“Take your medicine – it tastes awful, I know, but it will make you better and in a few days you’ll be glad you did.”
That doesn’t sound like high-tech medical care, more like a home remedy (castor oil?). That is, however, essentially the medicine being prescribed to deal with the current global economic misery – take a dose of austerity now (cut back government jobs and government spending) and you’ll feel better in the morning.
That may be the right prescription for a mild case of over-borrowing – for many developing countries in the late 20th century, who had vast loan packages thrust on them by developing national and multinational banks, it was important to reduce borrowing and raise taxes to bring government spending back into balance. Why? Because their debt became so great that no one was going to lend them any more money, and once that was known, nobody wanted to hold their currency, or invest in their markets, and their interest rates soared. So their currencies and stock markets crashed. But once they revamped their fiscal policy, and people became assured that government revenues were sufficient to service their debts, their credit lines re-opened, their currencies recovered, and their economies quickly bounced back to growth.
Yet that is not where the US is now — everyone wants to hold US currency and bonds, our interest rates are at historical lows, and the stock market is still, even after last weeks gyrations, almost double its level of two years ago. As Ken Rogoff has pointed out more clearly than anyone else, we are not in a severe but otherwise ordinary recession. And it was not caused by excessive government borrowing. Rather, we are in a true Depression, (call it the 2nd Great Contraction, like Rogoff, or the Lesser Depression, like Paul Krugman), that was brought on by individual households, banks, and corporations loading themselves up with way too much and too risky borrowing, backed up by insufficient assets and therefore never going to be repaid. And once that became known (starting with the collapse of Lehman Brothers), no one would lend money to anybody, and the economy completely froze up and started to collapse.
So governments around the world stepped in to shower money on banks and corporations, to try to reassure investors that there was enough money in the system to keep the economy going, and that the banks and corporations would be able to stay in business and eventually have enough profits to be able to write off their bad debt or repay it. But for all the individual households who had borrowed too much for homes or other purchases? They are still trying to figure out what to do to get out of their mess, and not spending as much, trying to save and reduce their debt, so the economy remains very weak.
Clearly, the economy is still awful – long-term unemployment is at levels not seen since the Great Depression, and overall economic growth has been flat for almost a decade. Unfortunately, we do not have a science of economics up to the task of telling us how to get out of this mess. The dirty little secret of economics is that while there is great consensus among scholars on how economies function in equilibrium – that is, when things are going normally and economic growth is in line with population growth or a bit better, and things are pretty steady except for the occasional hiccup of a short recession. Virtually all economists agree on models for this situation (called the “general equilibrium model”). This is what Larry Summers calls the “ketchup” part of economics – we can prove that under equilibrium conditions, the market price for a widely sold, competitively offered product, like ketchup, is such that a two-quart bottle of ketchup is exactly twice the price of a one-quart bottle of ketchup.
But economic science does not have any agreement on how economies function when they are out of equilibrium, whether that is when they are growing like gangbusters (that is, moving from underdevelopment to developed status) or when they are stuck in deep misery (like now).
Instead, we have various schools of economists that fight over whose ‘cure’ is the one that really works, much like vendors of competing cures in the wild west days of medicine. “Efficient market” theorists say that their model for equilibrium economies (the right prices clear all markets) is also the right model for a major depression. They say there is nothing the government can do to alleviate the misery; just let goods return to their ‘proper prices’ and efficient markets will clear things up. The problem with this theory is that recent evidence suggests that it is either completely wrong or a prescription for disaster. That is, if home prices, which have fallen by almost a third, are not yet at their ‘proper prices,’ how far do they have to fall? If they have already fallen to or below their proper prices, why is the housing market still moribund, despite the lowest interest rates in history? If they have to fall still further, how far? Will half the population have to go bankrupt if the ‘proper prices’ are another 20% lower than they are today?
“Keynesian” theorists do have a model of non-equilibrium economics, the model of how economies get stuck in a depression developed by John Maynard Keynes in the 1930s. They say the government can do something, that our problem is not distorted prices but a reluctance of anyone to lend anyone else money (because they don’t know if they will get paid back if the assets backing the loan are declining in value), and a reluctance of potential borrowers to borrow (because they are already maxed out or trying to reduce their debt). So economic activity remains depressed, and the lower that asset prices fall (deflation) the more economic activity will contract. So Keynsians want the government to do something – spend money and put it in the pockets of potential buyers. This will give companies more customers, and induce them to hire and borrow to meet that demand. In fact, the US followed Keynesian policies in 2009-2010, adopting a ‘stimulus package’ of spending, and just as the model predicted, the economy immediately stopped shrinking and started growing (see my post “Do the Facts Matter?”), and then stopped growing as soon as the stimulus started to run out.
Yet unemployment did not fall by much, but that is because the model and
experience tell us that unemployment is always the last element to recover from a depression; so the stimulus would have had to last longer for people to gain enough confidence that growth had returned to start hiring. But of course critics
point to the lack improvement on unemployment and say the Keynesian
policies just plain didn’t work.
Finally, we have the Tea Party/Republican prescription, which says that all government spending is bad, especially debt-financed spending, as it drives out private spending, and that it is better to let the government fire people from their government jobs even when unemployment is very high and make them look for work in the private sector, as that will make the economy as a whole better off. So their plan is to cut back government spending, reduce government borrowing, and not under any circumstances raise taxes. That sure sounds appealing and straightforward. The problem is that it is pure quack medicine, without a shred of evidence or any theoretical model held by any reputable economist to suggest that it will work to ignite economic growth or reduce overall unemployment.
So which medicine does it appear our economy is going to get for its misery? The scary answer, of course, is (c), the quack cure. Why? Because the serious economists cannot agree on which model is right for non-equilibrium conditions, and because the evidence from recent actions is too short or ambiguous to be decisive, and because when self-interest is at stake, ideology often prevails over science.
If there is any economist who I think actually has a cure for what ails the global economy, it is Ken Rogoff. His analysis of the problem, with Carmen Reinhart, is not based on abstract models or short-term evidence, but on the careful study of major contractions over hundreds of years of historical experience. His prescription is pretty simple – if the problem that sank the economy is that everybody has too much debt (not the government, mind you, but households, banks, and corporations), then you have to do something to lighten the debt so that people can start fresh. The best way to reduce everyone’s debt in real terms is to have a period of high inflation – three to four percent for a period of ten years would cut everyone’s real debt in half, raise the nominal value of their major assets (especially houses) and return the economy to something like normal equilibrium conditions. So let’s do it!
Of course we won’t, because in our world, real historical experience counts for less than either formal mathematical theories (which don’t agree) or ideology (which offers quack cures).
Here is a sentence you are unlikely to hear from any world leader: “Because the global crisis has hit hardest at the working and middle classes, who are burdened with falling home prices and stagnant incomes, we are going to make it the focus of our economic policy to restore the value of their hard-won assets and increase their wages.” Too bad – you’d think it would be a politically winning move, as well as good economic policy. But we seem to be living in a world where quack policies prevail.