Saturday, April 19, 2014
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John Stewart Mill vs. the European Central Bank

BERKELEY – One of the dirty secrets of economics is that there is no such thing as “economic theory.” There is simply no set of bedrock principles on which one can base calculations that illuminate real-world economic outcomes. We should bear in mind this constraint on economic knowledge as the global drive for fiscal austerity shifts into top gear.

Unlike economists, biologists, for example, know that every cell functions according to instructions for protein synthesis encoded in its DNA. Chemists begin with what the Heisenberg and Pauli principles, plus the three-dimensionality of space, tell us about stable electron configurations. Physicists start with the four fundamental forces of nature.

Economists have none of that. The “economic principles” underpinning their theories are a fraud – not fundamental truths but mere knobs that are twiddled and tuned so that the “right” conclusions come out of the analysis.

The “right” conclusions depend on which of two types of economist you are. One type chooses, for non-economic and non-scientific reasons, a political stance and a set of political allies, and twiddles and tunes his or her assumptions until they yield conclusions that fit their stance and please their allies. The other type takes the carcass of history, throws it into the pot, turns up the heat, and boils it down, hoping that the bones will yield lessons and suggest principles to guide our civilization’s voters, bureaucrats, and politicians as they slouch toward utopia.

Not surprisingly, I believe that only the second kind of economist has anything useful to say. So what lessons does history have to teach us about our current global economic predicament?

In 1829, John Stuart Mill made the key intellectual leap in figuring out how to fight what he called “general gluts.” Mill saw that excess demand for some particular set of assets in financial markets was mirrored by excess supply of goods and services in product markets, which in turn generated excess supply of workers in labor markets.

The implication of this was clear. If you relieved the excess demand for financial assets, you also cured the excess supply of goods and services (the shortfall of aggregate demand) and the excess supply of labor (mass unemployment).

Now, there are many ways to relieve excess demand for financial assets. When the excess demand is for liquid assets used as means of payment – for “money” – the natural response is to have the central bank buy government bonds for cash, thus increasing the money stock and bringing supply back into balance with demand. We call this "monetary policy."

When the excess demand is for longer-term assets – bonds to serve as vehicles for savings that move purchasing power from the present into the future – the natural response is twofold: induce businesses to borrow more and build more capacity, and encourage the government to borrow and spend, thus bringing the supply of bonds back into balance with demand. We call the first of these “restoring confidence,” and the second “fiscal policy.”

When excess demand is for high-quality assets – places where you can park your wealth and be assured that it will still be there when you come back – the natural response is to have credit-worthy governments guarantee some private assets and buy up others, swapping them out for their own liabilities and thus diminishing the supply of risky assets and increasing the supply of safe assets. We call this “banking policy.”

Of course, no real-world policy falls cleanly into any one of these ideal types. Right now, the European Central Bank worries that continued expansionary fiscal policy will backfire. Yes, it argues, having governments spend more money and continue to run large deficits will increase the supply of bonds, and thus relieve excess demand for longer-term assets. But if a government’s debt emissions exceed its debt capacity, all of that government’s debt will become risky. It will have relieved a shortage of longer-term assets by creating a shortage of high-quality assets, and so be in a worse position than it was before.

The ECB contends that the core economies of the global North – Germany, France, Britain, the United States, and Japan – are now at the point where they need rapid fiscal retrenchment and austerity, because financial markets’ confidence in the quality of their debt is shaken, and may collapse at any moment. And policymakers are falling into line: in late July, Peter Orszag, Director of the US Office of Management and Budget said that the coming fiscal consolidation in the US over the next three years will be the country’s deepest retrenchment in 60 years.

Yet, as I look at the world economy, I see a very different picture – one in which markets’ trust in the quality of government liabilities of the global North’s core economies most certainly is not on the brink of collapse. I see production 10% below capacity, and I see unemployment rates approaching 10%. More importantly for near-term economic policy, I see a world in which investors have enormous confidence in core economies’ government debt – for many, the only safe port in this storm.

In these circumstances, we can be sure of what Mill would have recommended.

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