclical policy in the face of crisis. This has made the economic downturn even
heavier to bear.
A number of European countries have experienced stagnation or a fall in GDP - some have
faced a considerable decline in nominal GDP. As a result, debt to revenue ratios have
increased, further reducing the ability to escape the debt crisis. The unrest surrounding
Europe is not making matters any easier. The Russian economy is struggling. There is war in
the Middle East and Libya. And on top of high levels of debt and mass unemployment,
countries all over Europe are now facing terrorist threats and a refugee crisis.
Only a few north European countries - including Norway - still have room for manoeuvre in
fiscal policy. These countries have a savings surplus and export capital. But there are few
northern European countries, including those within the EU, willing to finance southern
Europe's expenses over the tax bill - be it for refugees or for investment. With a common
currency, euro area countries cannot rapidly adjust relative intra-area wages and prices. And
there is no European federal government to enforce large-scale transfers from the north to
the south.
Building up even more debt is rarely the way to resolve a debt crisis. If a household, firm,
bank or government has become too heavily indebted, all experience to date indicates that,
sooner or later, the debt will have to be restructured.
Hayek would probably have reiterated the view he expressed in 1932:
" ..... the existence of public debt [on a large scale] imposes frictions and
obstacles to readjustment very much greater than [the frictions and obstacles
imposed by] the existence of private debt."
Perhaps Hayek, originally from Austria, had in mind Germany's enormous reparations debt
from the First World War, which probably contributed to the fall of the Weimar Republic.
We should not exaggerate: after all, Europe is still a region of peace, prosperity and
cooperation. This is perhaps the greatest difference between the current situation and the
1930s. Nonetheless, the 1930s taught us that deep economic crises can also have
substantial social and political consequences.
The European Central Bank - the ECB - is the only institution in Europe that can have a
material influence on developments across the continent in the short term. The ECB is
keeping government debt yields low by means of record-low policy rates and large
government bond purchases. This is keeping the wheels in motion. It is also supporting
government finances in a number of European countries. In today's situation, private
investors would probably have required considerably higher yields on sovereign bonds - as
was the case in 2011 and 2012 - if they did not know that the ECB was buying large
volumes of these bonds.
No treatment is without side-effects. The same goes for low interest rates: there is little
incentive to reduce debt and measures that could have strengthened government budgets
can be postponed. Firms that are not making money can continue to operate.
Monetary policy in Europe has been stretched to its limits. What monetary policy can do is to
build a bridge - from the old economy in crisis to a new economy. But someone else - and
something else - must create solid ground on the other side. Otherwise, the bridge will be
left hanging in mid-air.
Keynes would probably have supported the ECB's policy. Without countermeasures, a crisis
can become a catastrophe. A slower process of economic restructuring may be a reasonable
price to pay.
Europe is again seeing a modest pick-up in economic growth. Unemployment has reached
the peak and is falling in countries such as Germany, Ireland and Spain. It is a slow process
and the ordeal can seem unnecessarily protracted, but at least things are moving in the right
direction.
Can the crisis in Europe be curbed? The answer is probably yes, provided authorities
succeed in establishing a form of coordination that has so far been absent. At a deeper level,
there is a need for structural and institutional reforms.
Such reforms will take time.
Immune system
The situation in Europe illustrates how difficult it can be to curb a crisis once it has arisen. It
might therefore be wise to give priority to crisis prevention. A healthy economic system is
less vulnerable. Crises can be curbed - or even avoided - by boosting the resilience of the
economy. Rather than treating the disease after it has taken hold, much can be
accomplished by strengthening the economy's immune system.
The financial crisis revealed deficiencies and system failures worldwide. Many governments
and households had taken on too much debt. US investment banks such as Lehman
Brothers operated a high-risk business model with low levels of equity. European banks were
too dependent on short-term funding in international markets.
