After many discussions with conservative economists, often in the comment section of the numerous economic articles we've written, we think we're able to condense the main differences of views on the economy to essentially a single issue. Let's describe some of these differences, and see how they fit into a central theme. The main policy differences are, according to us:
- The risks of large budget deficits
- The risks and efficiency of hyper expansionary monetary policy
We will try to show that much of the difference in views about these policies depend on whether it is acknowledged that the economy is in some kind of 'special state.' Many liberal economist argue the economy is in such a special state (called a liquidity trap or a balance sheet recession) while many conservative economist keep on applying what we will call 'equilibrium', or 'full-employment' economics to the present economy.
Underneath it all is of coarse the even more fundamental difference that conservative economists believe in the self-healing (or equilibrium restoring) power of markets, which would make any prolonged 'special state' economy impossible, while many liberal economists argue that markets can fail and a prolonged period of underemployment equilibrium is possible, and that there is a role for the state to prevent this or get us out.
When we plea for increased spending we are invariably met by people worrying about the size of the public deficit and debt. While we certainly don't want to belittle these, we have solid economic reasons for taking our position, and we have often argued in favor of reigning in the deficit, but not just yet.
Something similar holds for our position on monetary policy, more especially the record low interest rates and rather unprecedented size of asset purchases by the Fed ('quantitative easing' or QE). Yes, these are policies that have both costs (low interest rates for savers) and risks (inflation), but on balance, they do more good than harm, and the risks are small and can be managed, in our view.
Why do we argue these things while the people we often find ourselves at odds with argue for solving the deficit now and/or reigning in the 'market distorting' (financial repression!) quantitative easing or even calls for the Fed to hike interest rates?
Basically, we would agree with these people under 'normal' circumstances, that is, if the economy would produce near full-capacity. But the economy isn't producing near full capacity, there is a large output gap, and this isn't caused by a garden variety business cycle downturn but the result of a financial crisis of rather epic proportions.
Full-employment economics versus a balance sheet recession
The effects of the latter have basically suspended many of the laws of 'normal,' or full-employment economics and given the economy a new, strange dynamic which sometimes even inverts the logic of full-employment economics. This alternative state, which can either be described as a balance sheet recession or a liquidity trap (the first is a term coined by Richard Koo from Nomura, the latter, of coarse, comes from Keynes). The differences between the Koo and Keynesian framework are not really important here, so we'll treat it as a unified perspective, that of a balance sheet recession:
A Balance sheet recession is characterized by:
- Households (US) or firms (Japan's lost decades) and bank balance sheet having been ravaged by the implosion of a credit infused asset bubble.
- Leading to a situation in which the private sector (households and/or firms) will not borrow more but instead save more and spend less, in order to repair the damage to balance sheets.
- This leads to a large surplus of private sector savings over investment, and this savings glut crashes interest rates (Central bank policy does the short end of the curve).
- Despite record low (zero, or even negative, in real terms) interest rates, borrowing doesn't revive until balance sheets are repaired, this is the famous liquidity trap.
Now, we think that this perfectly describes what has happened to the US economy post 2008. There was a whopping $9 trillion hit from falling house prices to household balance sheets and the private sector savings rapidly exceeded private investment:
There are also important policy implications:
- The paradox of thrift: everybody tries to repair their personal balance sheet by spending less and saving more, while this is privately optimal, socially it isn't as it leads to a negative spiral in the economy. My spending is your income, and vice versa. If we both spend less and save more, we both earn less and have to save even more to repair balance sheets. (We also note that we don't even talk about vicious cycles via the financial sector, probably an even bigger risk in creating vicious cycles)
- In a normal business cycle downturn, monetary policy can usually remedy a fall in spending by lowering interest rates. But during a balance sheet recession, just about everybody spends less and saves more in order to repair balance sheets, no matter how low interest rates go. Monetary policy loses much of its effectiveness.
- When the private sector spends less (and banks lend less, their balance sheets have also been affected negatively), the fall in spending has to be compensated somewhere, otherwise the economy risks falling into a vicious cycle. The only real candidate here is the public sector, hence the calls for stimulus packages.
- Since the private sector, in their efforts to repair balance sheets, generates a savings glut, there really is no lack of funds to fund increased public spending, quite the contrary. Hence the record low interest rates despite the large public sector deficits and debts.
In a full-employment equilibrium economics world:
- Large public deficits would risk driving up interest rates, and partially crowd out private investment
- Large asset purchases would boost bank reserves and this would boost lending, risking rising inflation
But we're not in a full-employment world, and 1 doesn't happen because the private sector generates a savings glut and 2 doesn't happen because, well, because the private sector generates a savings glut! There is simply little credit demand, which is why banks are overflowing with reserves, without this leading to accelerated lending.
