Hi all. Here’s another summer re-run I wanted to post at NC, but this time from Marshall Auerback. As you know, there has been a heated debate amongst economists as to what policy makers should do if anything about the loss of jobs and the attendant fall in demand and output in the wake of a large credit crisis. As I see it, there are four schools of thought. If I could give crude labels to them and their advocacy, I would say: a) Keynesians – monetary and fiscal stimulus b) Monetarists – monetary stimulus c) Minskyians/Richard Koo – fiscal stimulus d) Austrians – no stimulus
Marshall Auerback falls into camp three and he presents the argument for fiscal over monetary stimulus below. This post originally ran at Credit Writedowns in September 2010 but I think the concepts are as relevant today as they were then, especially in light of the pullback in both monetary and fiscal stimulus now two years into this interregnum recovery.
Regardless, there seems to be an inevitability about policy decisions at this juncture because we seem to be marching straight down the path I laid out in October 2009 in my post “The recession is over but the depression has just begun”:
- The private sector (particularly the household sector) is overly indebted. The level of debt households now carry cannot be supported by income at the present levels of consumption. The natural tendency, therefore, is toward more saving and less spending in the private sector (although asset price appreciation can attenuate this through the Wealth Effect). That necessarily means the public sector must run a deficit or the import-export sector must run a surplus.
- Most countries are in a state of economic weakness. That means consumption demand is constrained globally. There is no chance that the U.S. can export its way out of recession without a collapse in the value of the U.S. dollar. That leaves the government as the sole way to pick up the slack.
- Since state and local governments are constrained by falling tax revenue… and the inability to print money, only the Federal Government can run large deficits.
- Deficit spending on this scale is politically unacceptable and will come to an end as soon as the economy shows any signs of life (say 2 to 3% growth for one year). Therefore, at the first sign of economic strength, the Federal Government will raise taxes and/or cut spending. The result will be a deep recession with higher unemployment and lower stock prices.
- Meanwhile, all countries which issue the vast majority of debt in their own currency (U.S, Eurozone, U.K., Switzerland, Japan) will inflate. They will print as much money as they can reasonably get away with. While the economy is in an upswing, this will create a false boom, predicated on asset price increases. This will be a huge bonus for hard assets like gold, platinum or silver. However, when the prop of government spending is taken away, the global economy will relapse into recession.
- As a result there will be a Scylla and Charybdis of inflationary and deflationary forces, which will force the hands of central bankers in adding and withdrawing liquidity. Add in the likely volatility in government spending and taxation and you have the makings of a depression shaped like a series of W’s consisting of short and uneven business cycles. The secular force is the D-process and the deleveraging, so I expect deflation to be the resulting secular trend more than inflation.
- Needless to say, this kind of volatility will induce a wave of populist sentiment, leading to an unpredictable and violent geopolitical climate and the likelihood of more muscular forms of government.
- From an investing standpoint, consider this a secular bear market for stocks then. Play the rallies, but be cognizant that the secular trend for the time being is down. The Japanese example which we are now tracking is a best case scenario.
The relevant points are #4-8 because they are recursive. We have already seen one round through in 2010. My sense is that the pullback in policy stimulus will be greater this go round, in Europe, the US, and in China in particular. This will lead to another round of economic weakness – inviting an even more aggressive policy response.
By Marshall Auerback, a portfolio strategist and hedge fund manager.
As is often the case, the genesis of this post is a conversation initiated by Edward (Harrison) on the question of why we aren’t using monetary policy to stimulate aggregate demand. That question was posed here by Tyler Cowen at Marginal Revolution.
The short answer that I gave Ed is that you can’t really use monetary policy to stimulate aggregate demand because the impact of monetary policy is much more diffuse and variable. As I’ve said before, for every winner who derives benefits from lower rates, there is a loser in the form of, say, a pensioner, who is deprived of income. Tyler Cowen also points this out. Monetary policy is a very diffuse instrument – like using a meat cleaver instead of a scalpel for a surgery. I would also note that this dichotomy is of particular interest to people like Ed who worry that concentrating on aggregate demand obscures problems related to an economy’s resource allocation.
Fiscal policy is the only way to deal with both the problem of lack of aggregate demand and resource allocation. In particular, if we want to encourage private sector deleveraging, short of mass default or repudiation, this has to be supported by government spending, which means fiscal policy. This can take the form of direct government spending, but it can also take the form of tax cuts. That is a political/distributional question, as opposed to an economic one.
But for both, the underlying reality is the same: As the private sector withdraws spending (aggregate demand) and starts reducing its debt levels, the only way that GDP can continue growing is if there is an external trade boom (unlikely overall, especially since all countries by definition can’t become net exporters) and/or fiscal support.
Fiscal deficits have to provide the support to demand to keep national income growing to provide the capacity for the private sector to save. It is a basic macroeconomic reality. The paradox of thrift has to be subverted. As we’ve argued before, quantitative easing won’t cut it. Quantitative easing merely involves the central bank buying bonds (or other bank assets) in exchange for deposits made by the central bank in the commercial banking system – that is, crediting their reserve accounts. It’s an asset shuffle, plain and simple. It does nothing to enhance aggregate demand, but does penalize savers at the expense of debtors.
The idea that monetary policy can be used to “unblock” credit and hence stimulate additional demand is wrong on so many levels. At the most basic level, most of us would probably agree that we don’t want a return to the status quo ante, whereby growth is overly reliant on private sector credit growth. We want income growth, which means we should be targeting policies needed to generate full employment. Again, this comes back to fiscal policy.
The notion that the evil banks who have received all of this government money but are holding back recovery because of a refusal to lend is ludicrous. Banks are fully capable of making loans at any time, but are unwilling to do so under present circumstances because (a) aggregate demand is so weak that they cannot find creditworthy customers and (b) economic activity is insufficiently robust to engender any confidence among borrowers that the things they might be better off by expanding production (with working capital borrowed from the banks).
Credit follows creditworthiness, not the other way around. Virtually all proponents of “monetary policy uber alles” fail to understand this elementary point.
In other words, today’s ongoing sluggishness reflects a policy misperception at the heart of policy today in both the US and the UK (the euro zone offers separate challenges, due to its institutional structures). Both governments, under the sanction of their respective central banks, have placed inordinate reliance on monetary policy and too little on fiscal policy as the preferred policy response, and, moreover, have encouraged the hysteria surrounding the increasing deficit through their own comments (talking about “exit strategies”, etc). Ed believes this will continue and has suggested a second dip may be coming as a result.
The reason credit is tight in the US at present is because the banks are being very cautious and they do not perceive a strong demand coming from credit worthy customers. Once they assess that there are worthy borrowers they will lend regardless of the central bank expansion of reserves. Additionally, borrowers have minimal capacity or ability to borrow, due to declining incomes which precludes the ability to service existing loans. Credit, as James Galbraith reminds us, is a two-way contract between borrower and lender, not a one-way “credit flow” from banks to borrowers, which can be solved by “unblocking credit” via bank bailouts.
One other point which is seldom made on the virtues of fiscal policy: it actually enhances financial stability. A fiscal policy deployed properly toward generating full employment (say, via a Job Guarantee scheme) means you have growing incomes and, hence, a great ability on the part of the borrower to service his/her existing debts. Debt which is successfully serviced means reduced write-offs for banks and, hence, less impaired balance sheets. In other words, fiscal policy starts the process of financial reform from the bottom-up, rather than top-down. The sooner President Obama and others figure this out, the better will be the outlook for the US economy. But don’t hold your breath. We still seem far away from that.