Tuesday, 14 July 2009

1. Stimulus 2. Restructuring 3. Growth

Adam Posen's submission to the Treasury Select Committee - in advance of his appointment to the Bank of England's MPC - are reported by Stephanie Flanders today. Some interesting thoughts.

The first is that:
The bottom line, he says is that economists just don't understand deflation very well:

"I think these facts call for some degree of humility. The Bank of England is right to be engaged in quantitative easing to address our current problem. But I think we should stay away from very mechanistic monetarism that, 'Oh, boy, they've printed a lot of money so at some point that has to turn into inflation.' Or, 'If we do this specific amount of quantitative easing, so it will lead to this result.'

Looking at Japan, it is clear that their quantitative easing measures had the right sign, in the sense of being stimulative, but did not have a predictable or even large short-term result, let alone cause high inflation."
An intriguing comment and one that will no doubt make Scott Sumner happy. Frankly, there is a lot about macroeconomic behaviour that economists clearly don't have a good handle on, and I hope the current crisis will at least help us get better tools in this area.

I wouldn't fully agree with the implication that deflation is not harmful - arguably the Japanese deflation, by the end of the decade, cost the country perhaps 20% of the economic output it could now have been generating. But admittedly it didn't lead to a meltdown either.

And just to balance it out, something for Paul Krugman too - though Stephanie doesn't report it quite like that:
"Second, and more importantly, if you do not fix the banking system by the time your stimulus runs out, then private demand will not pick up when the stimulus runs out. That's what we saw in Japan in 1997, and that is what we saw in Japan in 1999-2000. So we have a clock ticking here in the UK as in the US and the euro area."

So, Posen doesn't think that government spending can create a self-sustaining recovery on its own.
Indeed - and I don't believe anyone else really thinks that either. The point about fiscal stimulus is that it helps bridge a gap in economic output while the economy adjusts to some shock or other. The shock might be exogenous - an interruption in oil supply or some other supply problem - or it might be endogenous - systemic financial problems and a loss of consumer and investor confidence.

Either way, government borrowing can temporarily sustain demand and employment, stop the shock from starting a self-sustaining cycle of economic decline, and in essence "restart the dynamo" of economic growth.

What Posen's comments do critically highlight is that stimulus is not enough on its own. The financial system does need to be fixed; resources do need to be reallocated from declining industries such as carmaking into new ones such as [pick your own winner here]. The economy, in short, has to be restructured. Apparently the gradual restructuring which is meant to happen continuously in a dynamic economy has not worked very well, so a slightly more wrenching reshaping of the system is now called for.

Indeed one reason the financial system is so important is because it is one of the main mechanisms by which this happens: differing returns on capital encourage resources to be shifted between sectors. Financial engineering - as Robert Peston complains about in his posting today - can sometimes arise from straightforward gaming of the system, but equally it can be a competitive response to suboptimal capital allocation. If I think Friends Provident is putting its money in industries where it will get a low return, I should certainly be making a takeover bid and promising to switching that investment into a better place.

No comments: