Government Needs to Invest More
The Nobel physicist Richard Feynman was once asked what single sentence he could devise to convey the maximum amount of information in the fewest possible words, in the event that all modern scientific knowledge were somehow lost.
His candidate was “all things are made of atoms.”
John Lanchester, writing in the London Review of Books, attempted to do the same should contemporary macroeconomics vanish into thin air and have to be reconstructed.
His first proposal was “governments are not households.”
Unlike households trying to balance the books, governments usually try to run countercyclical policies. That means pushing more money through the economy in bad times, and conversely, “taking away the punch bowl” during inflationary periods.
The Cameron government in Britain, despite a recession, opted for “austerity” to reduce its budget deficit, mostly by cutting spending. It assumed the cuts would have a multiplier of 0.5, meaning that for every £1 billion reduction in government spending, GDP would contract by £500 million. In that case, cuts would bring down the debt-to-GDP ratio. The IMF looked at the data and concluded that the real multiplier was in the range of 0.9 to 1.7, which means the same £1 billion in cuts removes as much as £1.7 billion of output.
The result: Reuters just reported that Britain is “perilously close” to a triple-dip recession.
This example seems to illustrate Lanchester’s other candidate sentence to encapsulate macroeconomic knowledge: “nobody knows anything.”
That’s because, despite the pretensions, macroeconomics isn’t science but rather a series of competing theories, some of which seem to work, but none of which can be tested using the scientific method – controlled and replicable laboratory experiments.
Moreover, neoclassical economics is based on several convenient but untrue assumptions. One is that capital flows freely. So why did credit markets freeze up in 2008 despite the Fed injecting trillions into the big financial institutions?
Another is that buyers and sellers have perfect information, which is preposterous. If true, there would be no “insider trading,” since everyone would have the same information. In reality, insider trading is endemic to Wall Street (See Goldman Sachs and “Abacus 2007”)
Additionally, the standard macroeconomic models failed to predict the 2008 crisis because, they assumed, markets were efficient and therefore, bubbles couldn't exist.
How can markets be efficient when banks collude to rig key interest rates like LIBOR, engage in systematic accounting fraud (like Lehman’s Repo 105s), peddle complicated securities designed to fail (see MorganStanley and “Stack 2006-1”) and suborn fraudulent mortgage underwriting?
As a result of the 2008 crisis, the U.S. lost 7 million jobs, producing a recession much like Britain’s.
Unlike Britain, the U.S. responded mostly with countercyclical policies, such as Obama’s stimulus program, the payroll tax holiday, and other measures, to pump more money into the economy. As a result, government spending is up eight percent on an absolute basis since 2009, according to Commerce Department data.
Despite those expenditures, because of subsequent growth, spending as a share of GDP actually declined by five percent. Unlike in Britain, both the U.S. deficit and unemployment peaked in 2009 and have been shrinking as the economy recovers.
Republicans are nonetheless pushing the same austerity agenda that damaged Europe’s economies, including deep cuts to the social safety net, and asserting that such policies would produce a different outcome in the U.S. They profess to be concerned about the deficit, but they voted for Paul Ryan’s budget which would have increased the deficit, proving that this fear-mongering is just another pretext to cut middle class programs and shovel more money toward the wealthy. We’ve seen that movie before.
In reality, economic growth could eliminate much of the remaining deficit. Bloomberg economists calculate that an increase of just 0.15 percent in the economy’s growth rate over the next 10 years would shrink the debt-to-GDP-ratio by almost as much as the “fiscal cliff” compromise that raised taxes. That argues for more government investment in high-return areas such as infrastructure, education, research, and tax enforcement, which -- unlike the supply-side fantasy -- do actually pay for themselves.
Moreover, the government can borrow short term money at negative real interest rates, and long-term at almost zero, suggesting that fixing the deficit is not urgent.
Recent data show that housing, which has brought us out of every previous recession, is growing at a faster rate than at any time since 1994.
There will come a time to institute countercyclical policies to dampen inflation and increase revenue, but not when unemployment is still over 7%.
This article was published in the The Free Press, Mankato, MN, February 1, 2013.