How economics deals with an overindebted private sector
Happy post-World Cup to you all. I missed my Friday catch-all post because I was out sick. So I am going to play catch-up today with a few thoughts on various topics.
Let’s start with the BIS. In general, I defend the BIS view because the BIS is rightly focused on the dangers of over-indebtedness. Gavyn Davies has put a good spotlight on the subject that I think frames the issue well. At the FT, he writes about ‘artificially’ high asset prices, asking whether “it is possible that the natural rate that seems appropriate for the real sector of the US economy might sometimes be lower than a wider definition of the natural rate, which applies to the entire global economy, including the financial sector in the longer term?”
This is the right question to ask, first and foremost because the ‘natural’ rate assumes some sort of macro-equilibrium that I believe rarely exists. So to the degree that there is a ‘natural’ rate to anything, it varies dynamically across sectors of the economy and with time. Moreover, as Gavyn points out, it is entirely possible – if not probable – that the ‘natural’ rate for keeping risk-seeking-return behavior anchored and not frothy is not the same ‘natural’ rate for maintaining the real economy at full employment.
The way I addressed this last week is by questioning the whole concept of depending mainly on monetary policy at all to do the heavy lifting of real economy cyclical adjustment. The Fed is already creating the next bubble precisely because it has been forced to use monetary policy to support the real economy in the absence of enough fiscal and supply side adjustments. Were those adjustments made in earnest, the ‘natural’ rate for the real economy would be higher and the Fed would never have had to take rates to zero.
Additionally, I would argue that once you lower rates to zero, the economy adjusts to that rate dynamically, such that unwinding that rate decrease creates a reaction function in credit and asset markets. The ‘natural’ rate in a scenario in which the Fed has not lowered rates is different than in one in which it has. If the Fed were to raise rates now, I would expect credit demand to be pulled forward, actually accelerating the destabilization that the low rates began in the first place. So it is not as simple as removing accommodation once the credit allocation process has been distorted. We are here now; the excess is baked into the cake. I would not say the Fed should raise rates now. I would say the Fed should never have gone to zero in the first place.
And this brings me to the incoherence of the economics profession. That’s the title of a good piece on Naked Capitalism by Philip Pilkington. He points out that the way economics works today, you can get support for virtually any position or policy prescription from a leading economist simply because economics has become incoherent as a profession. There is no consensus about anything, whether it be austerity, capital controls, interest rate policy or what have you. And as a result, debates on these issues are largely driven by ideology.
Personally, I tired of these debates long ago and have moved away from the whole advocacy blogging mode. As a business person or a financial analyst or investor, all of this ideology-driven palaver about what policy makers should do is next to meaningless. What matters is first, what policy makers will do and second, what impact this will have on the real economy and asset prices, both in the short-term and over a longer time horizon.
I think Pilkington is right that a lot of what you read in Post-Keynesian analysis remains unchanged, even in the face of a great financial crisis. That’s because much of the Post-Keynesian framework on debt dynamics, sectoral balances, and monetary policy is robust. The concepts that debt adds to demand, that bank loans create deposits, that reserves are mostly about the payments system and not a means for credit creation, and that government deficits add net financial assets to the private sector, are all consistent with what we have observed over the last seven years as crisis has unfolded.
So while I may agree with the BIS about debt dynamics, to the degree that their analysis takes on a position at odds with the fiscal space available in a fiat system, I am going to side with the post-Keynesians. That said, just like the BIS, I think we are well into this business cycle with dangerous private debt levels. The absence of wage growth will be the Achilles heel that ends up forcing a renewed deleveraging.
The data out of Europe outside of Spain and Ireland has been particularly weak in the last few weeks. German manufacturing is growing at the slowest rate in eight months. French manufacturing is shrinking. And industrial production across Europe actually fell the most on a month-to-month basis in May in nearly two years. This is hardly the stuff of robust cyclical recoveries.
You would think the Europeans would do a re-think. But they will not. The backloaded austerity paradigm will remain operative until we hit a major speed bump and have crisis. I know a lot of people are talking up the Renzi proposals for stimulus. And he may yet have his way. I see this as small beer. The paradigm will remain fiscal restraint and monetary ease until the downside of this approach is readily apparent. And then it will be too late.