Saturday, June 26, 2010

The Debate between Expansionists and Restrictionists

Right now there is an important debate going on in the United States and Europe between those who think the major aim of economic policy at the moment should be to do something about growing fiscal deficits and those who believe that the major aim should be to maintain economic activity.

Mohamed El-Erian argues that we need to go beyond what he calls "the false growth vs austerity debate" He argues that at this his weekend’s G20 meeting
In one corner stand the “growth now” camp, arguing that expansion is a pre-requisite to service their debt sustainably. Without it tax receipts implode, investment is turned away, and meeting future debt payments is harder. This camp abhors Europe’s shift towards austerity, questions Tuesday’s tough UK budget, and urges countries like Germany to adopt expansionary policies. Some advocate additional fiscal stimulus even for high deficit countries, like the US.
This debate he argues is "incomplete" and backward looking and countries need "to adopt both fiscal adjustment and higher medium-term growth as twin policy goals."
Squaring the circle of growth and fiscal stability needs policies that focus on long-term productivity gains and immediate help for those left behind. This means first enhancing human capital, including retraining parts of the labour force, and increasing labour mobility. Then new emphasis on infrastructure and technology investment is needed, with greater support for scientific advances that promise increased productivity. Finally all nations must begin an honest assessment of the social frictions coming in the next few years. In some countries (like the US) this means an urgent bolstering of social safety nets.
The world is facing deep structural challenges yet its leaders are stuck in a short-term, cyclical mindset. Until they break out of it we will see little more than fruitless discussions, national policy flip-flops, and a troubling lack of global policy harmonisation. Without action our future will be disappointing global growth and periodic sovereign debt crises. Let us hope this, if nothing else, is enough to bring the two camps together.
Paul Krugman is a major protagonist in this debate on the side of the expansionists. He is very critical of such views, implying that this is simply restrictionism.
In The Long Run, We Are Still All Dead

So, reading Mohamed El-Erian, I’m somewhat at a loss about what he’s actually saying; what, exactly, is the policy recommendation? But in any case, here’s what struck me: he writes,
The world is facing deep structural challenges yet its leaders are stuck in a short-term, cyclical mindset.
I disagree. If anything, we’re suffering from the opposite problem. Talk to German officials about high unemployment and the looming threat of deflation, and they ramble on about the demographic challenge and the cost of pensions.
I mean, why shouldn’t we be focused on the business cycle? We’ve suffered the worst cyclical downturn since the Great Depression; in terms of unemployment and output gaps, we have recovered almost none of the lost ground. Millions of willing workers are idle because of lack of demand; let them stay idle, and we can turn this into a long-term structural problem, but right now it is precisely a short-term, cyclical problem.
So saying that we need to focus on the long term, and not worry our little heads about trivial short-term issues like the highest long-term unemployment rate since the Great Depression, may sound like wisdom — but it’s actually folly.
Oh, and one more point — not about El-Erian, but about quite a few policymakers and economists: the attempt to shift the discussion away from the short run is not, as often portrayed, an act of vision of courage. On the contrary, it’s an act of cowardice, an attempt to evade responsibility for a disastrous state of affairs that we could fix, but choose not to.

Keynes had it right:
But this long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.
What is most interesting for me as I read these debates are the implications for Australia. And just how different the situation is in Australia. This seems to be another 'world' that they are writing about. This is increasingly being explained by the argument that the global financial crisis should be seen as the North Atlantic financial crisis. (NAFC doesn't have as sweet a ring as GFC and makes me think of a football club from Adelaide).

Australia's fiscal position is relatively sound and the nature of the political debate in Australia ensures that even the small level of public debt is seen as a 'problem' that requires immediate action. One of the reasons why the Rudd govt introduced the Super profits tax was to bolster the ability of the budget to return to surplus sooner than originally planned.

We are in a very good position right now, but as always we continue to be vulnerable. Our success (and we could do better) has been built upon long-term growth and increases in national income bolstered by the terms of trade effect (relative increases of export prices over import prices). But eventually what happens in Europe and the United States matters to Asia and to us. China has continued to expand because of a huge fiscal stimulus and in turn growth in Europe and the United States has been bolstered by budgetary stimulus, financial guarantees and bailouts, and low monetary policy.

Without govt efforts the world would now be in a deep financially-induced depression. This is what the restrictionists and ant-govt zealots need to realise. Equally, however, expansionists need to (eventually) think about the growth of govt debt. This will involve both sides of the fiscal equation - spending and taxing.

We now live in a more globalised world economy. One of the benefits of that is that increased growth and the advancement of many developing countries with China and India showing rapid rates of growth. But globalisation increases vulnerabilities to negative effects as well. The aim of the G20 should be to foster the increased economic cooperation necessary to manage an increasingly globalised world economy. But international cooperation is no easy thing! States will have to continue looking after their own interests first, but a bias towards expansion in depressed areas will be beneficial for globalisation in the long-run.

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