Four Fallacies of the Crisis

NEW YORK – The current twin crises in finance and the real economy, what Americans call Wall Street and Main Street, and the interminable discussions about financial reform and the prospects for economic recovery, have spawned several fallacies that need to be addressed and dismissed.

Fallacy 1:  The crisis would produce a “free fall.”

A free fall means just that. But, surely, the world economy, or even the United States or the European Union – to which this dire prediction was applied (by Joseph Stiglitz, for example, who wrote a book entitled Freefall) – has not been plummeting like Newton’s apple. Animated discussions as to whether either or both economies face an L-shaped or a V-shaped recession have given way to the reality of considerable volatility, for both income and financial indicators, around a mild upward trend.

Fallacy 2: Through monetary expansion, the US is manipulating the dollar’s exchange rate in the same way that it accuses China of manipulating the renminbi’s exchange rate.

The two cases are dissimilar. If one grants the premise that there is an insufficiency of aggregate global demand, the alleged Chinese undervaluation of the renminbi can, indeed, be seen as a beggar-thy-neighbor policy, which diverts inadequate world demand to Chinese goods at the expense of other countries.

On the other hand, the dollar’s weakening is a side-effect of US monetary expansion, undertaken after countries like China and Germany refused to spend more to increase world demand, and after no room remained for further fiscal stimulus. This is altogether different from a policy of weakening the dollar to divert inadequate world demand to American goods.

Fallacy 3: Current global imbalances will continue to afflict us.

Economists inevitably generalize from the current situation, so that today’s Chinese and German current-account surpluses and America’s deficit, for example, are seen as being here to stay. But history is littered with surplus countries that became deficit countries. One of my teachers when I was a student at Oxford, Donald MacDougall, a man who had once been Prime Minister Winston Churchill’s adviser, wrote a book entitled The Long-Run Dollar Problem, which suggested that the dollar was what the International Monetary Fund called a “scarce currency.” By the time the book appeared, however, the problem had vanished.

Initially, the Chinese surplus arose inadvertently, not by design. So did the US deficit, which resulted from the failure to finance the second Iraq war with new taxation – a decision rooted in the wild miscalculation that the war would be finished in six weeks.

Today, the Chinese themselves realize that their surpluses fetch miniscule returns when invested in US Treasuries. So they are keen to spend their earnings from foreign trade on domestic infrastructure instead, thereby removing serious bottlenecks to further growth, as in India.

As a result, Chinese imports will increase – and thus its surplus will fall – for two reasons. First, wages will be spent partly on imported goods. Second, infrastructure investment requires heavy equipment that is typically supplied by Caterpillar, GE, Siemens, and other, mostly Western, suppliers. Moreover, immense pressure in the US to undertake fiscal consolidation, reflected in President Barack Obama’s latest budget proposal, should reduce US import demand, further reducing the bilateral imbalance.

Fallacy 4: Forget about Keynesian demand management.

Some critics of Obama’s Keynesian stimulus spending, among them the economist Jeffrey Sachs, claim that what the US needs is “long-term” productivity-enhancing spending. But this is a non sequitur. As a Keynesian, I believe that the state paying people to dig holes and then fill them up would increase aggregate demand and produce more income. But Keynes was no fool. He understood that the government could eventually get huge returns if the money was spent on productivity-enhancing investments rather than on “directly wasteful” expenditure-increasing activities.

The question, then, is simple: which investments offer the greatest economic payoffs? But it is also fraught: when your bridges are collapsing, your school buildings are in disrepair, teachers are underpaid and have no incentive to be efficient, and much else needs money, it is not easy to decide where scarce money should be spent.

But one “structural” consideration is not well understood. Given the need to cut the deficit in the future and the need to increase it now in order to revive the economy, the problem facing Obama is how to shift smoothly from top gear into reverse. Clearly, the lesson is that governments need to attach less weight to spending that cannot one day be cut.

This was brought home to me when I saw an unfinished high-rise building in Osaka. A relic of the bust that followed Japan’s real-estate boom two decades ago, it became known as the Tower of Bubble.