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Festina lente – hurry slowly – is advice we have inherited from the ancient Romans. Western policymakers should now take it to heart. Confronted with huge fiscal deficits, many have concluded that they should hurry fiscal tightening on as fast as possible, in the hope that it will prove expansionary. What are the chances that they will be right? Small, I believe. Moreover, rather better alternatives are on offer. But their drawback is that they are unorthodox: alas, many “sound” people prefer orthodox recessions to unorthodox recoveries.

Why might a sharp structural fiscal tightening promote recovery? As Harvard’s Alberto Alesina and Silvia Ardagna note in an influential paper, smaller prospective deficits may improve confidence among consumers and investors, thereby raising consumption and lowering risk-premia in interest rates.* Meanwhile, on the supply side, fiscal tightening may increase supply of labour, capital or entrepreneurship. The broad conclusions of their paper are that fiscal adjustments “based upon spending cuts and no tax increases are more likely to reduce deficits and debt over gross domestic product ratios than those based upon tax increases. In addition, adjustments on the spending side rather than on the tax side are less likely to create recessions.” This line of argument has strengthened the will of George Osborne, the UK’s new chancellor of the exchequer.

Is it persuasive? In a word: no. The authors group together data for members of the Organisation for Economic Co-operation and Development between 1970 and 2007. But the impact of fiscal tightening is going to depend on circumstances.

A reduction in the fiscal deficit must be offset by shifts in the private and foreign balances. If fiscal contraction is to be expansionary, net exports must increase and private spending must rise, or private savings fall. Thus, experience of fiscal contraction is going to be very different when it occurs in a few small countries, not in many big ones simultaneously; when the financial sector is in good health, not impaired; when the private sector is unindebted, not highly leveraged; when interest rates are high, not close to zero, when external demand is buoyant, not feeble; and when real exchange rates depreciate sharply rather than remain fixed.

In short, when, as now, the economies affected by financial sector fragility make up half of the world economy (indeed, together with the still feeble Japanese economy, close to 60 per cent); when the most dynamic large economy in the world – China – is mercantilist; when interest rates are near zero; and when businesses and households are credit-constrained, the view that an early fiscal tightening will prove strongly expansionary is surely heroic. I hope it will be true. But there is little reason to believe it.

Another study, by the US Committee for a Responsible Federal Budget, examined the cases of Canada, Denmark, Finland, Ireland and Sweden. What emerges is the importance of external demand and, in several cases, of huge exchange rate depreciations (see chart). Are these successful examples really relevant to the US and European Union today? I very much doubt it.

Yet another approach is to find a situation that is indeed quite like today’s. The closest parallel is the 1930s, in terms of the proportion of the world economy affected by the crisis, the low interest rates and the disinflationary (or, in that case, deflationary) background. A study published last year concluded that fiscal stimulus was effective when tried.** It follows that fiscal tightening would have been – indeed was – contractionary at that time.

In current circumstances, the belief that a concerted fiscal tightening across the developed world would prove expansionary is, to put it mildly, optimistic. At this stage, I will inevitably be asked: what is the alternative? If these huge deficits continue, markets will take fright, interest rates will jump and the debt dynamics will become truly awful.

I have two responses to this.

The first, one I made a week ago, is that the deleveraging cycle is generating huge private sector financial surpluses across the developed world. Unless we expect a shift into aggregate external surpluses (and corresponding deficits in the emerging world), these surpluses must now to be invested in government liabilities. This helps explain why yields on the bonds of safer governments remain so low.

The second response is that if governments need to run deficits, to support demand at a time of private sector weakness, they can always borrow from central banks. Yes, this is “printing money”. It is also an insanely radical policy recommended by no less insane a radical than Milton Friedman, back in 1948. His view was that the government could expand the money supply during recessions and contract it in the subsequent booms. A country with a fiat currency and a floating currency could, thus, stabilise the economy without destabilising credit markets. The neat thing about this proposal is that one does not have to decide whether fiscal policy or monetary policy is doing the heavy lifting: they are two sides of one coin.

The argument for aggressive monetary expansion remains strong, though not equally everywhere, since the growth of broad money and nominal GDP is weak (see chart). So Friedman’s policy of “quantitative easing”, as it is called, still makes good sense. Am I recommending the economics of Robert Mugabe? No. As in everything else, it is the context that matters. At present, we have “too little money chasing too many goods”. In this environment, monetary policy must be aggressive. When the economy recovers, the monetary effects should be withdrawn, via budget surpluses obtained via long-term control over spending. In the short term, changes in reserve requirements can offset the impact on monetary expansion of the rise in deposits of commercial banks at the central bank. Since, in practice, the money supply is driven more by the demand for credit than reserves, this may be unnecessary.

The conventional wisdom is that a strong and co-ordinated structural fiscal contraction, focused on spending, will promote the growth of a thousand private blooms. I hope this will prove true. But I doubt it. Governments should hurry slowly. If they all hurry quickly, they – and we – may regret it nearly as soon.

