The gut-wrenching shifts and shocks of 2008 have left us all feeling less secure. Even the most seasoned bears have been surprised by the extent of the havoc.
In the latest Economist magazine, Olivier Blanchard, Chief Economist of the International Monetary Fund states that policymakers should focus on reducing uncertainty. His prognosis amounts to being bold with the sort of packages we are becoming familiar with: deal with toxic assets, rescue the financial sector, recycle funds away from safe havens to where they may do more good, and a little retail therapy.
Why the focus on uncertainty? Uncertain times lead to growing savings and disinclination to take risks because it is hard to know the size of the risk. When travelling, for example, there is a known risk of having an accident on take off although you can’t know if it will happen this time. Uncertainty is when we move beyond such calculations. There are too many “unknown unknowns”. If there is too much uncertainty, then markets seize up. But this got me thinking.
If things are so very uncertain, how do we know what to do? Blanchard thinks that he has techniques which can rescue us. The unknown unknowns are, he thinks, manageable. Such distinguished economists as Caballero (MIT), Shiller (Yale), Alesina (Harvard) and Thoma (Oregon) agree. They comment on Blanchard in an Economist blog. They are generally supportive (Alesina being more cautious) of a “do a lot” and “try a lot of different things” approach, given all the uncertainties. One writer suggests that it is like using a big dose of broad spectrum drugs in the hope that something will work.
So much for diagnosis! To the uncertainties of the situation, add the uncertainties of the economists over what to do, other than that it should be plenty.
But my distinguished colleagues - who have forgotten more complex equations than I’ve ever managed to grasp – seem to have overlooked some more basic economics. There are two ways of dealing with uncertainty in economics, neither of them being the kitchen sink approach of Blanchard and Co. First, one looks at the ability of a system to withstand shocks. Well, not much in this case. So, we certainly have a problem. Second, and logically enough, one works out from the “known knowns” towards the “unknown unknowns”. That is, start with the basics.
So, let's see. The goal is to reduce uncertainty. I’ve previously written about the challenge of restoring trust. So, using economic basics, what impact will the Blanchard policies have? A quick survey is alarming:
• Determined central bank action. Some is necessary. But whither monetary policy now that Greenspan has tested to destruction the conventional wisdom of (a) narrow focus on CPI and not worrying much about debt or asset price inflation, and (b) light-handed regulation of financial markets?
• Low interest rates. Sounds nice. But what happens when bond issues from all over the world flood the market? When supply surges price usually drops. Will the U.S. escape damage? If it does, which other major economies are at risk and with what knock-on effects?
• Rescuing the big banks. Maybe it’s a necessity in order to keep capital flowing. But, with major financial entities humiliated and in debt to the government, do we trust them any more? How can we gauge the impact on the financial sector of new waves of regulation and likely political direction on loans?
• The re-discovery of big government. Some fiscal stimulus is needed but how effective will massive, new spending be and who will get crowded out? If there is economic recovery, how easy will it be to roll back the stimuli? The New Deal changed the political shape of America forever.
• More government borrowing. Unavoidable, but we all know the issues about debt accumulation, servicing and repayment and the way we are heading into unknown territory. What will happen when the U.S. government can no longer meet all its domestic and international obligations and expectations – what gives?
• Raise household consumption. This could boost the economy if households can be persuaded out of a retrenchment phase. But more consumption equals less saving. Wasn’t too much borrowing and too little saving a part of the problem in the first place? So, can the government persuade households to spend more and should it try?
Under each of these headings, the policies Blanchard & Co suggest look more likely to increase than decrease uncertainty. Limited short run gains are liable to exacerbate long run instability. We are wading deeper into the unknown unknowns.
So, why pursue such policies if they fail the basic test of reducing uncertainty? Economists like to explain how difficult it is to fight market forces, such as price and quantity shifts that reflect fundamentals. Yet, here we have a bunch of knowledgeable economists admitting that they are all at sea but wanting to fight market fundamentals and uncertainty with whatever is at hand, even though that is liable to increase uncertainty. I suppose it’s difficult to resist coming up with detailed plans that somebody in Washington might like.
To achieve economic revival, the disease has first to be dealt with. Hence, the radical tenor of so many of the comments on Seeking Alpha and elsewhere. But common sense suggests the opposite of radical surgery: get back to basics. Faced with so many unknown unknowns, the solution is to work from what is known. Start at Econ 101. Too much debt? Pay it down by saving more and forgoing consumption. Non-viable banks and corporates? Beyond limited cushions, let them fail and the assets they have used poorly be redistributed around their wiser brethren. Yes, this will mean a nasty contraction but it clears away the debris and lets counter-cyclical forces get to work. Trying to avoid the adjustment exacerbates the unknowns, paralyzing private investment and risk taking, and thus the chances of sustained recovery, whilst getting deeper into debt.
Unlike House in the medical drama, our cast of expert economists seek to make the patient comfortable and hopeful, rather than relentlessly pursuing diagnosis and cure. Pity we all have a stake in the patient’s recovery.
