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There is more than one kind of economic mess to be in
Oct 12th 2016, 20:11 by R.A. | WASHINGTON
HERE is a funny little story about the history of economics. John Maynard
Keynes called his landmark economics text "The General Theory of Employment,
Interest and Money". The "general theory" in the title was doing double duty.
It modestly suggested a comparability between Keynes and Albert Einstein, a
genius whose work revolutionised his field. It was also meant to convey that
this was the big one might say macro idea shaping how employment, interest, and
so on all work. Keynes's peers, while impressed by the book, weren't quite sure
about its generality. John Hicks helped to turn Keynes's great work into the
models that would form the basis of macroeconomics textbooks, and shape policy
thinking, for decades to come. Yet he also needled Keynes, writing that the
great man's economics provided a novel way of thinking about depressions but
not much else:
[I]t is not the General Theory. We may call it, if we like, Mr. Keynes' special
theory. The General Theory is something appreciably more orthodox.
Burn. Yet interestingly, Keynes seems to have had the last laugh. Looking
around the world at this moment, one sees near-zero interest rates and weak
demand almost everywhere one looks. In this world, Keynes's depression
economics are the general rule of the road. They are so general, in fact, that
one could actually be forgiven for forgetting that there are other sorts of
economic mess to be in. Like Brazil's, for instance. Brazil is in the thick of
a special mess, which used to be a general sort of mess, before yesterday's
special conditions became general, if you follow. And so when news broke
earlier this week of the approval by Brazil's Congress of a constitutional
amendment placing sharp limits on growth in government spending, jaws dropped.
"I think this might be the single most insane fiscal policy proposal I have
ever heard in my life," tweeted Chris Hayes, a pundit of a left-leaning but
sober disposition.
Is it insane? Let's take a step back. The old normal the "more orthodox" world
Hicks described is one in which the economy is operating at its potential. In
that "classical" world, fiscal expansion uses capital that might otherwise fund
something else. Government borrowing raises interest rates, crowding out
private borrowing and preventing the expansion from generating much of an
increase in real output. Keynes's insight was that in conditions of depressed
demand, things don't work like that. Fiscal expansion raises employment without
much raising interest rates. Because there is no crowding out, stimulus boosts
real output. As real incomes rise, private firms and households regain their
appetite for consumption and investment, further boosting output (this is the
Keynesian multiplier).
Since 2008, much of the world has sunk into these special Keynesian
circumstances (thereby making them general). In this world, government
borrowing does not crowd out private borrowing. Interest rates across many rich
economies are near zero, or even negative, even in places with enormous public
debt burdens and persistent budget deficits. The multiplier in this world is
larger than would normally be the case. That is especially so since many rich
economies have sunk into a liquidity trap, in which central banks cannot
continue to provide monetary stimulus by cutting rates. There is disagreement
over how effectively they can stimulate through other means, but estimates of
the multiplier on fiscal contractions suggest that it is large: that austerity
places a drag on growth which central banks, for whatever reason, fail to fully
offset.
In this world, pundits have grown used to the idea that austerity is
necessarily bad. On the whole, that is a fairly reasonable bit of intellectual
shorthand. At any time austerity could be problematic, if it disproportionately
hurt the poor or led to underinvestment in public goods. Under circumstances
like the ones most countries now face it is almost inherently bad. Budget cuts
reduce real output, which reduces private consumption and investment, and which
often worsens the deficit. So for the pain, countries neither liberate capital
for private use or get all that much in the way of reduced debt. (Unless the
consolidation leads to a big rise in net exports, but that mostly shifts demand
weakness to other economies, most of which are in the same rut and are
therefore unable to offset the drag.)
But that's not the only way a country can be! That might be new normal, but
there are still those countries facing the old normal, and Brazil is one. In
recent years, the prices of the commodities Brazil exports tumbled, leading to
a sharp deterioration in its terms of trade. Capital flowed out, leaving the
Brazilian economy relatively starved of financing. Brazil sank into a sharp
recession; real output declined by more than 3% last year and is expected to do
so again this year. Brazil is not suffering from much of a shortfall in demand,
however. Nominal output has continued to expand, albeit at a slower pace than
before the recession, and inflation has risen into double digits. At current
commodity prices, Brazil is operating at close to capacity.
Under these circumstances, what could fiscal expansion accomplish? If it could
boost productivity dramatically, perhaps through investment in public goods,
that could be helpful. But lousy infrastructure is just one of the constraints
on Brazilian economic capacity. Complex tangles of taxation and regulation
contribute to what is known as the "Brazil cost": the added expense of doing
business in Brazil over and above what it costs elsewhere. In a Keynesian
world, calls for structural reform are often either misguided or somewhat
beside the point; not in Brazil.
Neither would it be especially helpful if spending added to aggregate demand.
Higher incomes would mean increased competition for already scarce goods and
services, leading to more rapid inflation. Accelerating inflation is especially
dangerous in a country with a recent history of hyperinflation. Government
borrowing would compete for access to scarce capital, pushing up interest rates
that are already in double digits. Higher interest rates are especially
dangerous in a country with what counts as a large public debt burden for an
emerging economy. Higher borrowing costs make servicing of Brazil's debts more
expensive, increasing the potential for a default. An increased default premium
could then raise rates still further, leading to a vicious spiral into crisis.
That, in turn, might create the possibility of money-financing of the
government's bills: a grand idea when firms and households are desperate for
liquidity but not very smart in conditions like those facing Brazil.
And while austerity could have distributional consequences, depending on how it
is implemented, it should not lead to the drop in demand that makes
consolidation in depressed economies so daft. Interest rates are high, which
means that any ebbing in demand can easily be offset by the central bank (which
was the general practice among central banks before the general became
special). Lower interest rates, in turn, are very good for the private firms
and households trying to make ends meet. In the examples of expansionary
austerity used so misleadingly to justify austerity in the depressed economies
of the rich world, big declines in interest rates were one of the key
mechanisms through which budget cuts led to output growth. Of course that
wouldn't work in places where interest rates were already pinned close to zero.
But the thing that made austerity so inapt a prescription for depressed
economies is precisely the thing that makes it a sensible solution, or at a
minimum a non-insane one, in Brazil. Spending restraint might well prove
painful for some members of Brazilian society. But hyperinflation and default
are hardly a walk in the park for those struggling to get by. Generally
speaking, austerity has been a misguided policy approach in recent years. But
Brazil is a special case. For now, anyway.