Friday, April 8, 2016

Nope, fiscal policy is not the solution

Let’s start by stating the obvious: the solution to the maladies of the 2008 global crisis that have been tried so far have been either a dismal failure (monetary policy consisting in a reduction by central banks of the interest at which they lend money) or right away counter productive (austerity measures which any sane Keynesian would have told you would further depress the economy, as they have consistently and undeniably done).

As the economic prognosis grow dimmer by the day (China growing less than 5%, even lower than the unreliable statistics of its central planners only partially acknowledge, the EU not growing at all, and becoming by the day more indistinguishable from Japan, already well into its second “lost decade”, the emerging countries not emerging much, and the USA growing anemically) it is not surprising that more and more voices claim for the obvious solution: states should start investing like crazies, but not pay those investments, as that would demand them to raise more money through taxes, and the impact of those additional taxes would be to further depress the economy. No biggie, our Keynesians tell us, now is a proper moment to incur additional debts (now that interest rates are low and the cost of financing the additional debt would be easy to shoulder), regardless of the debt level being stratospherically high for historic standards (wasn’t it Reagan, of all people, who showed the electorate that deficits don’t matter?). An example may be found here (Barry Eichengreen on piling up more debt: Get those damn printing presses moving!) but I could multiply them ad infinitum, from Paul Krugman in the NYT to Joseph Stiglitz everywhere.

As much as I think most of them are outstanding economists, and much more frequently in the right that the host of right-wing nutsos that like to contradict their claims, I’m afraid they are fundamentally wrong about this one, as the most robust fiscal expansion they could dream of would do glaringly little to “kickstart” either Western or Eastern or emerging economies. We may mortgage the future of our descendants as much as we want, and incur a sky-high level of debt in the process, but unless we fundamentally change the way we produce and distribute wealth such breaking of the bank won’t have much impact in terms of accelerated economic growth, return to anything close to full employment or reduction of the excess capacity now afflicting most of the world’s economies. In the remainder of this post I’ll explain why.

Let’s start from the fundamentals: In neoclassical economic theory we can distinguish three markets, those for goods (and services, we will delve into the potential difference later now, but now just bear with me that every time I refer to goods I’m also considering services there), labor and money. What the theory postulates is that at any given moment the three of them have to be in “equilibrium”, in a condition in which the total (aggregated) demand for the traded commodity equals its supply, determining its “value” (measured as price level for the aggregated goods and service, wages for the aggregated hired labor and average rate of interest for the aggregated money in circulation… averaging and adding all the actors in the economy has some tricky quirks, but again bear with me, as they don’t substantially modify the big picture I’m trying to paint here):

Since the time of Keynes we know that such equilibrium can happen at levels of output that do not require the utilization of all the productive assets of the economy, leaving both consumer goods (inventory), capital goods (factories, machinery) and people sitting idle. That is generally acknowledged as bad, which is already some improvement over classical economics, where people who did not work were considered as unrepentant moochers, as all they would need to do if they wanted to improve their lot was to lower their wage expectation and find an enterprising capitalist willing to hire them (you may notice that classical economics is alive and well in substantial segments of the US population, as manifested regularly in the comment section of any of their newspapers were any hint that there may be something as “involuntary unemployment” are routinely derided as being soft on “takers” and “welfare queens”) . There are roughly two opposing camps in macroeconomics regarding how such undesirable state of affairs can be corrected: monetarists argue that the only thing the state can do is to lower the interest rate, making saving less attractive and thus freeing money for investment. That increased investment in turn would make hiring more attractive (at the same wage level) for employers, which would then employ more people, increasing the total wages and thus allowing people to buy more goods, in a virtuous cycle that would get the whole of the economy growing (until full employment is reached, which would then create inflationary tensions and pause the cycle for a while, but more on that later).

The other camp is formed by the more or less orthodox Keynesians, who think that there are limits to the influence the state can exert on the interest rates (specially at its lower bound, as it seemed until recently that it could not be pushed below zero, but both the European and the Japanese Central Banks are questioning that line of thought). For them the solution is to make the state compensate for the sagging demand of the private sector either through a program of public investment or, as famously put by Keynes himself, by burying money in mines and letting people dig it out (in our technologically advanced era the concept has been replaced by the idea of “helicopter money”, which owes its name to the idea of throwing wads of cash to the needy masses from vehicles that hovered above them):

The difference between both camps is relatively unimportant for my argument, as the overall dynamic is the same. Monetarists believe that you have to first shift the savings curve in the money market to increase the demand by buyers, while the Keynesians believe you have to directly increase aggregate demand (making the state buy more things to compensate for the lagging demand of the private sector) which, if financed through deficits, will increase the money in circulation and lower the real interest rate (the real interest rate is the difference between the nominal rate that the banks charge and the inflation, and printing money and increasing deficit until now was a surefire to increase the expected inflation, thus reducing the real interest rate). Be it as it may, the reduction in the interest rate decreases savings, and makes the holders of those savings spend more, which in turn reduces inventories of unsold goods and induces manufacturers to increase their production, demanding more work (either from their existing workforce or, if that is not enough, from new hires) and increasing salaries, which in turn results in people having more money to spend and pushing demand to new heights. It all translates in a new equilibrium with more total goods (and services) produced, more total hours worked (ideally by more workers) and a higher percentage of utilization of the economy’s productive capacity.

