I am a big fan of Willem Buiter, even on those rare occasions when he is wrong. He is unusually blunt for a Serious Economist, and is willing to take on orthodox views and institutions frontally. He has, for instance, been quite critical of the Fed. He created a firestorm at its last conference in Jackson Hole when, in a presentation, he lambasted the central bank for what he called “cognitive regulatory capture”. That shouldn’t have been a surprise; Buiter had made that observation, forcefully, months ago. But the hosts must have operated under the delusion that Buiter would be deferential rather than speak his mind.
Buiter takes on another bit of orthodoxy today, and it’s a doozy. “Can the US economy afford a Keynesian stimulus?” And the headline is anodyne compared to the text.
It’s important to stress how much Buiter’s post is at odds with conventional wisdom, at least among economists. A whole host of credentialed writers have lined up, shoulder to shoulder, to defend massive deficit spending as the way to get the US out of its economic meltdown. For instance, Paul Krugman, staunch advocate of spending, is so convinced of the validity of his opinion that he adopts a dismissive posture towards opponents (he has elsewhere called them “niggling nabobs of negativism“:
Here’s how I see it: the opponents of a strong stimulus plan don’t really have an alternative to offer. They don’t even have a really coherent critique; as Brad DeLong points out, if you believe that a surge in private spending would raise employment — and even the critics agree on that — it’s very hard to explain why a surge of public spending wouldn’t have the same effect.
Update 1:45 AM: Krugman makes an even more strident case in today’s New York Times op-ed, “Fighting Off Depression.” Back to the original pos†.
True, there are a few naysayers, like Tyler Cowen, who plaintively contends that the evidence for the effectiveness for stimulus is thin and adds:
My view is the disaggregated one that sometimes private spending can stimulate employment and sometimes it cannot. Private spending has the greatest chance of stimulating employment when a) market psychology is on its side, and b) the financial system is relatively well-functioning. Neither is the case right now.
Note that under standard theory neither monetary nor fiscal policy will set right the basic problems from negative real shocks and indeed the U.S. economy is undergoing a series of massive sectoral shifts. That includes a move out of construction, a move out of finance, a move out of debt-financed consumption, a move out of luxury goods, the collapse of GM, and a move out of industries which cannot compete with the internet (newspapers, Borders, etc.)
I’ve never seen a stimulus proponent deny this point about real shocks but I don’t see them emphasizing it either. It should be the starting point for any analysis of fiscal policy but so far it is being swept under the proverbial rug.
Buiter tackles the problem from a different angle. He looks at the standing of the US in the world, economically and financially. He does not argue the Cowen angle, that deficit spending might not lead to growth. His point is different: the US is pretty close to the end of its rope, in terms of relying on the rest of the world for financing. He sees it as a no-brainer that a massive fiscal deficits, whether they are narrowly successful or not, will relatively soon (he estimates 2 to 5 years) lead to a collapse in prices of dollar denominated assets.
Now that point of view might not seem radical; some investors have spoken for some time of the likelihood of a dollar implosion. But among respectable economists, this would have been treated as a lunatic fringe view. But Buiter makes his argument using data and recognized economic constructs.
I am particularly taken with the intro to Buiter’s piece:
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.
An elite economist who is willing to say that economists really don’t know all that much deserves a hearing just for his commitment to intellectual integrity. As Will Rogers said, “it isn’t what you don’t know that will hurt you, it’s what you know that ain’t so.” Questioning accepted wisdom is vitally important, yet too often dissenters are ignored and marginalized.
It is going to be very interesting whether Buiter’s comments are addressed by the economists supporting the Obama program, or are politely ignored. His post is quite long, I strongly urge you to read it in its entirety, and I excerpt key sections below:
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.
The first error is the leap from the correct assertion that a long interval of time is the sum of successive short intervals of time to the incorrect impact that the long-run impact of a policy or event is in any sense the sum of its short-run impacts. The second error is the failure to recognise that our models (formal or implicit) of how the economy works are inevitably incomplete. Parts of the transmission mechanism – positive or negative feedbacks and other causal links between actions today, future outcomes and anticipations today of future outcomes and future actions – that can safely be ignored when we consider the impact of a policy over a year or two can come back to haunt us with a vengeance over a three-year or longer horizon. The third error is that, when economic agents, households, firms, portfolio managers and asset market prices are even in part forward-looking, the long run is now. More precisely, the long-run consequences of current policies can, through private sector expectations and through forward-looking asset prices influence consumption behaviour, employment and investment decisions and asset prices today.
Matching the Keynesian fallacy is the view that just because a certain set of policies is not sustainable, in the sense that it cannot be maintained indefinitely, such policies should not be implemented even temporarily. I will call this the sustainability fallacy…..
Yves here. One of Buiter’s weaknesses, having been in elite policy roles at various points in his career, is sometimes to expect more of government than it can deliver. The real danger, in my mind, of policies that ought to be temporary, is that political processes and human inertia mean that they do not get reversed quickly enough. For instance, Janet Yellin today noted (in effect) that the Fed has no exit program for its fancy alphabet soup of facilities even though they were all supposed to be temporary. If the Fed is afflicted with this problem, imagine how hard it is to turn off programs that are implemented via legislation. That does not mean that they should not be tried, but in evaluating them, one needs to take a hard look at what happens if they persist well past their sell-by date.
Back to Buiter (boldface ours):
First, the fiscal policy actions pursued thus far by the Bush administration, but even more so the policy proposals leaked by Obama’s proto-administration are afflicted by the Keynesian fallacy on steroids. They appear to exist outside time, with neither the long-run consequences of the actions like to be implemented over the next couple of years, nor the history that brought the US to its current predicament, the initial conditions, being given any serious attention….
