Fear-driven economics

On Monday, I attended a fascinating debate on the Economics of Deficit Reduction at the House of Commons (audio link in this post). Essentially the debate was about the pros and cons of fiscal austerity versus stimulus. On the "stimulus" side were Prof. Paul Krugman and Jonathan Portes of NIESR: on the "austerity" side were Bridget Rosewell of Volterra Consulting and Stephen King, Chief Economist of HSBC.

The definitions of both "austerity" and "stimulus" were somewhat unclear. As far as I could tell none of the four were remotely in favour of the severe austerity measures being imposed on some members of the European Union. Furthermore, none of the four were in favour of extensive cuts to capital investment such as the current Coalition government and its Labour predecessor have already undertaken (and more are planned). In fact Rosewell, supposedly anti-stimulus, actually said she was in favour of increased government borrowing for capital investment projects. In her eyes, the debate was really about whether continued support for current consumption was an appropriate course of action at the present time, given the levels of public debt and the fact that the UK is running a significant fiscal deficit.

Except that it wasn't. The debate was about whether the government should continue its austerity programme (Rosewell and King) or change to a debt-financed stimulus programme to encourage growth (Krugman and Portes). Internally rebalancing the current austerity programme towards capital investment and away from supporting consumption wasn't discussed. Nor was the IMF's advice, which is to allow automatic stabilisers to operate freely but refrain from explicit debt-financed fiscal stimulus measures. There was also no discussion of the sort of balanced-budget stimulus measures suggested by Simon Wren-Lewis: this is something of a pity, because it means that the debate tended to become a discussion about whether or not the UK government could afford to borrow the extra money required, which isn't really the issue (as I shall explain later). It all made for great debate, but sadly no practical solutions to a difficult situation.

Krugman delivered a consistent and well-thought-through message, well-supported by Portes, who actually gave a figure (2-3% of GDP) for the amount of stimulus he thought the economy needed. But I was disappointed with Rosewell's presentation. My notes taken at the time comment on the inconsistency of her message, which appeared to be driven largely by her fear of a return to the financial markets' dislocation of 2008.

The trouble with fear is that it inhibits both thinking and action. As the Bene Gesserit in Frank Herbert's Dune have it, "Fear is the mind-killer". Fear is one of the biggest issues I deal with in my work. Once someone gives in to fear, they stop thinking, and something that they actually are perfectly capable of doing becomes an impossible task. (As an aside - perhaps my own difficulty with maths is because I fear it?) The Hitchhiker's Guide to the Galaxy famously had "Don't Panic" in large, friendly letters on its cover. I, too, have "Don't Panic" written in large (and I hope friendly) letters at the top of sight-reading exercises for my students.

Fear also inhibits appropriate action. People who are afraid may do nothing, like the rabbit caught in the headlights which stands and waits to be hit instead of legging it at top speed - or like a student who suddenly becomes incapable of singing a single note. Or they may do stupid things. My sight-reading students have a distressing tendency to invent the music instead of reading what is on the page. They are perfectly capable of reading the music when they aren't panicking, but when they are, they are incapable of reading the music at all, so they make it up.

I think fear is the cause of a large part of what is wrong with the world at the moment. People are either doing nothing, or they are doing stupid things - such as imposing severe austerity on fragile economies in the mistaken belief that sharply cutting public expenditure will somehow magically bring about economic recovery. And people who believe that it is only going to get worse are adjusting their behaviour in the expectation of future losses.  Ordinary people are paying off debt and saving like crazy because they fear cuts in their real income shortly. Businesses are not investing because they see no prospects for an improvement in customer demand. Investors are prepared to accept gradual erosion of capital through negative real interest rates because they are terrified that default and/or hyperinflation will wipe them out. So I am concerned that the thinking of an influential economist such as Rosewell is so influenced by fear.

Having said that, rather than dismissing her fears, we should consider whether they are justified. Like pain, fear is a warning: if we are afraid, we should examine that fear and consider whether it is rational, and if it is, what an appropriate rational response should be. Is there REALLY a risk that financial markets would seize up again? Rosewell correctly notes that we don't actually know what causes financial markets to freeze, and she appeals for the economics profession to develop models that better explain and predict the behaviour of the financial system. I absolutely endorse her remarks. Classical economic models have excluded the financial sector, effectively treating it as passively reactive to real economic forces. We now know that nothing could be further from the truth - it is clearly an active driver of economic change, and not always for the better. But we don't know enough about what does drive market behaviour. So further research is needed.

