Why do economies grow?

There is a massive literature seeking an answer to this question, and I have no wish to provide a survey. However, I am struck by the disconnect between the academic literature on growth and the current economic policies pursued by the UK government and central bank.

The centerpiece of the current strategy is bank lending. It is almost universally agreed that the UK doesn't have enough credit growth at the moment and that every tool available must be directed towards increasing lending. Why is lending so important?

Basically, it's a demand-side argument; if credit contracts, consumption and investment fall, causing a decline in GDP. Falling demand leads to rising unemployment, which multiplies the negative impact of the initial credit contraction.

Like all dangerous arguments, it contains an element of plausibility. For example, it's not hard to see how a firm wishing to invest would be constrained by a sudden lack of bank credit. Let us ignore for a moment that banks are not the only source of capital. Firms can issue equity or use retained profits to finance investments. Let's concede the point and recognize that bank lending might influence growth through investment channel. More bank loans mean more capital which translates into a larger supply of goods.

However, this argument cannot apply to consumption. If an individual takes out a loan to finance a flat screen TV, demand increases today, but the individual now has a debt that must be repaid in the future. A personal loan transfers income from the tomorrow to the present. Debt cannot make a person richer; it makes them poorer because they have to pay interest.

The sad truth about the UK economy is that growth was temporarily boosted by a flood of cheap consumer credit, which allowed the household sector to transfer future expected income into the present. In turn, this led to rising household debt levels, with interest payments eating into a larger proportion of disposable income. Banks created this credit by massive leveraging and when default rates rose fractionally, it pushed the UK banking sector to the edge of total destruction. We all now understand this, however, few have fully acknowledged the implications of this new reality.

The lesson is both simple and unpalatable. The UK can no longer rely on an artificial boost to demand caused by reckless bank lending and the insatiable appetite of households for credit. Household balance sheets are stretched to the limit and a period of painful consolidation would be the best strategy.

However, UK policymakers think they have an answer to the financial crisis. It is to cut borrowing costs to a minimum and to the extent possible turn interest rates negative. The government replaces households and borrows huge amounts of money to keep demand high. The Bank of England plays its part by printing cash. If all goes well, inflation will rise and eat away at the nominal value of household sector debt.

In other words, the government intends to inflate the problem away, robbing savers in order to protect borrowers. It's a massive wealth redistribution scheme, which if we are honest, we would call theft.

However, let's leave moral indignation for another day and return to our original question. Will this strategy led to higher economic growth in the long run? Call me a cynic, but I am doubtful that we will be better off as a result of today's zero interest rates and huge government borrowing.