Wednesday, July 14, 2010

Fiscal Tightening - A Nasty Surprise? - Alpha

The world will begin its largest real-time experiment testing the ideas of two dead economists. I feel deeply uncertain about the outcome, as things could get nasty.

The big policy question today: Are governments removing stimulus policies and tightening too quickly?

-The 1930's Lesson: FDR made this mistake in 1937 (after reflating the economy in 1932-35), in response to budget/debt hawks, causing the second Great Depression (there were two depressions in the 20th century, one from 1929-1932, the other from 1937-1938). See: http://en.wikipedia.org/wiki/Recession_of_1937%E2%80%931938

Christina Romer, now a top Obama economics advisor, explains the lessons from the 1930s here: Romer Speech on the Depression

-PRO Spending (The economist Keynes' view): If governments remove stimulus spending too early (by cutting spending and raising taxes), when confidence is low, unemployment high, and factory utilization capacity low, it could plunge the world into depression again. Right now, governments are the only entities that can keep demand and the economy up, and they should counter debt deflation (when people just save and pay off debt, hurting the economy) by spending. Otherwise, the world will go into a vicious cycle, confidence will go down as unemployment gets worse, and the world will reach a bad economic equilibrium point.

Paul Krugman explains the logic of a "spend more, cut later" view in simple terms in two editorials:
http://www.nytimes.com/2010/06/21/opinion/21krugman.html

http://www.nytimes.com/2010/06/18/opinion/18krugman.html?ref=paulkrugman

Also the FT's Martin Wolf gives more nuanced detail here on why monetary and fiscal stimulus must continue: http://www.ft.com/cms/s/0/fc8d1dd4-78b6-11df-a312-00144feabdc0.html

http://www.ft.com/cms/s/0/969c17c6-7e2b-11df-94a8-00144feabdc0.html


-CONTRA Spending (The economist Hayek's view):
If governments spend too much and build up deficits, it makes the economy structurally uncompetitive and leads to the long term mis-allocation of resources, not to mention strange boom bust cycles (and it supports failures and penalizes the successful, with the banking bailouts being a perfect example). There is also a risk of debasing all the major global currencies, which would have deleterious effects.

Or as Keynes himself put it:
"The best way to destroy the capitalist system is to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens."

Also, countries that overspend can get stuffed with too much debt, and they can go bust like Greece recently did, in a nasty way. So the best view is to tighten and let natural forces of austerity, default, and unemployment take hold. This view is actually quite similar to Treasury Secretary Mellon's view in the US in 1930 (leading to the Great Depression):

"Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate."

Many argue that it made the Depression worse (some argue it was worse in the short run, but healthier/better in the long run). The austerity hawks point out that Japan's massive fiscal and monetary stimulus after 1990 didn't help, but that may be an incorrect analysis, as Adam Posen discusses here: Posen BoE Speech

Today, the data seems to suggest that most developed country (OECD) governments are tightening. Germany is taking the lead with the most draconian austerity measures, showing discipline. The US is the exception because economics advisors Summers and Romer seem to have convinced President Obama that stimulus now is better - note, the only US deficit hawk in the govt,. Paul Orszag, resigned this week. One interesting analysis from Bob Davis of the WSJ:

"Essentially, the world’s two largest economies — the U.S. and the EU –are addressing their biggest current and historical fears. For the U.S., that’s a repeat of the mistakes of the Great Depression when Presidents Hoover and then Roosevelt withdrew stimulus too soon, which prolonged and deepened the downturn. For Europe, it’s a fear of repeating the mistakes that produced the hyperinflation of the 1920s which gave rise to Nazism, added to the current fear of repeating the problems of Greece, which teetered on the edge of debt default before an EU-International Monetary Fund rescue package was approved. Hence, the European focus on austerity."

DATA POINTS FROM AROUND THE WORLD (RECENT NEWS)

Western world cuts back spending: http://www.ft.com/cms/s/0/aaa8ffc2-7e2b-11df-94a8-00144feabdc0.html
Europe tightens fiscal policies: http://www.ft.com/cms/s/0/9acbb194-5eaa-11df-af86-00144feab49a.html
German finance minister explains austerity and scolds the US: http://www.ft.com/cms/s/0/9edd8434-7f33-11df-84a3-00144feabdc0.html

UK presents extreme budget cuts: http://www.ft.com/cms/s/0/0db4130a-7c8c-11df-8b74-00144feabdc0.html
Canada cuts spending: http://www.ft.com/cms/s/0/2c15e9fc-7bc1-11df-aa88-00144feabdc0,s01=1.html
Japan begins to cut spending and stabilize debt: http://www.ft.com/cms/s/0/b10c1e24-7dab-11df-a0f5-00144feabdc0.html
The US is still trying stimulus measures: http://www.reuters.com/article/idUSTRE64F21Q20100516

The new head of ECB/EU monetary policy likely will be Axel Weber, a strict hawk more concerned about inflation that employment:
http://www.bloomberg.com/news/2010-06-17/weber-defies-trichet-over-europe-bond-bailout-as-ecb-succession-approaches.html
http://blogs.wsj.com/economics/2010/06/23/krugman-criticism-bolsters-weber-in-germany/

I don't know which economic worldview is correct, but I have an uneasy feeling about how this will end.

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