* Large changes in fiscal policy, working paper 15438, www.nber.org

** Almunia et al, The effectiveness of fiscal and monetary stimulus in depressions, www.voxeu.org

martin.wolf@ft.com

FT.com / Columnists / Martin Wolf – Why it is right for central banks to keep printing.

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I. MISTAKING BEAUTY FOR TRUTH

It’s hard to believe now, but not long ago economists were congratulating themselves over the success of their field. Those successes — or so they believed — were both theoretical and practical, leading to a golden era for the profession. On the theoretical side, they thought that they had resolved their internal disputes. Thus, in a 2008 paper titled “The State of Macro” (that is, macroeconomics, the study of big-picture issues like recessions), Olivier Blanchard of M.I.T., now the chief economist at the International Monetary Fund, declared that “the state of macro is good.” The battles of yesteryear, he said, were over, and there had been a “broad convergence of vision.” And in the real world, economists believed they had things under control: the “central problem of depression-prevention has been solved,” declared Robert Lucas of the University of Chicago in his 2003 presidential address to the American Economic Association. In 2004, Ben Bernanke, a former Princeton professor who is now the chairman of the Federal Reserve Board, celebrated the Great Moderation in economic performance over the previous two decades, which he attributed in part to improved economic policy making.

Last year, everything came apart.

Few economists saw our current crisis coming, but this predictive failure was the least of the field’s problems. More important was the profession’s blindness to the very possibility of catastrophic failures in a market economy. During the golden years, financial economists came to believe that markets were inherently stable — indeed, that stocks and other assets were always priced just right. There was nothing in the prevailing models suggesting the possibility of the kind of collapse that happened last year. Meanwhile, macroeconomists were divided in their views. But the main division was between those who insisted that free-market economies never go astray and those who believed that economies may stray now and then but that any major deviations from the path of prosperity could and would be corrected by the all-powerful Fed. Neither side was prepared to cope with an economy that went off the rails despite the Fed’s best efforts.

And in the wake of the crisis, the fault lines in the economics profession have yawned wider than ever. Lucas says the Obama administration’s stimulus plans are “schlock economics,” and his Chicago colleague John Cochrane says they’re based on discredited “fairy tales.” In response, Brad DeLong of the University of California, Berkeley, writes of the “intellectual collapse” of the Chicago School, and I myself have written that comments from Chicago economists are the product of a Dark Age of macroeconomics in which hard-won knowledge has been forgotten.

What happened to the economics profession? And where does it go from here?

As I see it, the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth. Until the Great Depression, most economists clung to a vision of capitalism as a perfect or nearly perfect system. That vision wasn’t sustainable in the face of mass unemployment, but as memories of the Depression faded, economists fell back in love with the old, idealized vision of an economy in which rational individuals interact in perfect markets, this time gussied up with fancy equations. The renewed romance with the idealized market was, to be sure, partly a response to shifting political winds, partly a response to financial incentives. But while sabbaticals at the Hoover Institution and job opportunities on Wall Street are nothing to sneeze at, the central cause of the profession’s failure was the desire for an all-encompassing, intellectually elegant approach that also gave economists a chance to show off their mathematical prowess.

Unfortunately, this romanticized and sanitized vision of the economy led most economists to ignore all the things that can go wrong. They turned a blind eye to the limitations of human rationality that often lead to bubbles and busts; to the problems of institutions that run amok; to the imperfections of markets — especially financial markets — that can cause the economy’s operating system to undergo sudden, unpredictable crashes; and to the dangers created when regulators don’t believe in regulation.

It’s much harder to say where the economics profession goes from here. But what’s almost certain is that economists will have to learn to live with messiness. That is, they will have to acknowledge the importance of irrational and often unpredictable behavior, face up to the often idiosyncratic imperfections of markets and accept that an elegant economic “theory of everything” is a long way off. In practical terms, this will translate into more cautious policy advice — and a reduced willingness to dismantle economic safeguards in the faith that markets will solve all problems.

Full article: September 6, 2009 How Did Economists Get It So Wrong? By PAUL KRUGMAN

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” (…) The idea that flexibility is good and rigidity is bad continues to influence the minds of policymakers and analysts. Rating agencies, for example, continue to give a more favourable rating to US and UK sovereign debt based on the notion that the greater flexibility of these countries gives them a better capacity to adjust to the crisis than rigid countries such as Spain, Italy and Ireland.

The opposite is true. Today, rigidities in wages, employment and social security allow countries to deal better with the great rigidity that the fixed levels of debt impose on households and companies. We should cherish these rigidities. (…)”

Paul De Grauwe, FT.com, February 22 2009

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(…) “Why has the Obama administration been silent, at least so far, about one of President Obama’s key promises during last year’s campaign — the promise of guaranteed health care for all Americans?” (…)

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“(…) If, after all, the banking system is so vital to a modern economy that it cannot be allowed to go bust – and the dangers of socialised risk and privatised profit are so evidently great – then it is too important to be left in the hands of private companies dedicated to maximising profits for their shareholders. (…)”

The Guardian, Seumas Milne, Thursday 22 January 2009

See here the entire article.

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