Wednesday, June 6, 2012

More on the great macroeconomic debate of our time

I have written about this before. But the debate rages on and I am no more wiser on this than before. The aftermath of the Great Recession has triggered off one of the fiercest debates in economics between those advocating Keynesian government stimulus spending and those proposing austerity.

The former argue that given the depth of the recession, persistence of unemployment, and the relative ineffectiveness of monetary policy at the zero-bound, the only way to boost aggregate demand is through massive stimulus spending. The latter claim that the huge public debt overhang has spooked the markets, eroded business confidence, and depressed growth. They contend that the only way out is for austerity to rebalance the economy and restore market confidence.

The small sub-plot to the fiscal policy debate is the arguement held by people on both sides that monetary policy still has traction and can be used to restore growth. Even many of those opposing fiscal spending favor accommodatory monetary policy and unconventional responses like quantitative easing. Some influential economists are now suggesting the use of nominal GDP targeting by central banks and governments. Critics however point to the resource misallocation and bubble formation dangers associated with such loose monetary policy. They liken it to pumping more and more steroids on to a struggling patient.

Now, there is little likelihood of any satisfactory conclusion to this debate. There are positive and negatives with both sides of the argument. Though more inclined towards the Keynesian arguement, I can't make up my mind on it with any comfortable degree of certainty. There are clearly compelling arguments on both sides.

In a recent FT op-ed Raghuram Rajan, one of the most ardent adocates of austerity, made two interesting points to support his position. One, he attributes the fall in demand to the housing bust and attendant mortgage meltdown which has left millions of households with an overhang of debt. Therefore, whatever pump-priming government does, it is not possible to stimulate demand without repairing household balance sheets. Second, he argues that the pre-crisis demand was unsustainable, driven as it was by debt, and therefore it may not be desirable to return back to the pre-crisis growth pattern.    

I have mixed opinions on the two points. The former arguement is questionable on multiple grounds. For a start, there is now ample evidence to dispute the claim that the property bubble and mortgages caused the sub-prime crisis and Great Recession. Further, even if we assume that claim to be true, the current economic situation - the depth of the recession, persistance of high unemployment rates, and across the board decline in economic activity - is that the recession is an economy-wide problem and not something confined to certain specific sectors or categories of population. With households debt-ridden, banks wary of lending, corporates holding back investments due to uncertaine conomic environment, the only stimulus for growth has to come from governments.

But I agree with the second point made by Prof Rajan. It is very clear that American consumers binged on cheap imports and borrowings over the past decade. That level of consumption, especially when compared with incomes, cannot be sustained and therefore any effort to restore growth to the pre-crisis trends may not only be not possible but also may be undesirable. To this extent, he is right in claiming that "demand, without the dangerous stimulant of borrowing, will stay weak".

The fundamental issue is this - how do we stimulate growth? This would require households to start spending again (but not at the frenetic pre-crisis pace), banks re-start lending, and businesses to resume investments. Further, the impact of the depressed economic activity is being felt by local governements whose tax revenues have dipped, thereby forcing many of them to cut down on services and lay-off public employees. Each one is inter-related with the others and remains constrained. How do we break this gridlock?

Keynesians favor government spending to kickstart and provide the stimulus to restore growth. But there is the danger that the stimulus may not be properly targeted and/or the fiscal policy instrument deployed is not the most effective one to combat the current recession. And even if it is targeted and the optimal instrument deployed, it may be too small to make any serious dent. A further danger is that the government is fiscally constrained due to high public debt and fiscal deficit and therefore a failed stimulus would worsen the situation and make recovery steeper. Critics also argue that any such recovery will come in the way of wringing out the excesses from the sub-prime bubble era.

Supporters of austerity feel that a period of fiscal adjustment and reforms will repair the battered household and business balance sheets and restore the animal spirits that will encourage banks to lend and businesses to invest. But the danger with this is that fiscal adjustment could drive the starving man to death. What if none of the expected outcomes materialize? Further, what if the economy slips further down the slope? There are also the longer term social and economic consequences of being out of the labour market for a long time.

In the circumstances, even as the debate rages on, there are atleast two things on which some form of convergence of views may be possible. One, those most affected by the recession will have to be provided an extended basic social safety net coverage. This will not only mitigate the personal sufferings and social tensions associated with such dismal times but also provide some form of floor against a free fall in aggregate demand. Second, given the size of the hole in household balance sheets, policy will have to focus on starting an agressive repair process. In this case, those underwater home mortgages will have to be quickly restructured.

Update 1 (27/6/2012)

Paul Krugman describes three dimensions of the ongoing debate between classical macro (freshwater school) and Keynesian macro (saltwater school),
One was interest rates: would large budget deficits drive rates up, as a classical view implied, or would they do no such thing under depression conditions? A second was the effects of austerity (which has been much larger than the weak efforts at stimulus, and therefore provides the real test); would austerity policies release resources to the private sector, as per the classical view, or lead to economic contraction? Finally, a third implication involved inflation: would large increases in the monetary base produce soaring inflation, again as classicists of all kinds claimed, or do no such thing under depression conditions?
Krugman and Richard Layard have this joint FT op-ed which they describe as a "manifesto for economic sense".  They argue that "conditions for the crisis were created by excessive private sector borrowing and lending, including by over-leveraged banks" and no by "excessive government borrowing". The austerity policies that have been put in place have worsened the situation.

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