How the situation present is different
We have some sympathy for free market economist, because the present state is almost like some kind of alternate universe, were many of the normal economic laws are suspended, or even inverted:
- Public sector borrowing, even on a large scale does not lead to high interest rates and thereby crowd out the private sector
- "Money printing," even on a large scale, does not lead to accelerating inflation
- Fiscal policy is the only (macro) policy lever left, no surprise, the essence of a balance sheet recession is that the private sector is deleveraging and the reduction of spending needs to be compensated. Not by monetary policy, as the private sector is reducing debt, rather than adding to it.
We happen to think that there is overwhelming evidence that the economy is in such a special situation in which normal laws don't apply:
- Despite record public deficits and debts, rather than having high (or at least increasing) interest rates, we're having record low interest rates
- This is a situation that can sustain itself for a long-time, witness what has happened in Japan over the last two decades
- We've been countered with arguments that interest rates (those on bonds, that is, bond yields) are so low because the Fed buys so many. Well, QE probably has had some impact, but not much. It's been announced three times and stopped twice, without this making much of a difference on yields. If you still don't believe us, look at the past decades in Japan. The BoJ embarked only six years on QE, and this hasn't made much of a difference on yields either.
- Despite record QE ("money printing!"), inflation has been entirely subdued. Again we point to Japan, which has a much longer lasting experience with this, despite six years of QE and large public sector deficits and debts, it suffers from deflation, not inflation.
- Premature fiscal contraction, in a situation in which the private sector is still delevaraging, is counterproductive. Witness Spain, the US in 1937, or Japan in 1997. In each case, fiscal stimulus was ended prematurely, with rather disastrous results.
It must be hard for conservative economists to make sense of this alternate universe, and we've seen many falter. Inflation will come, some of them predict, year after year. Interest rates will rise. But none of this has happened and from Japan we know that the special state can last a long time, even decades.
With respect to Japan it's now interesting that they're finally going to throw everything and the kitchen sink to the situation, they've been far too conservative all that time and deflation got hold of the economy. The US shouldn't fall in that trap, it shouldn't use equilibrium, full-employment economics in a situation in which the economy clearly doesn't work that way.
As far as macro policy risks, there are 'liberal' and 'conservative' risks. The conservative risk is to apply equilibrium economics in a balance sheet recession (leading to disastrous advice of ending QE, hiking interest rates and embarking on austerity, for instance). Here is Alan Meltzer, really not just anybody:
Milton Friedman often said that "inflation was always and everywhere a monetary phenomenon." The members of the Federal Reserve seem to dismiss this theory because they concentrate excessively on the near term and almost never discuss the medium- and long-term consequences of their actions. That's a big error. They need to think past current political pressures and unemployment rates. For the next few years, they cannot neglect rising inflation.
That was early May 2009, four years ago. The article gets off to a bad start by comparing the present, balance sheet recession to the inflationary period of the late 1970s, but if you have only one model for the economy, what you put in is what you get out.
The liberals have a mirror image risk, to employ liquidity trap economics in a normal economy. We've written about Argentina, and how they escaped their own crisis, and how they continued to pump the prime long after it was useful and they are now sitting on 30% inflation. That's no surprise to us.
We do acknowledge that the economy will, at some time in the future, emerge from the balance sheet recession deleveraging and accompanying liquidity trap, and return to 'normal,' that is, a state in which the normal economic relationships work as the conservative (and most liberal!) economist predict it they will. A liquidity trap is not forever. Then it will be time to embark on the conservative recipes, but not before.
We also belief that the transition can be managed. The economy will grow faster when the private sector is no longer deleveraging, credit demand will revive, and interest rates can move up and QE stopped. The growth will also improve public finances, in fact, this is already happening.
At the heart of the problem is that conservative economists tend to see the economy as self-healing. The price mechanism will restore equilibrium so an output gap or large unemployment are not phenomena that can exist for very long, let alone the downward spirals of a Fisherian debt-deflation or a Keynesian paradox of thrift.
The first describes a dynamic were falling asset prices feed on themselves, the paradox of thrift describes a situation in which everybody tries to save more by spending less, leading to a fall in demand, output, employment and people starting to save even more.
Therefore, the belief that markets always restore equilibrium leads to a denial that a balance sheet recession or a liquidity trap are even possible, and arguing that equilibrium economics has universal validity.
But work by Fisher, Keynes, and Richard Koo (the Nomura economist that coined the term balance sheet recession) have, quite convincingly (both theoretically and perhaps even more importantly, empirically) shown that this isn't the case. As we've shown above, the economy can move away from full employment for prolonged periods of time and during that time normal economic relationships can be suspended, or even inverted.