For this last installment, let me lay down the four necessary conditions for a sustainable recovery:
1. Increase the stimulus now
The economy is on an artificial respirator. I would be faltering without government support. It’s no time to stop taking the medicine.
2. Cut future fiscal outlays in an unmistaken and credible way
The "budget curve" needs to be flatten: more spending in the present and significantly less in the future, post-recovery.
Yes, Krugman is right. He likes to pick up fights, especially against Republican leaning economists. Again, recently, he was on Rajan's case after Rajan published a piece about his distaste for the zero-interest rate policy of the Fed. Mark Thoma started the fight and Paul was happy to put more salt on Rajan's opened wounds to prove his point that now is not the time to reign in the stimulus. It seems that since Rajan started his blog a few weeks ago, he has been on the defensive. Don't pity the guy: he is able to defend himself and it gave his blog instant visibility. Yet the debate rages on between the three.
I nevertheless read Rajan's piece (and his subsequent blogs on the topic) and I thought that some of the arguments were pretty insightful. Rajan is actually not calling directly for an increase in interest rates as both Thoma and Krugman claim that he is. I believe that he is mainly questioning the efficiency of a zero-interest rate policy. And he has a point. Unfortunately, the point is being lost in the debate; probably partly because of politics: the other side would hate that there might be some rational for increasing rates right now. It does not mean that rates should increase but it seems appropriate to point out that there are also negative consequences to the zero-rate policy of the Fed.
Here is the argument expressed in my terms which I think make the point clearer. Since investment decisions usually have long term consequences and since interest rates in part determine investment decisions, interest rate policies will ultimately determine resource allocation. Thus, if low interest rate policies are leading investors to allocate resources inefficiently, a low interest rate policy could have negative long term consequences for growth. This of course should be weighed against the benefits of lower rates. When the level of investment is insufficient, low interest rates should help. But low rates can also lead to investment that won't be sustainable when interest rates will be higher. A lot of home owners apparently made that mistake when they decided to take advantage of low rates to invest in real estate. I am not sure how significant empirically this misallocation of resources effect actually is. But, in principle, it potentially could be very important if the people allocating the capital in the economy are incompetent, biased or subject to influence. In developing countries where bankers are though not be that competent and easily corruptible, it is a widespread concern. After the recent performance of our bankers maybe we should worry to about their ability to allocate capital for the purpose of investment.
I made this long point just to argue that the same logic applies to fiscal policies. Yes, Paul Krugman is right: it is not time to reduce the stimulus now; at least, not for the wrong reasons which are currently being invoked by both sides in Congress. However, the inefficiency and wasted funds associated with the fiscal stimulus should be of concern. Also the danger that some programs meant to be temporary become permanent and eventually crowds out private investment is another valid concern. There are ways to stimulate the economy in the short term using fiscal policies but it is important to try minimising the negative impact of such policies on long term growth and the trajectory of future government expenditures.
For that, the most important measure is to drastically reduce actuarial deficits. If Greece did this if would get out of trouble fast. France just announced that it is increasing the retirement age as proof that they understand the importance of projecting fiscal discipline in building credibility.
This brings me to where and how the money should be spent and the third condition to create the environment for a sustained recovery:
3. Deleverage the economy
We have to deal with the leverage in the economy. We hear all the right stuff. For instance the G20 recognizes in their last communiqué that “further progress on financial repair is critical to global economic recovery. This requires greater transparency and further strengthening of banks’ balance sheets and better corporate governance of financial firms.”
But it seems that one ingredient is missing. Beyond tighter regulation, better governance and stronger recapitalisation, it is still not a clear how we are going to get there and deleverage the economy. The path to point B from point A is the missing link of this recovery. The current efforts are all focused on the banks themselves; in large part because banks hold the political power and lobby hard to get our (taxpayer) cash and to keep a tight control over the new rules that are going to govern them in the future. All the official talk form the G20 or other policy makers "sounds" good but it's being carefully drafted by bankers themselves through the influence of their lobbyists on our policy-makers. Because of the crisis, bankers are careful not to offend us too much and now agree to some restrictions that they would never have agreed to before the crisis. But bankers have just become more subtle than they were pre-crisis. They have adapted to a more hostile and alert public. And as result the policy environment is still very much banker friendly and the concerns remain deeply bank centered.
But it is not the bank that should be at the center of our effort. It is the leveraged consumer. Deleverage the consumer and the bad assets of banks are going to shrink like snow banks in the spring. Yes, without a doubt, eventually do put in place all the proper rules to regulate banks but this is not what is going to kick start the system for now. It might help prevent the next crisis but we need to deal with the current crisis first as it is not over yet. What good does it do to prepare ourselves to fight the next war if we lose this one? And, at the risk of repeating myself, I (and others) have made proposals to achieve the objective of deleveraging the consumer. Unfortunately, this will take money. But it will be money well spent. In fact, I will go further, any other money that will not address this problem of consumer leverage will be money wasted.
Something will also need to be done to reduce consumer’s incentives to leverage themselves. In Canada, the financial system was not so much saved by better bank capital ratio and regulation but by the fact that consumers did not have the same advantage or capabilities to use leverage (no interest rate deductibility, a requirement that you must have a minimum of capital in your house and the existence of less gimmicks to fool consumers into thinking that debt is good for them). Such measures are needed as well. But, again, because they have the power, banks are able to push these kinds of proposals away as they would hate it if consumers had fewer incentives to borrow (see Rajan’s book on this): It would cut into one of their most profitable business lines.
Which brings me to the last conditions:
4. Find a way to hit the reset button on the allocation of power.
Bankers are obviously in a conflict of interest when it comes time to designing rules and regulation not only for the financial system but for the whole economy. They need to be kept at bay. This may be the most difficult conditions to implement. I think that it will take another deeper crisis to convince politicians and policy-makers to free themselves from their influence. Unfortunately, we may be closer to that crisis than we think.