September 22, 2016

Mainstream Economics Has Failed, Part 1

One of the long-standing themes in my macroeconomic writing is the structural decline in growth in the Western world. Recently others have slowly began to give the sluggish growth the attention it so desperately needs. One of the better examples is a new report for JP Morgan where economic analysts Michael Hood and Benjamin Mandel write:
Considerable dissatisfaction among policymakers and voters surrounds economic performance in developed and merging economies alike. Despite very supportive monetary policy stances, growth is running at a weak pace by historical standards. To a large extent, this sluggishness reflects a structural slowdown in potential growth, driven by demographic changes. Given that estimates of these trend rates are uncertain, though, central banks have continues to explore ways of boosting demand, acting in increasingly unconventional fashion ... But now these actions appear to have come close to their limits. As a result, calls for greater use of fiscal stimulus have grown louder. 
Before we move on, a note of caution.

Every time someone suggests that the structurally slow growth in the Western world is caused by some sort of demographic "change", please reach for your rhetorical revolver. There is no evidence worth even a cursory look that a decline in birth rates is responsible for the decline in growth. If population growth was instrumental to economic growth, then countries like Bangladesh, Malawi and Burkina Fasu would be economic powerhouses; by contrast, China with its one-child policy would have its feet solidly planted in the same agrarian land that Mao crossed during his Long March.

With that said, it is refreshing that the JP Morgan analysts recognize that the growth slowdown in the West is structural, i.e., permanent unless structural measures are taken to fix the problem.

Unfortunately, the world is long on economic stagnation and short on structural solutions. According to Hood and Mandel the latest idea among policy makers is to return to the days of fiscal stimulus. After years of (highly irresponsible) expansionary monetary policy more and more politicians in the West are coming to realize that flooding the economy with liquidity does not help. In a comment on the JP Morgan report, the Wall Street Journal explains (Sept. 15, p. A2):
Now, just as [expansionary monetary policies] reach their limits, government are quietly stepping up. Fiscal policy across the developed world is collectively turning more stimulative for the first time since the end of the recession. This may be the most under-appreciated economic development of the year. While the scale of the stimulus is modest in dollar terms, it signals a profound shift in the political winds. 
The shift consists of a demotion of budget deficits, from being highly ranked among politicians to being almost not spoken of. Instead, the fiscal-policy spotlight is increasingly falling on stimulative measures. 

Sadly, there is about as little economic merit to more deficit spending as there is to lax monetary policy. Here is what conventional macroeconomic wisdom says:
  • Monetary expansion depresses interest rates whereupon private-sector investors can take cheaper loans and execute investment plans that they have had in their desk drawers but not found profitable enough at higher rates;
  • Fiscal expansion generates a multiplier effect because of increased activity in the economy, by means of growing household income, increased consumer spending and, in response, rising business investments.  

In the past few years the Federal Reserve, the European Central Bank and the Bank of England have all taken monetary expansion to an extreme. Interest rates are negligible and there is more liquidity in the economic system today than there is water in the Atlantic Ocean. Thanks to negative overnight deposit rates banks are penalized if they try to deposit excess liquidity with their central bank, creating yet another incentive for banks to lend, 

The problem is that very slow growth is like a rationing tool for profitable business opportunities. Markets are stagnant, profit margins depressed and the risks associated with investments rise quickly as soon as the projects get just a little bit outside of the mainstream. Therefore, demand for credit to fund business investments is limited and in itself stagnant. 

Long story short, monetary policy has not worked as intended. 

Fiscal policy would enter the same macroeconomic context where monetary policy has failed. The key variable here is not business investments but consumer spending; the theoretical argument is that when government spends more money, new private-sector jobs create more household income, out of which consumers always spend a stable, highly predictable part. The rest is saved.

There is just one flaw in this argument, and it has the same foundation as the flaw behind the argument for monetary stimulus. There, businesses refuse to invest because they are either uncertain about the profit of potential investment projects, or certain that they will lose money on them. In the context of the fiscal stimulus, consumers are uncertain about the future of their own earnings and their ability to continue to earn a paycheck. This keeps them from spending money; whatever they have they use to pay down loans or pile up savings (which, theoretically, is the same thing since it increases the individual's net worth). It also keeps them from increasing their debt.

In short: a stagnant macroeconomic environment is rife with uncertainty; in times of uncertainty, "he who hesitates is saved to make a decision another day" (Paul Davidson: Money and the Real World).

The solution to the perennial stagnation in Western economies does not lie in policy instruments designed for an era when 3-4 percent growth could be taken for granted. The era of the macroeconomic quagmire, in which we currently live, requires radically different policy solutions. 

What solutions? Stay tuned for Part 2.

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