In a period of growth, it is easy for banks to obtain funding. But the system is fundamentally
unstable. Without adequate capital requirements in the banking system, credit growth can
spiral out of control.
Hayek gave lectures on this topic at the London School of Economics in the early 1930s.4
The LSE is still home to many economists who argue against the risks of debt-financed
growth.5
Solid banks are built in good times. Solid banks bolster the resilience of the economy and
make crises easier to manage. Since the financial crisis, the G20 countries have
implemented substantial changes in the global regulatory framework for banks. Under new
rules, investors are required to take losses if large global banks encounter difficulties.6 A
system for joint supervision and resolution of systemically important banks was put into
operation by the euro area countries in 2014 and 2015.7 This is great progress. A credible
global system for crisis management and bank regulation will in itself contribute to crisis
prevention.
Bank's capital requirements have increased, in Norway as elsewhere. This is a good thing.
We are going to need solid banks.
Reforms and economic restructuring
The Norwegian economy is not in a crisis, but we are facing a period of restructuring. We
have been in a similar situation before - when oil prices fell in 1986. The crisis that ensued
eventually also led to positive changes. In the wake of the crisis, the authorities implemented
reforms through the first half of the 1990s that laid the basis for renewed economic growth.
The Act establishing the Government Petroleum Fund was adopted in 1990. Banks were
instructed to increase efficiency. The 1992 tax reform streamlined the tax system and tax
rates were substantially reduced. It became easier for investors to find projects that yielded
high returns. State-ownership policy in Norway was changed to introduce a clearer division of
roles and healthier commercial principles. And not least, the EEA Agreement provided
access to the European Single Market for most of the Norwegian business sector.
When oil prices fell again in 2014, Norway was better prepared. But as a nation, our income
has nonetheless been reduced by the fall in oil prices and we should be cautious about
introducing measures that will increase consumption. Reasonable measures in a period of
restructuring are those that promote economic growth over time, without crowding out private
enterprise.
Monetary policy can facilitate restructuring. And it is able to do so because there is
confidence that inflation will remain low and stable. With low and stable inflation, a weaker
krone and higher import prices will not pass through to wage growth and inflation, as was the
case after the fall in oil prices in 1986. On the contrary, the depreciation of the krone over the
past couple of years has compensated for more than a decade of high cost inflation. This has
improved the competitiveness of Norwegian firms - in foreign and domestic markets. In
addition, lower interest expenses are easing the burden for many households and firms.
There is still room for manoeuvre in monetary policy. In contrast to most European countries,
Norway also has room for manoeuvre on the fiscal front, if necessary. But - as in the rest of
Europe - the authorities cannot solve the deeper challenge, namely the need to establish
new private sector activity. This is a task for the business sector. What the authorities can do
is to establish framework conditions that promote innovation and growth.
Hayek and Keynes
In my introduction, I posed the question: can crises be curbed? quickly followed by: can
misjudged attempts to curb a crisis sow the seeds of an even deeper crisis?
Keynes and Hayek did not come to agreement on how a crisis should be managed. Their
debate is still relevant today. Keynes advocated the use of public spending to curb crises.
Hayek warned against such a policy: the misjudged application of government measures
could easily lead to deeper crises and credit bubbles.
Both were right. Crises can and should be curbed, using measures to strengthen the
economy's immune system as well as measures that reduce the impact once the crisis has
erupted. This means that government intervention using public funds may be the right
approach in a situation of decline and deflation, low interest rates, high unemployment and
pessimism. But crisis-related measures must also be focused on the deeper causes of the
crisis in order to strengthen economic sustainability over time. Countercyclical policy must
not become counterstructural policy.
Crises are not necessarily just an evil. A crisis can lead to reforms and measures that foster
progress, as it did in Norway in the 1990s. The regulation of the banking sector in the wake
of the global financial crisis is another example. Experiences such as these may give us
some comfort in the bleakest of times. The world will go on, even after a deep crisis.
Thank you for your attention.