So yes, there is a risk that financial markets might freeze again. But Rosewell then goes on to make a priori judgements about what would cause that to happen. In effect she suggests that the UK government borrowing another 2-3% of GDP for capital investment and perhaps private debt relief or tax cuts might cause the sort of market panic we saw in 2008. I really can't follow her logic here. In what way would a responsible government borrowing a small percentage of its GDP to invest in the future of its economy equate to a catastrophe of the same order as the failure of Lehman Brothers? Krugman dismissed Rosewell's fears about the financial markets as "fantasy", and to be honest I am inclined to agree. I can't see that she is comparing like with like.

Having said that, the financial markets do seem to be behaving irrationally - if fear is irrational. It seems to me that fear is the principal driver behind most investment decisions at the moment: fear of default, fear of inflation, fear of collapse, fear of loss.......fear of the unknown. As Christopher Cole of Artemis Consulting puts it, we have a "bull market in fear". So I suppose that it is entirely possible that financial markets might respond very negatively indeed to an already-indebted government borrowing a bit more. The likely effect would be a significant increase in the yields on government debt and perhaps a cut in its credit rating (not that anyone takes much notice of credit ratings any more). But yields on government debt are currently well below inflation and being pushed down by QE. There is room for quite a considerable rise in yields without causing financial distress to the UK sovereign.

But even if the UK borrowing more did cause financial markets to reject its debt, the UK has other weapons up its sleeve, like forcing pension funds and banks to buy its debt - it has already done this to some extent - or even, as a last resort, monetizing the debt at the Bank of England. The UK is not going to suffer a debt crisis of the same order as Greece. It has a sovereign government and a central bank. Greece has neither.

What the UK could suffer as a consequence of increased borrowing, or rather monetization of increased borrowing, is currency collapse. I find it extraordinary that despite all her fears of financial market dislocation, Rosewell ignored this risk. Markets know that sovereign governments with central banks can always pay their debts. So if they don't like the behaviour of the government they reject the currency in which the debt would be paid, not the debt itself. The last time this happened in the UK was in 1976, when the government was forced to seek assistance from the IMF to choke off a run on sterling arising from loose fiscal and monetary policy.

But again, let's consider the risk. Is the UK government borrowing an additional 2% of GDP for investment in a stagnant economy really likely to cause a run on sterling? I doubt it. Financial markets may be irrational, but surely not that irrational. The inflation risk from that amount of borrowing in a stagnant economy is tiny. Implosion of the Eurozone and collapse of the Euro is a much bigger risk. Even if the UK Government borrowed more, I think investors would still see it as a safe haven from the Eurostorm.

So broadly, I don't think Rosewell's fear-driven analysis stacks up. And I am particularly concerned by the illogicality of her conclusion, which is that the Coalition government is "getting things about right". Even from her own analysis, it is getting things very wrong. She is in favour of borrowing for capital investment, whereas the Coalition government is cutting capital investment to the bone. Furthermore, she has not explained why she regards reducing public borrowing as more important than allowing the private sector to reduce its debt burden. Non-financial corporate and household debt of over 170% of GDP is surely a much larger brake on growth than public debt of under 80% of GDP. And as Krugman explained in his opening remarks, it isn't possible for both to deleverage at the same time without provoking what he calls "a depression, properly understood".

The trouble is, there are an awful lot of people who think like Rosewell. The world is on an austerity drive, with crippling effect on the real lives of ordinary people and businesses. And perhaps more importantly, in the UK (and I suspect other countries such as France) where there hasn't yet been much real austerity, the FEAR of austerity is driving people into self-protective behaviour that seriously reduces economic activity. We are frightening ourselves into a completely unnecessary depression.

Comments

  1. Economies, and the so-called financial markets, seem to be driven by fear or greed. We are now in the fear phase, following an extended period of greed, which ended the myth of 'an end to boom and bust'. So when we have worked our way out of this period no doubt there will follow more 'excessive exuberance', then some more fear, and so on, ad infinitum. Question is, should I fear greed?

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  2. Hmmm ...

    There is the long-running 'debt theater' taking place that includes characters like Krugman ... marketing 'more debt = prosperity tomorrow'. It's always tomorrow with guys like Krugman? Have you noticed?