Even before the crisis erupted, around the middle of 2007, the US economy was in fundamental disequilibrium. The external primary deficit (the external current account deficit plus US net foreign investment income) was running at around five or six percent of GDP. The US was also a net external debtor, Its net external investment position (at fair value, or the statisticians best guess at it) was somewhere between minus 20 percent and minus 30 percent of annual GDP. The US economy managed to finance this debt and deficit position quite comfortably because it gave foreigners an atrocious rate of return on their investment in the US – a rate of return much lower, when expressed in a common currency, than the rate of return earned by US-resident investors abroad…..
The past eight years of imperial overstretch, hubris and domestic and international abuse of power on the part of the Bush administration has left the US materially weakened financially, economically, politically and morally. Even the most hard-nosed, Guantanamo-bay-indifferent potential foreign investor in the US must recognise that its financial system has collapsed. Key wholesale markets are frozen; the internationally active part of its financial system has either been nationalised or underwritten and guaranteed by the Federal government in other ways. Most market-mediated financial intermediation has ground to a halt, and the Fed is desperately trying to replace private markets and financial institutions to intermediate between households and non-financial operations. The problem is not confined to commercial banks, investment banks and universal banks. It extends to insurance companies (AIG), Quangos (a British term meaning Quasi-Autonomous Government Organisations) like Fannie Mae and Freddie Mac, amorphous entities like GEC and GMac and many others.
The legal framework for the regulation of financial markets and institutions is a complete shambles. Even given the dismal state of the legal framework, the actual performance of key regulators like the Fed and the SEC has been appalling, with astonishing examples of incompetence and regulatory capture.
There is no chance that a nation as reputationally scarred and maimed as the US is today, could extract any true ‘alpha’ from foreign investors for the next 25 years or so. So the US will have to start to pay a normal market price for the net resources it borrows from abroad. It will therefore have to start to generate primary surpluses, on average, for the indefinite future. A nation with credibility as regards its commitment to meeting its obligations could afford to delay the onset of the period of pain. It could borrow more from abroad today, because foreign creditors and investors are confident that, in due course, the country would be willing and able to generate the (correspondingly larger) future primary external surpluses required to service its external obligations. I don’t believe the US has either the external credibility or the goodwill capital any longer to ask, Oliver Twist-like, for a little more leeway, a little more latitude. I believe that markets – both the private players and the large public players managing the foreign exchange reserves of the PRC, Hong Kong, Taiwan, Singapore, the Gulf states, Japan and other nations – will make this clear.
There will, before long (my best guess is between 2 and 5 years from now) be a global dumping of US dollar assets, including US government assets. Old habits die hard. The US dollar and US Treasury Bills and Bonds are still viewed as a safe haven by many. But learning takes place. The notion that the US Federal government will be able to generate the primary surpluses required to service its debt without selling much of it to the Fed on a permanent basis, or that the nation as a whole will be able to generate the primary surpluses to service the negative net foreign investment position without the benefit of ‘dark matter’ or ‘American alpha’ is not credible….
The US Federal government has taken on massive additional contingent liabilities through its bail out/underwriting of the US financial system (and possibly other bits of the US economic system that are too politically connected to fail). Together will the foreseeable increase in actual Federal government liabilities because of vastly increased future Federal deficits, this implies the need for a future private to public sector resource transfer that is most unlikely to be politically feasible without recourse to inflation. The only alternative is default on the Federal debt. There is little doubt, in my view, that the Federal authorities will choose the inflation and currency depreciation route over the default route.
If I can figure this out, so can anyone in the US or abroad who follows recent economic developments. The dawning of the realisation will lead to the dumping of the assets….
I now anticipate a Federal deficit of between $1.5 trillion and $2.0 trillion for 2009 and something slightly lower for 2010…
Those familiar with the post World War I and post-World War II public debt levels will not be impressed with even a doubling of the public (Federal) debt held by the public as share of GDP, from its current level of around 40 percent of annual GDP (gross public debt, including debt held by other government agencies, like the Social Security Trust Fund, stands at around 70 percent of GDP)…..Following World War II public debt stood at more than 100 percent of annual GDP.
That, however, was then. The debt was incurred to finance a temporary bulge in public spending motivated by a shared cause: defeating Japan and the Nazis. The current debt is the result of the irresponsibility, profligacy and incompetence of some. Achieving a political consensus to raise taxes or cut spending to restore US government solvency is going to test even the talents of that Great Communicator, Barack Obama…..
So will the Keynesian demand stimulus work? For a while ( a couple of years, say) it may. When the consequences for the public debt of both the Keynesian stimulus and the realisation of the losses from the assets and commitments the Fed and the Treasury have taken onto their balance sheets become apparent, the demand stimulus will fade and may be reserved as precautionary behaviour takes over in the private sector. My recommendation is to go easy on the fiscal stimulus. The US government is ill-placed financially and fiscally, to engage in short-term fiscal heroics. All they can really do is pray for a stronger-than-expected revival of global demand, without any major stimulus from the US…
Given the bad fiscal position of the US Federal government and given the vulnerability of the external position of the US and its growing reliance on foreign funding, the scope for expansionary fiscal policy in the US is much more limited than president-elect Obama’s advisers appear to realise. Underneath the effective demand problem is a deep structural rot, especially in household sector and financial sector balance sheets. Keynesian cyclical policy options that would be open to more structurally sound economies should therefore not be tried on anything like the same scale by the US authorities.
There is plenty more here. Go read it immediately.