On a number of occasions I have cautioned against deficit-financed fiscal stimuli in countries whose governments have weak fiscal credibility, that is, countries where current tax cuts or public spending increases cannot be credibly matched by commitments to future public spending cuts and tax increases of equal present discounted value. I believe that both the US and the UK fall into this category.
I have spent a good part of my career as a professional economist working on developing countries and emerging markets – in South America, in Central and Eastern Europe and the former Soviet Union and in Asia. Increasingly, I find it helpful to analyse the crises afflicting the US and the UK as emerging market crises – perhaps they could be called submerging markets crises.
During the decade leading up to the crisis, current account deficits increased steadily and became unsustainable. Strong domestic investment (much of it in unproductive residential construction) outstripped domestic saving. Government budget discipline dissipated; fiscal policy became pro-cyclical. Financial regulation and supervision was weak to non-existent, encouraging credit and asset price booms and bubbles. Corporate governance, especially but not only in the banking sector, became increasingly subservient to the interests of the CEOs and the other top managers.
There was a steady erosion in business ethics and moral standards in commerce and trade. Regulatory capture and corruption, from petty corruption to grand corruption to state capture, became common place. Truth-telling and trust became increasingly scarce commodities in politics and in business life. The choice between telling the truth (the whole truth and nothing but the truth) and telling a deliberate lie or half-truth became a tactical option. Combined with increasing myopia, this meant that even reputational considerations no longer acted as a constraint on deliberate deception and the use of lies as a policy instrument.
I used to be optimistic about the capacity of our political leaders and central bankers to avoid the policy mistakes that could turn the current global recession into a deep and lasting global depression. Now I’m not so sure.
I used to believe that the unavoidable protectionist and mercantilist rhetoric would not be matched by protectionist and mercantilist deeds. Protectionism was one of the factors that turned a US financial crisis into a global depression in the 1930s. Protectionism imposes large-scale structural sectoral dislocation, as exporters are ejected from their foreign markets and domestic producers that depend on cheap imported imports suddenly find themselves to no longer be competitive, on top of the global effective demand failure we are already suffering from.
I used to believe that our central bankers would overcome their natural conservatism, caution and timidity to do what it takes to bring to bear the full measure of what the central bank can deliver on a disfunctional financial sector and on a depressed economy, at risk of deflation. Now I’m not so sure. While the Fed is turning on most of the taps (albeit in a unnecessary moral hazard-maximising way), the Bank of England and the ECB are falling further and further behind the curve. What the Bank of Japan does, no-one fully understands, and I will observe a mystified, if not respectful silence.
I used to believe that our fiscal policy makers would, when faced with a combination of national and global disaster, manage to come up with a set of national fiscal packages that would be modulated according to national fiscal spare capacity and that would be designed not only to boost domestic and global demand but also to eliminate or at any rate reduce the underlying global imbalances that are an important part of the story of this global crisis. Instead we find the US engaged in fiscal policies that will aggravate the underlying global imbalances.
Timothy Geithner, the nominee for US Treasury Secretary, has risked damaging the global economy even before his confirmation by the full Senate. In a written answer to questions from US senators, Geithner said: “President Obama – backed by the conclusions of a broad range of economists – believes that China is manipulating its currency”. In the US, the words “currency manipulation” are fighting words. If the US administration were to formally name China as a currency manipulator, a range of trade sanctions could be imposed by the US government.
The threat to world trade comes from the Omnibus Trade and Competitiveness Act of 1988. The section dealing with the exchange rate, bilateral current account balances and the overall current account balance is a monument to economic illiteracy.
Economic policy is based on a collection of half-truths. The nature of these half-truths changes occasionally. Economics as a scholarly discipline consists in the periodic rediscovery and refinement of old half-truths. Little progress has been made in the past century or so towards understanding how economic policy, rules, legislation and regulation influence economic fluctuations, financial stability, growth, poverty or inequality. We know that a few extreme approaches that have been tried yield lousy results – central planning, self-regulating financial markets – but we don’t know much that is constructive beyond that.
The main uses of economics as a scholarly discipline are therefore negative or destructive – pointing out that certain things don’t make sense and won’t deliver the promised results. This blog post falls into that category.
Much bad policy advice derives from a misunderstanding of the short-run and long-run impacts of events and policies. Too often for comfort I hear variations on the following statements: “The long run is just a sequence of short runs, so if we make sure things always make sense in the short run, the long run will take care of itself.” This fallacy, which I shall, unfairly, label the Keynesian fallacy, compounds three errors.