    Just like on TV: happiness in the consumer utopia is always just around the corner ... one more rain forest bulldozed into the wood chipper in the name of 'progress' ...

    Then another rain forest then another lake then another mountaintop then the oceans ... then all the mountains together ... one doesn't need a weatherman to know which way the wind blows ... right?

    Beneath the debt theater is the onrushing cannibalization of capital. If value isn't destroyed at a constantly increasing pace there is 'contraction' ... larger/smaller numbers appearing in a column on a computer screen. Changing numbers is something that moderns cannot possibly bear. A small number in a column means somewhere a plutocrat has to make do with less ... with slightly less expensive wristwatches or shorter yachts. This in turn diminishes the foundational appeal of plutocracy ... of winning in the casino or rather ... owning the casino.

    Capital has been destroyed on an industrial scale beginning at the end of the 19th century. Humans have become very good at destroying capital ... the cheap capital is now exhausted with nothing at all useful to show for it ... some hand-waving and empty abstractions such as 'prosperity' and 'success' ... plus a billion used cars.

    Instead of new capital arriving for our furnaces to consume, there are new capital-related costs that appear at our doorsteps. The dilemma: without new capital the waste-based economy dies, any capital to be had at continually increasing cost only buys temporary reprieves. How many trillion$ have the Spanish committed to gain ... 50% youth unemployment? How many more trillion$ are needed for Spain to 'enjoy' 100% unemployment across the entire country? How many trillion$ more will be committed to destroy the Euro-zone? What, then is the dollar or euro or pound-sterling worth, exactly?

    The 'either-or' dilemma is not a good place for the human race to be in ... our food supply is 100% dependent upon a cheap and plentiful supplies of petroleum. The bosses never bothered to think this through when hundreds of trillion$ in investment 'funds' were first borrowed- then devoted to building out our fabulous automobile infrastructure ... which now directly competes with human beings for nourishment and support. You wonder why people are frightened?

    Lady, they aren't nearly frightened enough!

    If UK GDP is US$2.5 trillion (equivalent current dollars) how is 'investing' US$75 billion or even US$275 billion going to make any difference? No amount of money can retrieve capital that has been wasted. The country would be another amount in the hole to Wall Street- or City of London financiers. Investments would flow toward capital destroyers: highways, bridges, Pizza Huts, more highways, ring roads, more automobiles, more highways, military hardware, more highways still ... 'investments' long ago became counterproductive: see 'China'.

    The smart people are already out the door and looking over their shoulders ... so is the smart money. Insightful folks have looked at the UK fuel situation and have gone to Canada.

    In reality doing so is silly ... there is nowhere to run, nowhere to hide. If you aren't terrified, you aren't paying attention, you're sleeping.

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    Replies
    1. This comment is an example of exactly what I'm talking about. It is a confused, rambling attempt to voice nameless and irrational fears. There is little logic in it, and even less fact.

      The fact is that we are immeasurably richer now than we were at the end of the 19th century. You might like to recall that back then, the majority of people didn't have things like running water and sanitation that we now consider basic essentials. To say that we have been "destroying" capital since the end of the 19th century is to ignore all that we have achieved and write off the considerable improvement in human living standards worldwide in the last century.

      One crisis does not force us to forego all that we have achieved. We may slip back a few steps, that is all.

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    2. Well said.

      All too often this is what passes for an argument on this side of the pond. Perhaps your side of the pond as well.

      Krugman, Delong et al. are very conservative economists. Their very narrow point, ignored by many, is when monetary policy no longer has traction, a fiscal stimulus is required to reinvigorate the system. The emphasis is on system.

      The logic of business confidence leading the way in a recovery is tortured. What businessman in his right mind will expand his enterprise and the cost side of his balance sheet when demand growth is not yet even a glimmer? The smart move is to sit on cash and wait for a better day. Individual businesses, even entire business sectors cannot move demand with their hiring.

      If businesses are not hiring they are not confident their investment will be justified.

      So, it is up to the public sector to take steps that cure the system. The better roads, schools, schools and telecommunications infrastructure that will result will benefit us for generations. The government money borrowed at a microscopic interest rate will pay private enterprise to produce these societal improvements. Private enterprise will hire new employees to do the work, and these new hires will buy goods and services and pay taxes. And the taxes produced by growth will repay the debt.

      As Krugman has pointed out: England handled this much better in the Great Depression than currently. That is a shame.

