Slash rates, save car plants: the arguments against

The prevailing consensus is that the present economic crisis is an incipient Great Depression and that it must be countered by the three principal measures. Almost all academic and policy experts, including the senior officials of the outgoing Bush Administration and the Obama appointees, and their counterparts in other major governments - except the German government - are agreed.

The three measures are: cutting interest rates to encourage investment; direct grants, at first only to financial institutions, but then extended to automobile companies; and public works, or rather a great increase in spending on infrastructures of all kinds.

There is no debate about this, because the world's investors show their lack of confidence silently - by not buying equities in the world's stock markets, and by withholding direct investments - while the German government mostly prefers to disagree quietly by blocking European initiatives.

Economic crises assure future growth by bankrupting inefficient businesses

The starting point of many investors - and the German government - is that capitalism must have its downs to have its ups, its busts to have its booms, and that its crises are essential to liquidate over-investment, over-spending and over-compensation.

Above all, crises assure future growth by bankrupting inefficient businesses that misuse labour, capital, and land to destroy wealth. Their collapse liberates resources for more efficient businesses that can grow and create wealth - the classic theory of 'creative destruction'.

In this view, for example, General Motors' misuse of its diminishing capital to keep misusing labour has caused the decay of Detroit and has damaged the US economy as a whole.

Its bankruptcy would be followed by the arrival of expanding businesses and start-ups eager to buy ex-GM machines at scrap prices, employ ex-GM labour at prevailing wages, and cheaply rent space in ex-GM factories. They might be very small at first but they could grow perhaps quickly, while GM can only decay.

As for the three prescribed measures to deal with the crisis, there are objections to each of them.

The argument against near-zero interest rates, as announced yesterday by the US Federal Reserve, or less-than-zero rates (net of inflation), is that in advanced societies many retired people depend on interest earnings (more now, because of the flight from equities). Therefore, cutting interest rates reduces total demand, which in turn reduces investment even if interest costs are very low.

The objection to direct grants, at first given only to financial institutions but now also to automobile companies, is that public money is thus used to subsidise inefficiency, reducing the resources available for the efficient.

The objection to the public works solution, or rather a great increase in spending on infrastructures of all kinds, is that it is a simple fact that in advanced societies (eg the USA, though not China) money allocated to build highways, bridges, tunnels, waste-management plants etc does not result in the purchase of machinery and the hiring of labour until the lawyers on all sides have agreed on the environmental impact, neighbourhood impact etc. That takes years, during which only a few lawyers are employed.

Barack Obama's faster solution is to transfer money to states and cities which already have fully approved plans. That might work at first, but scandals that put a stop to all work except for lawyers are inevitable when federal funds are passed down in this way.

Who is right? We will know by the end of 2009. If a recovery is underway, the conventional wisdom will have proven to be correct. Otherwise, the three measures should be reconsidered.