Tom Clougherty
Executive Director of the Adam Smith Institute

By Tom Clougherty

Three years on from the peak of the financial crisis, and the newspapers are still full of headlines that paint a grim economic picture. Whether it is lacklustre economics growth, dangerous sovereign debt, or renewed instability in the financial sector, things are not nearly as rosy as we would like them to be.

Needless to say, this has led to countless calls on the government to “do something”. But anyone who tries to sell you a quick fix has failed to understand the nature of recessions; they have failed to appreciate why we are where we are; and what needs to happen before we can return to growth.

The trouble is that people tend to think of the economy as though it were a motor that has stalled and needs to be jumpstarted. They imagine that given the right mechanic, and the right tools, we can be back up and running again as though nothing had ever happened. Unfortunately, however, the real world is far more complicated than that.

During the boom years, the economy becomes distorted. Encouraged by cheap credit and easy money, people (and governments) spend too much and save too little; they take on debt when they shouldn’t, and invest in projects that will not turn out to be profitable. Bubbles emerge in some areas of the economy, and resources are drawn inexorably towards them. This is precisely what happened in the 2000s.

Recession, painful as it can be, is about rebalancing. It is about bad investments being liquidated, debts being repaid, savings and capital stocks being replenished, and scarce resources being reallocated. In other words, it is a process of adjustment-and it takes time.

The bigger the boom was, the more unbalanced the economy will have become, and the more time it will take. But you can’t rush these things: if you want real, sustainable growth, and not just a series of bubbles, you need to let things work themselves out.

Roughly speaking, that’s where we are today: in the middle of a process of adjustment. We still have an economy that’s skewed unhealthily towards financial services and the public sector; we still have something of a housing bubble; and we still have too much debt, and too little saving and private investment. To put it simply, we need to be patient a little while longer: good things will come, if we’re prepared to wait.

But that’s not necessarily a manifesto for doing nothing. On the contrary, there are plenty of things the government should do to help things along. First of all, they must stick to their plans for fiscal consolidation. A healthy economy requires both less debt and a smaller public sector. But this should be an exercise in reform, not merely cuts.

Secondly, the government must maintain monetary stability, and steer a careful course between inflation and deflation. That’s much easier said than done, but a stable monetary environment is essential to the adjustment process: a sharp deflation could plunge us back into crisis, but inflation will pump up old bubbles and create new ones.

Thirdly, the government needs to develop a credible plan for ‘resolving’ banks that become insolvent — they need to find an orderly way to wind down bust financial institutions, without threatening the safety of the system as a whole.

Finally, they need to reduce red tape on entrepreneurs and make labour markets more flexible, so that businesses can grow and create jobs more quickly, and reform the tax system, so that it rewards saving and investment rather than punishing it.

The British economy can return to growth. And it will — if we let it.