But remember that I opened my post stating that this solution (which I dubbed “fiscal policy”) would not work this time, as it has worked so many times before (can you recall the happy noughties when economists confidently declared that the business cycle was over and that we had reached a level of understanding of how economy worked that we could “engineer” ceaseless growth, recessions being a thing of the past? Happy times indeed!). There are two reasons for such lack of effectiveness:

1.       There are two ways a producer can respond to increased demand. One (the one we assumed in the previous scenario) is to hire more people to increase the supply of the demanded goods. The other, of course, is to invest in more machinery to increase production through a more intensive use of capital. It seems that in the advanced world the latter has been the preferred method, overwhelmingly so since the “end” of the last recession

2.       For there to be increased spending after a reduction in the interest rate, people need to have liquid assets (essentially, money) they can put to alternative uses, in this case to present consumption instead of savings. But what happens if people were already spending all of their income and had no assets?  Regardless of how much the reward of saving decreased, they would not save any less, as they were not saving anything to begin with. That’s why financial crises caused by excessive debt are so much more arduous to escape from than simple overproduction ones: before starting to spend more people, companies and whole countries have first to deleverage (pay their previous debts) and only after doing so can they start increasing their spending to move aggregate demand rightwards.

We may think that it’s not so bad after all. We have been in serious financial crises before, and after enough time the economy was back on track, growing again, so all it takes is to be a bit more patient and in a few years we will have reabsorbed today’s unemployed back in the workforce and we will be seeing hearty rates of growth (3% and above in developed countries, 5% and above in developing ones and 7% and above in China and who knows? Maybe India). Keep on dreaming. To argue how implausible I find such rosy scenario I will turn back to a longer term analysis of economic trends that, like a persistent wind behind our collective sails, have pushed the world’s economies forwards, with some minor bumps, through the severest recessions and depression for the better part of three centuries now. As you may have guessed, the main trends to look at are demographic growth and technical innovation. Let’s look at the effect of both separately, starting with demography.

Nothing new here. Just having more consumers increased the demand for goods and services (some of them quite inelastically), lowered salaries, increased the amount of money in circulation (and if money supply did not keep pace, caused serious deflation and overproduction crises) but overall increased the GDP, making everybody wealthier (of course, not in equal proportion). Interestingly enough, it would have also caused the interest rate to fall, as noted by Karl Marx in one of his most famous predictions, which he saw as the unavoidable final cause of the demise of capitalism, and the one spectacularly not borne out by reality. Was he utterly wrong? Well, of course he was, but for a reason he of all people should have intuitively grasped (being a vocal proponent of the impulse that same doomed capitalism provided for technological innovation): demographic growth does not happen in a static environment, but in a changing landscape of new inventions that are continuously modifying the way goods are manufactured and distributed:

You may notice that some of the effects of new technologies add to those of the ones we saw derived from population increase: the amount of goods (and services) produced and traded increases, the salaries decrease, and the total amount of money in circulation increases. But other effects have a countervailing tendency to those of demography: while more consumers means more scarcity and tend to push the price level up, more advanced technology means (tautologically, that is exactly what “more advanced” implies) more efficiency in the use of resources (technically, more total factor productivity), which pushes prices down; while more workers (at lower wages) tend to push the total hours worked up, better technologies allow to produce the same amount with less effort, thus pushing those same hours down; finally, while the demographic growth of the market pushes the rate of interest down, technological progress through “creative destruction” finds new profitable uses for capital and is ready to invest more at any given rate, thus moving the investment curve rightwards and pushing for a higher equilibrium interest rate (and finding use for more total savings).

It is legitimate to wonder, then, what the combined effect of the substantial demographic increase and technological advance we have witnessed going hand in hand since the middle of the XVIIth century (first in the West, since recently in all the rest) may be. Although with some fine grain variations, the global picture looks like this:

Now you may have noticed I needed to do a little sleight of hand with the effect of new technologies on the demand for labor, as to fit with the historical record I have made it go exactly in the opposite direction I showed in my previous figure (so it goes rightwards instead of leftwards). I’ll justify it saying that on average the cheapening of traditional jobs caused by technology has been more than compensated by the creation of better paid jobs (requiring a mastery of more complex processes and tools), and that such creation has been enough so far to compensate the effect both of the substitution of human labor for machine labor and of the pressure of additional workers ready to do the job. What is barely up for discussion is that almost three centuries after the Industrial Revolution the total amount of goods produced (and services traded) has increased exponentially, the total amount of work devoted to such production has been able to keep pace, as has been the total amount of money in circulation (which at some point in the last century required the abandonment of any pretense of it being based on any kind of finite metal, thus going full fiduciary), while the price level (in real terms), the interest rate and the average wage have more or less remained the same (a case could be made for the average wage being substantially above the subsistence level, at least in advanced economies, and starkly above the “Malthusian trap” levels that have dominated for most of Humanity’s history… the picture is not as clear the moment we factor in developing countries, and I maintain that the increase have been at most of a factor of two, which pales in comparison with the more than fiftyfold increases in GDP, monetary mass and total hours worked by the similarly increased population).

Those were powerful trends, and they explain why even the Great Depression seems today like a historic anomaly within a global tendency of almost uninterrupted growth towards ever greater levels of material bliss. Can we then relax a bit, and assume that it’s just a question of time before they also take us from our current predicament and continue performing their magic? Of course not, because as any reader of this blog knows, I firmly believe there is a) no real technological progress in the last 30 or 40 years (except in the realm of software, which has at best a negligible effect in economic output, as any analyst would tell you) and b) demographic growth is also essentially coming to an end, having reached its peak some decades ago in the West, and now reaching it in the fewer and fewer regions of the Earth where it was still happening.

Get used, then, to the new normal, so much grimmer that the old one. Is there something that can be done, apart from dreaming with impossible alternative social compacts (see my series on Anarcho traditionalism and the future of the planet 500 years from now)? Of course there is, but that, my friends, will be the subject of another post. 

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