Automobile producers all over the world are in dire straits. Sales and production are plummeting. Unsold inventories are building up on dealers’ lots. Christmas is coming too soon for many workers whose normal end-of-year break has been extended by days or even weeks. Losses are rising fast. Bankruptcy is looming for quite a few household names. What, if anything, should governments do?
The US government has just announced a $17.4 bn loan to the three American automobile producers GM, Chrysler and Ford, $13.4 bn up front, with the rest coming in February 2009 – on Obama’s watch. The loan is short-term, until the end of March, 2009. The bulk of the money, if not all of it, is likely to be drawn by the two basket cases – GM and Chrysler.
The German federal minister of finance, Peer Steinbrueck, does not like anything that increases government deficits. He does not like them, Sam-I-Am. I believe he is wrong – very wrong and dangerously wrong. In the interest of Anglo-German harmony and ever-closer cooperation, I have written this post.
It explains that there are bad deficits and good deficits. Or, in the words of Ecclesiastes: “To every thing there is a season, and a time to every purpose under the heaven:” a time to cut taxes and a time to raise taxes, a time to borrow and a time to refrain from borrowing.
Today is a time, even Ecclesiastes would agree, made for increased government borrowing, provided a few key conditions are satisfied.
President-elect Barack Obama will not be short of economic advice. Little of that advice will be unanimous. The Byzantine complexity of the White House economic policy-making machine means that a range of institutions and individuals will be pushing, pulling and shoving in different directions. With a new President who knows little if anything about economic matters, the adviser who comes out on top in the internecine struggle to be the Alpha-Adviser will effectively be running US economic policy. What are the institutions and who are the people in this play? Will it be drama, tragedy, comedy or farce?
The diminished role of monetary policy
The paralysis of financial intermediation today means that monetary policy (cuts in the official policy rates) have become largely ineffective in stimulating demand. Such cuts now appear to have little if any effect on either the marginal cost or the availability of external funds to non-financial enterprises and households. For individual open economies, the exchange rate provides a mechanism for stealing aggregate demand from the neighbours. If most of the neighbours are also in a situation of deficient aggregate demand, this redistribution of global effective demand – which is all that changes in exchange rates accomplish – robs Peter to pay Paul and is not part of a global solution at all.
The continuing importance of liquidity policy
Central banks are doing the right thing by massively expanding their balance sheets to put as much liquidity into the economy as possible. The balance sheets of the Fed and of the Bank of England have doubled since the crisis started and the balance sheet of the Eurosystem has expanded by about 50 percent. This has been accomplished through open market operations of various kinds, through which the central banks have increased their holdings of private securities by expanding the monetary base, mainly by increasing bank reserves with the central bank and other central bank loans.
Central banks will have to continue to do this. The private financial sector has to deleverage massively, but would (with credit markets and wholesale financial markets closed for business) do so in an unnecessarily destructive way if left to its own devices. The household sectors in the US, the UK and a number of other European countries have to deleverage (start saving seriously) on a significant scale. Left to its own devices, the short-run Keynesian aggregate demand fall-out from a necessary reconstruction of household financial wealth could be disastrous. So the public sector has to leverage up (borrow) at the same time the household sector is forced to deleverage.
This process of monetisation of private sector financial instruments can continue almost indefinitely. It is restricted only by the total stock of private financial instruments outstanding and by the central bank’s willingness to add private securities with higher and higher degrees of default risk attached to them to its balance sheet.
The central bank as the handmaiden of fiscal policy
With monetary policy almost powerless and with liquidity provision also subject to strongly diminishing returns, a traditional fiscal stimulus is the only show in town that has not yet been tried.
In an earlier post to this blog, I raised the possibility that the UK might face a triple financial crisis: a combined banking crisis, sovereign debt crisis and sterling crisis. Let me be clearer than I was before about what I mean by a financial crisis. A financial crisis is a situation where quantity rationing of would-be borrowers and would-be sellers of securities suddenly replaces normal market clearing through variations in interest rates or market prices of securities.
So a sterling crisis does not require a fixed or managed exchange rate regime for sterling. It can occur even when sterling floats, that is, when its external value is market-determined, as it is today.
I’m afraid this post is going to be rather boring (the comment “What’s new?” is taken as made). I intend to take you on a trip through Barack Obama’s Transition Economic Advisory Board.