Did your mother ever tell you to be afraid of umbrellas because they could take your eye out? When I was a child, the humble umbrella transformed itself into a weapon of mass destruction in our house capable of all classes of contortions, which would lead directly to poking some misfortunate’s eye out. I have no idea where the fear of the upturned umbrella came from, but someone, somewhere must have seen an eye poked out by the sharp end of a brolly rib – maybe it was my own mother or my granny. But the upshot was excessive caution around
umbrellas.

Now, obviously, the umbrella anxiety is run-of-the-mill, but there are many real examples where some truly traumatic experience changes the way people behave for years.

For example, my mother lost her brother to meningitis in the 1940s when he was only eight years old. This led to her subsequently having excessive anxiety about any pains her own children might have in their necks and the base of their skulls. So when I was a kid, a stiff neck, headaches or any rashes prompted all sorts of fears and dire diagnoses around the kitchen table. In psychology this reaction is called “fear conditioning”. Unlike phobias, it is actually quite logical. Excessive anxiety is not that abnormal, because these deep personal experiences stay with us and change the way we see the world.

Imagine if the economy worked the same way. Or more accurately that we behaved the same way when it came to money. Studies have shown that the generation which lived through the Great Depression in the US remained excessively cautious and frugal throughout the rest of their lives because of the searing experience of the Depression.

Could this happen here? Has the traumatic effect of the collapse in property values, the explosion of debt and the realisation that many tens of thousands are broke and will never be able to get out of debt, led to excessive nervousness about debt and spending? Like my mother and meningitis, has the crash resulted in excessive caution which will affect how we behave in the future? If so, we might be in what could be called an “anxiety recession”.

An anxiety recession is very different from the “normal” recession we experienced in the 1980s.

Look at the chart (taken from a paper written by Japanese economist Richard Koo*). It shows anxiety recession in Ireland in the past few years and how it materialises. Ordinary Irish people began to save and pay back debt in l ate 2006 when they realised that the housing market
had peaked. Since then, we have been saving enormous amounts of our income. Irish firms took a while to cop on that the economy had turned but, since 2008, firms have been saving and paying down debt as fast as they can. Irish households were borrowing 10 per cent of GDP in 2006; now we are saving just under 5 per cent of GDP. This is an extraordinary turnaround.

If we add together the change in spending and saving behaviour of families and firms, we see that 21.55 per cent of GDP which was being spent is now being saved. Therefore, 21.55 per cent of GDP has been taken out of the economy. Of the firms, the most essential sector in this analysis are the banks because they are paying down their debts, shrinking lending and trying to suck in deposits. All this is reinforcing the debt anxiety of the already-indebted population.

We can also see that, as we stopped spending, the government started spending to offset this. One way of looking at government spending is that, without the government running huge deficits, the fall in GDP and rise in unemployment would have been much sharper.

The anxiety recession is different to the typical recession in one crucial aspect: people are so indebted that they don’t want to borrow,and banks are so indebted that they don’t want to lend, no matter how low the interest rate. In a traditional recession, the economy slows down, people get laid off and interest rates fall. This fall in interest rates prompts people to invest and spend, and the banks start to lend because that’s how they make money. In time, demand comes back and monetary policy works as normal.

But in an anxiety recession, people want to pay down their debts because they have been traumatised by too much debt. This is what Keynes described as a “liquidity trap” in the 1930s. It was also what happened in Japan and what led to the 20-year post-crash slump in Japan. The economy didn’t recover because of the anxiety about spending and the excessive caution of the average Japanese who had lived through the 1980s boom and had seen their assets collapse in
value.
If people remain excessively anxious, then the recovery can’t happen. Many economists argue – not necessarily in Ireland, but elsewhere - that the answer to an anxiety recession is for someone or some institution to break that anxiety by spending and keeping demand in the economy from collapsing totally. The implication of this is that the Irish government should continue to run deficits and continue spending, rather than cutting back.

But what if the state is also bankrupt? What happens if the financial markets don’t want to lend to you – as is the case in Ireland?

One obvious solution is to impose capital controls and force – or at least incentivise – Irish savers to finance the government. Thus the government recycles the savings of the anxious savers, thereby
propping up demand, and eventually allowing the broken balance sheets of the Irish people to be repaired. Once the balance sheet is repaired, normal economics will resume once again.

But this could take time, and the government’s debt-to-GDP ratio would rise to possibly 200 per cent – where Japan’s is now. Doing something like this would require the state to leave the euro, impose capital controls and issue its own currency all in one weekend. Even if you thought it was the right thing to do, it might be a tall order to execute. Plan B perhaps?
The other way out is to have a massive programme of debt relief because without the debt, people’s anxiety lifts. This would mean defaulting on huge amounts of debts and stiffing the ECB in the
process, because the only way Irish banks could absorb all this domestic debt relief would be if they defaulted on their main creditor, the ECB. This must still be part of plan A. If neither of these choices is being entertained, then the anxiety recession looks likely to condemn this country to possibly a decade of stagnation. It is hard to see – with the huge debt we are carrying, and the trauma associated with the crash – how the economy can perform otherwise. If this excessive caution proves to be enduring, rather than temporary, the economy will not rebound for years. If you doubt that this can happen and can go on for years, consider that the Nikkei Index, Japan’s stock market, ended 2011 at a 19-year low.

Happy New Year – and be careful of that umbrella in the hall.

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