The Ghosts of Economics Past: Archive Entry From Brad DeLong's Webjournal

January 25, 2003

The Ghosts of Economics Past

Project Syndicate: The Ghosts of Economics Past: J. Bradford DeLong: December 2002.

In Charles Dicken's great novel "A Christmas Carol," the soulless businessman Ebeneezer Scrooge is tormented by a visit from the Spirit of Christmas Past. Today, economists are similarly troubled by unwanted ghosts, as they ponder the reappearance of economic ills long thought buried and dead.

From Stephen Roach at Morgan Stanley to Paul Krugman at Princeton, to the Governors of the US Federal Reserve and the senior staff at the European Central Bank, to almost everyone in Japan, economists all over the world are worrying about deflation. Their thoughts retrace the economic thinking of over fifty years ago, a time when economists concluded that the thing to do with deflation was to avoid it like the plague.

Back in 1933 Irving Fisher --Milton Friedman's predecessor atop America's monetarist school of economists-- announced that governments could prevent deep depressions by avoiding deflation. Deflation --a steady ongoing decline in prices-- gave businesses and consumers powerful incentives to cut spending and hoard cash. It reduced the ability of businesses and banks to service their debt, and might trigger a chain of big bankruptcies that would destroy confidence in the financial system, providing further incentives to hoard.

Such strong incentives to hoard rather than spend can keep demand low and falling, and unemployment high and rising, for a much longer time than even the most laissez-faire-oriented politician or economist had ever dared contemplate. Hence the Keynesian solution: use monetary policy (lower interest rates) and fiscal policy (expanded government spending and reduced taxes) to keep the economy from ever approaching the precipice where deflation becomes possible.

But if this is an issue solved over fifty years ago, why is it haunting us now? Why is this menace a matter of grave concern in Japan today, and a threat worth worrying about in the US?

In the late 1940s, those present at the creation of the post-World War II international economic order tried to create an international monetary system that would (a) allow for exchange rates stable enough for producers and consumers to escape the risks of excessive and irrational exchange rate fluctuations, (b) allow countries to follow their own domestic macroeconomic policies, and (c) prevent the catastrophic panics affecting not just individual banks but whole countries that produced the destructive international financial crisis of the Great Depression.

The result was the fixed-but-adjustable exchange rate system of Bretton Woods, which over time mutated into the floating-rate system of the 1980s. Then came the 1990s. All of a sudden tremendously destructive herd-driven financial crises were back: Mexico, Thailand, Korea, Brazil, and so on looked like nothing as much as the US financial panic of 1873 or the Austrian Creditanstalt crisis of 1931. Argentina's crisis at the end of 2001 looked remarkably like Argentina's Baring Brothers crisis of 1890 -- save that politicians and international bankers seem to have had a much better idea of what to do to minimize the damage in 1890 than they do today.

But if those who built the post-World War II international monetary system worked to guard against the dangers posed by panic-driven international financial crises, why are these financial devils back?

The truth is that economic policymakers are juggling sets of potential disasters, exchanging the one that appears most threatening for a threat that seems more distant. In the US, the Bush Administration is skeptical of the stimulative power of monetary policy and wants bigger fiscal deficits to reduce unemployment, hoping that the future dangers posed by persistent deficits -- low investment, slow growth, loss of confidence, uncontrolled inflation and exchange rate depreciation-- can be finessed, or will not become visible until after the Bush team leaves office.

In Europe, the European Central Bank believes that the danger of uncontrolled inflation following a loss of public confidence in its commitment to low inflation outweighs the costs of European employment that is far too high. In developing countries, capital controls to prevent financial crises are feared as obstacles to attracting the finance necessary for industrialization, and as potential sources of corruption as financial flows somehow pass through the hands of the Vice Minister of Finance's nephew-in-law.

Flexible exchange rates, designed to allow the market to signal when confidence in the currency is declining, also put exporters at a competitive disadvantage against foreign-country producers whose prices aren't batted around by unpredictable exchange rates. Even the import-substitution policies, now universally scorned, were originally adopted by the developing world for good (as well as bad) reasons: the protectionist shutting-off of developed-country markets during the Great Depression which had disastrous consequences for the developing economies.

The ghosts of economics' past return because the lessons of the present are always oversold. Politicians and policymakers advance their approach to economics as the "One True Doctrine." But what they are doing, however, is dealing with the biggest problem of the moment but at the price of removing institutions and policies that policymakers before them had put into place to control problems which they felt to be the most pressing.

