This article originally appeared on my site Credit Writedowns
As we approach the new year, I have decided to write a few thematic posts as a look back at some of the more important economic topics that this credit crisis has uncovered. The thinking is that tying posts together in a theme might give a better holistic view of a few themes than the posts do in isolation.
The first topic is this: does fiscal or monetary stimulus work? That has been a consistent theme here at Credit Writedowns. And given my recent post backing away from fiscal stimulus as a policy tool, I thought it an opportune moment to explore the subject a bit via a full-scale review of previous posts at Credit Writedowns.
Broadly speaking, the policy choices in a deep downturn are the ones I outlined last month in "Stop the madness now!."
You have four options:
- No stimulus. Let the chips fall where they may. Yves Smith calls this the 'Mellonite liquidationist mode.' The thinking here is that trying to avoid the inevitable bust only makes it that much larger. And the economic policies during recessions in 1991 and 2001 seem to bear that out. The Harding Recession of 1921 is commonly seen as gold standard response.
- Monetary stimulus only. Quantitative easing mania. My understanding is this is what Ambrose Evans-Pritchard has been advocating. The thinking here is that the flood of money and the low rates will eventually jump start the economy. No deficit spending needed.
- Monetary and fiscal stimulus. Full-tilt Keynesian. This is the Krugman view. The thinking here is that one needs to credibly commit to higher inflation and close the output gap to avoid a deflationary spiral. If that is insufficient, then one needs to go full bore on fiscal stimulus aka deficit spending. And if that doesn't work, subsidize jobs. The New Deal is commonly seen as the gold standard response.
- Fiscal stimulus only. Deficit spending. I have been talking up this view. The thinking here is that we need to both close the output gap to prevent a deflationary spiral and revive private sector savings in order to promote deleveraging.
There is no magic bullet here. We are living through a situation unique in time with few historical precedents. And there are a lot of competing ideas being tossed about. So policy makers are groping around, desperately seeking the holy grail of depression-busting economic policy. In that regard, I don't envy them. They are certainly going to make a lot of mistakes. It may seem at times that I don't realize this given the harshness of my critiques, but I do.
When I started writing about the financial crisis, I took the first view, best exemplified in my pre-Lehman posts on the origins of the credit crisis and precedents in Japan and the Great Depression. My thinking at the time was that if policy makers recognized the full extent of the crisis and stayed ahead of the curve, we could get through this with a short but very sharp downturn.
- The US Economy 2008 - Mar 2008
- Credit deflation and the Japanese problem - Jun 2008
- The Japanese Problem is now ours - Jun 2008
However, policy makers were woefully behind the curve. A recent article in the Washington Post highlights how Ben Bernanke and the Federal Reserve were blindsided by the crisis. So, when the panic that resulted from the Lehman crisis struck, I felt that the jig was up. We had been catapulted overnight into a seriously debt-deflationary economic environment in which monetary policy was ineffective. Option number two was out as a policy tool. Quantitative easing was not going to work.
The following posts outlining our thinking on these topics.
- Quantitative easing: printing money like mad to ward off deflation - Nov 2008
- Nouriel Roubini: Will massive stimulus ward off stag-deflation? - Dec 2008
- Quantitative easing and inflation expectations - Dec 2009
As I saw it, the Lehman failure marked a clear change in possible policy paths. As I outlined yesterday:
when Lehman Brothers collapsed in a heap, it was clear to me that we faced a stark choice. One choice was a deflationary spiral and the associated economic dead weight loss of a non-equilibrating global economy in Depression. The other choice was a soft depression cushioned by fiscal (and monetary stimulus). About a year ago I wrote an ode to Keynesian economics called Confessions of an Austrian economist in which I said that I choose fiscal stimulus to cushion the downturn and prevent a depressionary spiral.
And this is the line I stuck to. I think the real debate about whether or not to try fiscal stimulus revolves around the role of government and its limitations. Ideologues on one side see government as a parasite which interferes with the free market. On the other side, ideologues see government as the only way out of a crisis of this magnitude. The key sticking point is not just the size of government, but also its effectiveness - the political will to effect change rather than to favor constituents as recent research suggests bailout money was used.
I have tried to outline this debate with a few posts that point to both sides of the issue.
