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Sloppy economics 3

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Sloppy economics 3

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On the one hand, it is unfortunate that the U.S. Federal Reserve under the leadership of Ben Bernanke intervened aggressively to save the financial system from a meltdown in the fall of 2008, and that the U.S. Congress enacted a $800 billion stimulus package to prop up demand. If there had been no policy response whatsoever to the collapse of the financial system in 2008, the U.S. and most of the world would now be in a Great Depressions. Credit markets would have frozen completely, major global financial institutions would have failed (Goldman Sachs would no longer have been around), consumer and business confidence would have plummeted towards 0, and unemployment rates would be be approaching 20% and rising.But at least this would have demonstrated once and for all that there is no automatic and relatively painless adjustment mechanism in unregulated markets.

On the other hand, it is very fortunate that Bernanke and the U.S. Congress did act. The economic damage that would have resulted from inaction would have been catastrophic, vastly eclipsing the worst case scenarios threatened by global warming alarmists.

But now, less than 24 months after the trough of the recession and the brink of disaster, “many prize-festooned economists” (to quote David Brooks), most European leaders and central bankers, and many economists at international institutions (according to David Brooks) are arguing in favor of fiscal restraint and higher interest rates. Even as the economic recovery in the U.S. and the EU weakens and unemployment rates remain stubbornly high, neo-classical economists and their capital market stooges are criticizing the policy decisions of the past 20 months, and are claiming that the greatest threat to a sustained recovery is further fiscal and monetary policy stimulus.

The neo-classical economists, and this group does include most central bankers, believe that credible fiscal restraint will boost confidence, which in turn will lead to growth in consumer and investment spending.

David Brooks, writing last week in the New York Times, took a swipe at economists such as Paul Krugman who are advocating another round of fiscal stimulus, and he seemed to side with the neo-classical economists. While Brooks was sceptical of the value of the models of so-called “Demand Side” theorists, he did not seem to challenge the models of the critics. Yet, their models contain serious flaws and never have provided a useful basis for policy. But the only way their models could have been discredited, once and for all, would have been to run the experiment of non-intervention that I described at the beginning.

Brooks stated: “These days, debt-fueled government spending doesn’t increase confidence…You (referring to President Obama) can’t read models, but you do talk to entrepreneurs in Racine and Yakima. Higher deficits will make them more insecure and more risk-averse, not less. They’re afraid of a fiscal crisis. They’re afraid of future tax increases. They don’t believe government-stimulated growth is real and lasting. Maybe they are wrong to feel this way, but they do. And they are the ones who invest and hire, not the theorists.”

Almost sounds convincing.

However, confidence is driven by jobs, income growth, sales and profits, and these depend on demand, which depends on fiscal and monetary stimulus when the economy is in a recession or experiencing sluggish growth. Fiscal deficits do not negatively impact confidence at such times. Nor do fiscal deficits negatively impact confidence during the early stages of a recovery. The demand siders fully understand this.

The neo-classical economists, on the other hand, put forth their models based on the assumptions (and no more than this – the math is irrelevant) that large deficits negatively impact confidence and markets adjust automatically and quickly to any shock (does anyone remember rational expectations?), in order to argue in favor of a much diminished role for government. It is this group that engages in wishful thinking and sloppy economics.

The opinions expressed in this blog are personal and do not reflect the views of either Global Brief or the Glendon School of Public and International Affairs.

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2 Comments

  1. Irvin Studin July 12, 2010

    Great blog, F.

  2. Jaspreet Narula July 21, 2010

    Very true!

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