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2016-10-20 14:22:16
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.