Pity the lost generation

The time for cutting public spending is not now, not next year and not the year after. We must help

The spectacular failure of Lehman Brothers a year ago has become a convenient excuse for those who failed to spot the recession. "Once events changed, dear boy, I responded," is the established line. Sorry policymakers, not good enough: you missed the greatest financial crisis for a century. Interest rates should have been cut earlier. Not good enough, journalists, who kept writing that we weren't in recession and that it was only the threat of inflation that mattered. So they argued interest rates needed to be high, and that made matters worse. Wage price spirals were everywhere, they thought, but it turned out they only existed in their imaginations. The collapse of Lehman was a symptom, not the cause. It was all terribly predictable.

Here is my evidence. First, by September 2008, the US had been in recession for nine months and the US housing market for 18months; unemployment had been rising for even longer. Second, in the UK, Northern Rock had failed in September 2007, and we had been in recession since the spring of that year, while the UK housing market had peaked a year earlier. Third, the Baltic Dry had lost two-thirds of its value between June and early September 2008. This is the best measure of world demand. It isn't subject to speculation.

The world was in deep recession before the fall of Lehman, which was a shock to the financial system and made matters worse. But would we have been in better shape if Lehman had been rescued? Absolutely not. This is because policymakers around the world had not understood the seriousness of the crisis. Academic economists were of little help. Since the events of a year ago, it is interesting how few of them have stood up and told us where the profession went wrong and why, and what we should do to get out of this mess. For example, where were the 31 full professors of economics that I count on the website at the LSE and the 27 full professors of economics I count at the University of Oxford, along with lecturers, senior lecturers and readers? You pay their salaries. It's about time we heard from them. Speak up!

The collapse of Lehman was a body blow to those economists around the world who had designed worthless mathematical models, based on unrealistic assumptions that they then used to convince themselves that a recession of this kind could never happen again. Some even got Nobel prizes for trotting out this worthless twaddle, such as Robert E Lucas Jr.

Scientists around the world would be appalled to hear that economic policy was made on the basis of abstract models that had not been tested against the data. Unsubstantiated assertion ruled, which meant that large parts of economics had become closer to theology than to the natural sciences. People weren't supposed to act in herds, but they did.

So where did all these useless economic models get us? Actually, in pretty dire straits. Most worrying to me, at present, is the state of the youth labour market. Britain has nearly a million people under the age of 25 who are already out of work; two-fifths of the unemployed. And their numbers are high because of a demographic echo that dates from the baby boomers, who have since had their own children and so on. There are 13.5 per cent more 20-year-olds today than there are ten-year-olds and 11.5 per cent more than the number of 30-year-olds.

Unemployment is going to continue to rise this year and may keep on rising. If spending cuts are made too early and the monetary and fiscal stimuli are withdrawn, unemployment could easily reach four million. If large numbers of public sector workers, perhaps as many as a million, are made redundant and there are substantial cuts in public spending in 2010, as proposed by some in the Conservative Party, five million unemployed or more is not inconceivable. Crime will inevitably rise and there will be widespread social unrest if this happens. But this isn't the fault of the millions of young people who have had the misfortune to be born at the wrong time. And those with student loans to pay back are especially distressed at the thought of being unemployed. They could be our lost generation.

We must not repeat the mistakes of the 1930s by assuming a recovery is taking place and then cutting spending and raising interest rates too early. Such action could push the economy into a decade-long depression. In fact, we should not think of any fiscal retrenchment until we have reached what Robert Skidelsky calls a "quasi boom". Just like pornography, I don't know how to define what this is, but I will know it when I see it. We are not there yet. Actually, even though the acute phase of the crisis is over, we are not out of what Keynes, in 1930, called the "dragging conditions of semi-slump". The time for cutting public spending is not now, not next year and not the year after.

It is not hard to work out that, with unemployment rising fast, it isn't the right time to cut public sector jobs, wages or public spending for that matter. These are automatic stabilisers. Mr Osborne, I really don't know which economists are advising you on this brilliant strategy to increase unemployment, but feel free to give me a call. Unemployment makes voters unhappy.

All of this, then, opens a big opportunity for the Labour Party to define itself against the Tories. Gordon Brown needs to focus the government's efforts right now on getting our people back to work. Priority number one. And the main focus should be on the young, who are scarred by unemployment spells in a way that older people are not. Policy action has been taken, but not on a large enough scale. The Labour party conference would surely back such a plan. And so, I suspect, would the electorate. Reducing unemployment is a vote winner. Go for it, Gordon; it isn't too late.

David ("Danny") Blanchflower is professor of economics at Dartmouth College, New Hampshire, and the University of Stirling
His economics column will appear weekly

Watch an interview with Danny Blanchflower at youtube.com/user/newstatesmanmagazine