What a Strange World

What a very strange world indeed.

This morning we have Joe Stiglitz, who has a reputation for being a bit of a renegade in economics, arguing against more quantitative easing in an op-ed piece for the Financial Times. At the same time we have Gavyn Davies reporting in the same paper that Bernanke is hell bent on just such a policy. Last I looked both Stiglitz and Bernanke were card carrying members of the economics elite. I wonder if they talk to each other.

Meanwhile in France the locals are all in a huff that the government is trying to raise the retirement age from 60 to 62. The fun part is that the main core of the striking horde is now made up of students whose retirement is, presumably, a fair way off. The French love strikes and take to them with gusto, but this is ridiculous. By the time those students retire the government will be bankrupt as it tries to pay for retirees living for 25 to 30 years beyond their retirement age, when the funding assumed they’d all only live for about 10 years. So they had better watch what they wish for.

But back to Stiglitz and Bernanke.

The central point that Stiglitz makes is based upon the thinking that earned him the Nobel Prize a few years back. This is that the economy is inherently uncertain. Well he didn’t go that far, he is way too establishment to be that controversial. He couched it in sensible and bureaucratically acceptable terms: there are “asymmetries” of information that disrupt the smooth and perfect workings of the market place. In vernacular terms: I may know something about the thing I am selling that you, that you, the buyer, don’t. Duh. Unfortunately this is the kind of commonsense that passes for dramatic and deep insight bin theoretical economics. Anyway. Stiglitz deploys this stunning piece of thought against the proposed monetary policy we know as “quantitative easing”, or QE2 – the ‘2’ implying this would be a second version.

Here’s his argument: advocates of monetary policy assume that we know the outcome of that policy. They argue there is a clear cause and effect. The cause being the introduction of a wad of cash into the economy. The effect being a surge in investment, and thus spending, associated with that wad of cash. Stiglitz points out, correctly in my view, that the relationship between cash infusion and investment/spending is not that clear. We only have to look at the current situation to see that. The economy is awash with cash that no one seems in a hurry to invest. Plus, the banks are flush yet are not willing to lend. Small businesses especially are finding it hard to get credit, and the rates being charged when credit is granted bear little relation to the Fed funds rate. So the causal link between the central bank’s action and the real economy is less straightforward than the theorists think it is.

Nonetheless Bernanke, ever the earnest academic, is fretting about what to do with the malaise. He has written extensively on the Japanese and their ineffective approach to solving a similar crisis. He berated them for inaction and for being tentative. So his current bout of ineffective and tentative policy making must be – I assume – driving him crazy. He is hemmed in by austerity freaks and assorted other anti-social elements within the economics fraternity, but I get the sense he wants to break free and do QE2 with gusto. The problem is that QE2, like all medicines, has unfortunate side effects. Which Stiglitz, unencumbered by the need to do anything on his own account, is kind enough to point out to us. You see it isn’t just that the connection between monetary easing and investment growth is unclear, there is also the small matter of the implied losses in the easing, and the potentially disruptive effects on global currencies..

When the Fed buys a ton of assets from the markets in order to inject cash into the economy, it is taking a risk. Like all investors it now has a portfolio that rises or falls in value as interest rates rise or fall. This is awkward. The whole point of stimulus is to get the economy going. The implication of a stringer economy is that the Fed will have to raise interest rates to head off potential inflation. The moment it does this its portfolio of bonds goes down in value. In effect the Fed is buying high and selling low. Not very sound. We, the taxpayers, will presumably underwrite that loss. Just add it to our – very extensive – tab.

Then there’s the impact that all those extra dollars will have on foreign markets. They will flood out towards high return economies and thus become “hot” money capital flows into emerging markets. The governments of those nations are none too pleased at the prospect of the Fed undermining their currencies and trade. So currency and trade wars are looming. This is not at all helpful: one of the things that made the Great Depression truly great was the breakdown of trade that went along with the responses made by governments of the day.

So, Stiglitz has a good point.

His alternative is to argue for fiscal policy instead of monetary policy. This is heretical since economic orthodoxy has become beholden to monetary policy being the more efficacious and thus the preferred option. Fiscal policy is viewed as a desperate last resort. Hence the hand wringing and wailing during the whole stimulus debacle. All those orthodox economists being dragged kicking and screaming into a Keynesian policy world was not a pretty picture. Now, as things settle down somewhat, those same economists are all reverting back to type by arguing that we abandon fiscal policy and go back to using the good old monetary approach. This is, by the way, the same policy approach that pumped the economy so full of debt that we created the internet and real estate bubbles. But, hey, who’s counting those?

Yet fiscal policy is far more precise. It can be targeted exactly. And we know what it does. Spending on unemployment assistance is well known to increase demand. The relationship is tight, and as exact as can be in any economy. So too does spending on infrastructure. Fiscal policy just works. The problem is that the cost is entirely exposed for all to see: the deficit rises, and the national debt goes way up. This allows the weaker amongst us to cry wolf: they see the debt as a burden on the future and a possible problem to our creditors. They prefer either that we do not act and just suffer through a depression; or that we sweep the cost of our action under the monetary policy carpet where we can pretend there is no lingering cost at all. But nothing costs nothing. And cleaning up the mother of recessions cannot be cheap. Besides proper government investment is well known to bring long lasting returns to society. Like the internet whose research and development was a government project. Or the interstate road network. Or, more prosaically, keeping thousands of fire and police workers on the job to protect us all from calamity. Fiscal policy works.

And that’s what its opponents cannot abide. The idea that the government is actually good at providing certain services, at lower cost and with wider coverage, than any private provider could is too much for the more ideologically committed free market supporters to bear. So they do everything in their power to denigrate the effectiveness of fiscal policy. Most often without the benefit of any evidence they simply rant about it and attack the supposed increase in government in the economy.

Which brings me to my last point on this strange day.

Despite what you might have heard, the size of government has not increased. It has tracked along with the economy pretty much as usual. The way to look at this analytically is to project what government spending would be as a relationship with the economy’s normal growth path. Once we do that we see that the share of GDP represented by government spending is stable. It has not suddenly exploded and swallowed the economy whole as some of our right wing friends would argue. Not at all. The image of a huge government takeover of the economy comes from two associated phenomena. First: the private sector collapsed into a monumental funk due to its vast over indebtedness. Second: government revenues dropped like stone as a result of that collapse. Taxes dropped because incomes dropped. But government spending kept on rising. In relationship to our severely depressed economy it appears to have grown substantially. But compared with where it would be had we avoided the crisis it is normal.

Which is exactly what we want to happen. That steadiness of government spending helps offset the private sector collapse. Imagine where we would be had the government gone on an austerity kick to balance its books. Deep in depression. On second thoughts don’t imagine that. It’s too ugly to contemplate. Far too ugly.

Yet there are people who would send us down that hole.

What a strange world it has become when some serious people would wish us to be in a depression rather than spending money to save ourselves.

Very strange indeed.