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March 8, 2009

Economist's View - 3 new articles

"Snake-Oil Assets"

Robert Shiller:

A failure to control the animal spirits, by Robert Shiller, Commentary, FT: ...We are seeing, in this financial crisis, a rebirth of Keynesian economics. We are talking again of ... the Great Depression. This era, like the present, saw many calls to end capitalism as we know it. The 1930s have been called the heyday of communism in western countries. ... The General Theory became the most important economics book of the 20th century because of its sensible balanced message.

In times of high unemployment,... governments should expand demand by deficit spending. Then, in times of low unemployment, governments should pay down the resultant debt. With that seemingly minor change in procedures, a capitalist system can be stable. There is no need for radical surgery on capitalism. ...

[T]he General Theory also ... explained why capitalist economies,... without the balancing of governments, were essentially unstable. ... The key to this insight was the role Keynes gave to people's psychological motivations. These are usually ignored by macroeconomists. Keynes called them animal spirits, and he thought they were especially important in determining people's willingness to take risks. ...

There are times when people are especially adventuresome – indeed, too much so. ... These are the upswing of the business cycle. But then the animal spirits also veer in the other direction, and then people are too wary. ...

To a remarkable extent we have got into the current economic and financial crisis because of a wrong economic theory ... that ... denied the role of the animal spirits in getting us into manias and panics.

According to the standard "classical" theory,... the economy is essentially stable. ... What this theory neglects is that there are times when people are too trusting. And it also fails to take into account that if it can do so profitably, capitalism will produce not only what people really want, but also what ... people mistakenly want.

It will produce snake oil. ... [W]hen confidence is high, and since financial assets are hard to evaluate by those who are buying them, people will and do buy snake oil. And when that is discovered, as it invariably must be, the confidence disappears and the economy goes sour.

It is the role of the government at two levels to see that these events do not occur. First, it has a duty to regulate asset markets so that people are not falsely lured into buying snake-oil assets. Such standards ... make as much common sense as the standards for the food we eat, or the purchase medicine... But we do not want to throw out the good parts of capitalism... To take advantage of the good parts of capitalism, when fluctuations occur it is the role of the government..., through its counterbalancing fiscal and monetary policy, to maintain full employment.

The principles behind such an economy are not the principles behind a socialist economy. The government insofar as possible is only creating the macroeconomic conditions that will allow the economy to function well. ... Its role is to ensure a "wise laisser faire". ...

I'm not sure that confidence and too much trust on the upside and the pessimism and fear we see on the downside are the causes rather than the effects of cycles (and I'm also not sure that Shiller is making that claim). That doesn't mean that psychological factors don't have important feedback effects that help reinforce booms and busts, or that these reinforcing effects can't produce volatile swings in the economy that need to be prevented or dampened through government action, only that the changes in mood seem to be more a part of the process than a primary cause of it. But I don't want to close my mind to the possibility.

Rogoff: Countries Risk Drowning in Red Ink

Ken Rogoff with lots of gloom and doom:

Countries are so deep in debt, they risk drowning in red ink, by Kenneth Rogoff, Project Syndicate: No one yet has any real idea about when the global financial crisis will end, but one thing is certain: Government budget deficits are headed into the stratosphere. ...

Although governments may try to cram public debt down the throats of local savers (by using, for example, rising influence over banks to force them to hold a disproportionate quantity of government paper), they eventually will find themselves having to pay much higher interest rates as well. Within a couple of years, interest rates on long-term U.S. Treasury notes could easily rise 3 per cent to 4 per cent, with interest rates on other governments' paper rising as much, or more. ...

With the credit crisis still making it difficult for many small-and medium-sized businesses to obtain even the minimal level of financing necessary to maintain inventories and conduct trade, global GDP is on a precipice in 2009. A real possibility exists that global growth will register its first contraction since the Second World War. ...

Worse, unless financial systems spring back, growth could disappoint for years to come, especially in "ground zero" countries such as the United States, Britain, Ireland and Spain. U.S. long-term growth could be particularly dismal, as the Obama administration steers the country toward more European levels of welfare assistance and income redistribution.

Countries with European-style growth rates could handle debt obligations of 60 per cent of GDP when interest rates were low. But with debts in many countries rising to 80 per cent or 90 per cent of GDP, and with today's low interest rates clearly a temporary phenomenon, trouble is brewing. ...

Many of the countries that are piling on massive quantities of debt to bail out their banks have only tepid medium-term growth prospects, raising real questions of solvency and sustainability. Italy, for example... Other countries, such as Ireland, Britain and the U.S., started with a much stronger fiscal position but may not be much better off when the smoke clears.

Exchange rates are another wild card. Asian central banks are still nervously clinging to the dollar. But with the U.S. printing debt and money like it is going out of style, it would appear the euro is set to appreciate against the dollar two or three years down the road – if the euro is still around, that is.

As debt mounts and the recession lingers, we are surely going to see a number of governments trying to lighten their load through financial repression, higher inflation, partial default, or a combination of all three. Unfortunately, the endgame to the great recession of the early 2000s will not be a pretty picture.

That's why I wrote this. As I noted, there are plenty of people who are anxious to pin our economic problems on the deficit, and going one step further, the welfare state (e.g. the "growth could be particularly dismal, as the Obama administration steers the country toward more European levels of welfare assistance and income redistribution" statement above). But government intervention is not going to make things worse for, say, the typical unemployed worker, it will make things better by improving job prospects and providing an enhanced level of support while unemployed (health care, unemployment insurance, food stamps, and similar programs). The stimulus package won't prolong the recovery period, it will shorten it by jump starting the economy in important areas and keeping it going until the private sector can take over (think of the government spending and tax cuts as a bridge over troubled assets).

So I want to emphasize one more time that stabilization policy does not have to change the size of government in the long-run (and see pgl for a debunking of some of the claims about the size of government. i.e. he notess that "Federal spending as a share of GDP was about as high in 1985 as it is projected to be for 2019"). Fiscal policy can increase the size of government, but it can also shrink the size of government (lower taxes in the downturn, then cut spending when things are better to eliminate the deficit and government will shrink). So the criticism is not about the use of stabilization policy to help people during the downturn and to give the economy a boost, instead it's a claim about the long-term political aims of the administration with respect to the size of government. However, according to pgl's calculations, the projections are that the size won't exceed what we had under that well known socialist sympathizer Ronald Reagan.

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