- What does Mises say about trying to stimulate the economy out of recession - Dec 2008
- A brief philosophical argument about the role of government, stimulus and recession - Dec 2008
- Peter Schiff: "Government is a burden on the economy" - Jan 2009
- Marc Faber: The economic crisis is a consequence of U.S. government intervention - Feb 2009
- The choice is between increasing or decreasing aggregate demand - Oct 2009
- A few thoughts about the limitations of government - Nov 2009
The majority of Americans fall in neither of the two ideological camps. I would argue that the reason Barack Obama was elected was his message of hope and the promise of "change you can believe in". That had many of us - including me - thinking government can add stimulus while simultaneously encouraging saving and deleveraging, reducing dependence on asset prices, and allowing zombie companies to fail. This is government dispensing with crony capitalism. The posts below are an ode to that reasoning. You can see Buffett, Kasriel, Gross and Galbraith all taking this line.
- Congress ready with second stimulus package - Sep 2008
- Bill Gross: This economy requires a check from the government - Feb 2009
- Some tidbits about stimulus, recovery, and the Great Depression - Feb 2009
- Jamie Galbraith: Stimulus not enough - Feb 2009
- Galbraith and Buffett think a second stimulus is necessary - Jul 2009
- Does the US need a second stimulus package? - Jul 2009
- Japan does not demonstrate the failure of stimulus - Nov 2009
- Are we pushing on a string or crowding out? - Dec 2009
So, how has this worked out in practice? Not so well. From the very start, Obama's lead by negotiating with oneself approach led to a weak and poorly crafted stimulus package. My comments in "Obama takes middle road on stimulus and taxes that leads nowhere" from February sum up what was likely to happen (emphasis added):
In my view, it has become ever more apparent that the Obama administration is caught in some sort of muddle, trying to fudge between the calls for fiscal discipline from conservatives and the calls for stimulus from liberals. Obviously, it is in Obama's nature to lead by consensus, and he has looked for an inclusive political and economic strategy since he came to office. However admirable these intentions may be, this middle path is unfortunate because it will leave no one satisfied. Moreover, taking this middle path on the economic front -- some stimulus but not massive stimulus, some tax cuts but also some increased spending, increased spending now but tax increases or budget cuts in a few years - is the worst of all outcomes; the economy will not gain enough traction to get the desired 'jump-start' and stimulus will ultimately be seen as ineffective. If the Obama Administration later attempts to return to Congress for more of the same after a failed stimulus bill, it will find a more skeptical response...
My view here is that Obama is forging a middle path that leads to a dead-end. The stimulus is not nearly enough by half to get the job done. The proposed deficit reduction measures for 2013 are outright scary as they risk repeating a mistake from the 1930s. And the banking sector and mortgage plans, both of which I failed to mention, are dubious half-measures as well. One needs to act aggressively and proactively or not at all.
This is exactly what has transpired. To make matters worse, his team's lack of accurate economic forecasting has led to an Armageddon scenario at the state and local level, where even unemployment benefits are not adequately funded. All of this was predictable as evidenced by these two posts from early in the year.
- Obama's stimulus bill is a tough sell so far - Jan 2009
- Will federal largesse be countered by state and local cutbacks? - Jan 2009
The President has effectively discredited fiscal stimulus as a policy tool. What's more is the bailout of the too-big-to-fail institutions without strings, the apparent cronyism in how these bailouts were done, and the gutting of financial reforms by the financial lobby has also discredited government as an agent to level the playing field for struggling households and taxpayers. See Blodget: Obama suffers because "taxpayer always finishes last" for now, but I will take this subject up in another thematic post.
I certainly underestimated the degree to which cronyism and special interests ruled the roost in Washington. I no longer believe government can be an effective agent of change in the U.S any more than it has been in Japan (see "Japan: stimulus without reform leads to a policy cul de sac"). As I wrote in "Stop the madness now!
If you are going to deficit spend you need to do it in a big way. You need to stop the deflationary spiral. That means hitting the reset button by promoting private sector savings and deleveraging and purging all built-up malinvestments. The risk in addressing the situation this way, of course, is replacing the imperfect invisible hand of markets with the imperfect hand of politicians and legislative fiat.
This is a risk I no longer see as worth taking. I have bailout and deficit fatigue just like most Americans. It is abundantly clear that this Administration has absolutely zero intention of purging any malinvestment or promoting any deleveraging. All they want to do is continue business as usual and go back to the asset-based economy that caused this mess. This is why we have seen bailout after bailout coupled with easy money. It makes for record profits on Wall Street but it does nothing for the unemployed.
Moreover, the political process in the U.S. is such that any stimulus money will be diverted to pet projects and used to pay off political constituents. While this may increase aggregate demand, it does so at the risk of serious social unrest as the outrage will certainly spill over into populism.
So, I have developed a case of big government revulsion as I suspect many Americans have done. I will let my friend Marshall Auerback argue the case for fiscal stimulus and its role leading to a sustainable recovery. I am moving away from stimulus happy talk to focus on malinvestment.
Comments are appreciated.