      Feedback systems work both ways. We are at the bottom of a negative feedback cycle. The system needs a nudge from the public sector and the private sector will take it from there.

      Delete
    3. Well said.

      All too often this is what passes for an argument on this side of the pond. Perhaps your side of the pond as well.

      Krugman, Delong et al. are very conservative economists. Their very narrow point, ignored by many, is when monetary policy no longer has traction, a fiscal stimulus is required to reinvigorate the system. The emphasis is on system.

      The logic of business confidence leading the way in a recovery is tortured. What businessman in his right mind will expand his enterprise and the cost side of his balance sheet when demand growth is not yet even a glimmer? The smart move is to sit on cash and wait for a better day. Individual businesses, even entire business sectors cannot move demand with their hiring.

      If businesses are not hiring they are not confident their investment will be justified.

      So, it is up to the public sector to take steps that cure the system. The better roads, schools, schools and telecommunications infrastructure that will result will benefit us for generations. The government money borrowed at a microscopic interest rate will pay private enterprise to produce these societal improvements. Private enterprise will hire new employees to do the work, and these new hires will buy goods and services and pay taxes. And the taxes produced by growth will repay the debt.

      As Krugman has pointed out: England handled this much better in the Great Depression than currently. That is a shame.

      Feedback systems work both ways. We are at the bottom of a negative feedback cycle. The system needs a nudge from the public sector and the private sector will take it from there.

      Delete
  3. Quite right! I used to live on Kraft cheese slices and sugar.

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  4. Kraft cheese slices and sugar? You had it easy! I would be lucky to suck on an old bone once a week.

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  5. Why is reducing public borrowing the most important type of debt reduction? Because public borrowing is not voluntary. Abstract figures take on board debt on your behalf, without asking you to analyse a propositional contract which you can then sign, or choose to not sign. Imagine if your neighbour signed you up for a contract that entangled you in debt without even consulting you, let alone receiving your signature. Even if it provided a material benefit to you, which you in the end recognised, allowing for such things leads to chaos. As for rationality, this excellent behavioural economist gave a great lecture on that issue!

    We're All Predictably Irrational

    http://www.youtube.com/watch?v=JhjUJTw2i1M

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    Replies
    1. No, in a democratic society where rich and poor alike have the power to vote, that answer won't do. We elect our politicians, and they decide to take on debt on our behalf. If you were talking about money issuance, I might agree with you since the Bank of England is nominally independent. But debt - no, sorry, we agree to that.

      We can have an argument about the rights of those who aren't born yet, if you like. But I must warn you that the "debt is wrong because future generations have to pay it" argument is disputed by much better people than me.

      It is not possible to reduce public debt without taking money from the private sector, either in the form of tax rises (which you don't agree with) or in the form of spending cuts which force the private sector to pay for things that they don't currently pay for. Giving public sector debt reduction priority reduces the private sector's discretionary spending power and impedes their desire to save. When the private sector is highly indebted and trying to deleverage, I question the wisdom of giving public debt reduction priority, because it is bound to be economically contractionary - and in an already fragile economy that is likely to cause recession. It was that question I asked Rosewell on Monday and I didn't get an answer.

      This is not to say that fiscal deficits don't need to be reduced. They do - but it is a question of timing and priorities.

      Delete
  6. Fair point, but take it another step further. Your local council and not the central government can take on debt on your behalf. You're afforded the chance to vote into place council members but you are not then consulted about the contracts they sign in your name. I think it is easy to deploy "democracy" as a catch all phrase to temper concerns about excessive government spending. As for taxes, you could confiscate all the profit and assets of the Fortune 500 and you still would not have made any meaningful impact on debt reduction. As crazy as it may seem, Tony Robbins has actually demonstrated this in quite a clear way.

    The National Debt and Federal Budget Deficit Deconstructed
    http://www.youtube.com/watch?v=jboTeS9Okak

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    Replies
    1. No, you are not consulted, because in electing them you have appointed them to sign those contracts in your name. It would be ridiculous and impossible to hold a referendum for every individual borrowing decision.

      Delete
    2. By the way, please just say if you dislike me posting links to various things of your website. I do not mean to deface it in any way, and I remember you saying I always send you silly links! :-)

      Delete
  7. Nice say on this blog about Fear-driven economics.
    Investment Advice

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  8. This is a refreshingly sensible and informative blog. Thank you.

    ReplyDelete

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