Ebeneezer Scrooge's nocturnal visitors were able to convince him of the errors of his ways. Let's hope that today's economists also learn the lessons of their unwanted ghosts. Posted by DeLong at January 25, 2003 04:31 PM | Trackback

the Bush Administration is skeptical of the stimulative power of monetary policy

Brad, do you have a cite for this? I've not seen that anywhere.

and wants bigger fiscal deficits to reduce unemployment

Are you making "tax cuts" and "fiscal deficits" synonyms here? Yes, one can lead to the other, but as is usually the case, domestic non-militiary spending is rarely mentioned as a negative in this neighborhood.

hoping that the future dangers posed by persistent deficits -- low investment, slow growth, loss of confidence, uncontrolled inflation and exchange rate depreciation-- can be finessed, or will not become visible until after the Bush team leaves office.

Is anyone not associated with the "tax cuts over my dead body" school of thought credibly forecasting "persistent", say decade-plus, deficits?

And it is really cheeky, after the prior administration presided over a mammoth asset bubble and a horrifically failed non-proliferation policy, to accuse the W crowd, just halfway through one term, of planning/hoping its errors won't appear until the next administration.

Posted by: Bucky Dent on January 25, 2003 04:45 PM

Bucky Dent thinks that you're being too hard on the Bush administration. I think you're being way too generous. The goal in Bush's huge tax cuts is not to reduce unemployment, but to reward his allies. Deficits are a side-effect.

Posted by: Daryl McCullough on January 25, 2003 06:56 PM

>>Bucky Dent thinks that you're being too hard on the Bush administration. I think you're being way too generous. The goal in Bush's huge tax cuts is not to reduce unemployment, but to reward his allies.<<

It's odd. Last month (when I wrote this), the word was that the Bush Administration was going to propose some serious fiscal stimulus for 2003. But that seems to have largely evaporated...

Posted by: Brad DeLong on January 25, 2003 07:03 PM

Last month (when I wrote this), the word was that the Bush Administration was going to propose some serious fiscal stimulus for 2003. But that seems to have largely evaporated...

So the tax cuts are NOT "serious fiscal stimulus"? So it is possible to have a large UNstimulative budeget deficit?

IOW, the line is now that deficits driven by social spending are stimulative/good, and those driven by tax cuts are UNstimulative/bad?

Posted by: Bucky Dent on January 25, 2003 07:28 PM

>>Last month (when I wrote this), the word was that the Bush Administration was going to propose some serious fiscal stimulus for 2003. But that seems to have largely evaporated...

>So the tax cuts are NOT "serious fiscal stimulus"? So it is possible to have a large UNstimulative budget deficit?

I think Brad thinks Bush should propose one for 2003, instead he propose one has little effect on the deficit for 2003.

>IOW, the line is now that deficits driven by social spending are stimulative/good, and those driven by tax cuts are UNstimulative/bad?

IOW, the line is now that deficits driven by any spending are stimulative/good, and those driven by tax cuts are stimulative/good, but only for 2003.

Posted by: George Stebbins on January 26, 2003 01:48 AM

Uh, how about Mitch Daniels? Or does "the foreseeable future" not count as persistent?

Posted by: Nick on January 26, 2003 03:42 AM

Now, Bill Gates and Warren Buffett have pointed to the lack of economic stimulus in the proposed dividend tax cut. What do they know, anyway.

Yes, there really can be a federal budget deficit increase that will not stimulate the economy. Really.

Posted by: anne on January 26, 2003 10:27 AM

>>So the tax cuts are NOT "serious fiscal stimulus"?<<

You're missing the point. The tax cuts are too small and too backloaded to be a serious fiscal stimulus this year--when we need one. The tax cuts are, however, large enough and persistent enough to be a serious drag on economic growth come 2006-2016. What we want are bigger deficits now and surpluses later. What we are going to get is deficits now and bigger deficits later...

Posted by: Brad DeLong on January 26, 2003 12:05 PM

Be careful what you wish for, guys. Bush's proposal is only negotiating position. I'm guessing he's shrewd enough to meld the Democrats' plans with his. And the Dems (and Paul Krugman) have offered him, on a sliver platter, the opportunity to end Social Security As We Know It; all in the name of "stimulus".

Posted by: Patrick R. Sullivan on January 26, 2003 12:27 PM

Brad
This whole input today is very interesting and informative. Thanks. I have a question about this:
"low investment, slow growth, loss of confidence, uncontrolled inflation and exchange rate depreciation-- "
At some point inflation has to be the answer to deflation. Capital has to become convinced that spending now will be cheaper than spending latter. Right now the major corporations are at best using debt to refinance debt, rather than using debt to expand. So how do you get the inflation?
(They always seem to do this backwards.)

Also I was living in the Bay Area when SF real estate was just booming out of control around 1980. For all the hoopla about inflation and interest rates it really seemed that boom was ended when the City changed the Condo laws.

Thanks again
Bruce

Posted by: Bruce Ferguson on January 26, 2003 02:01 PM

You're missing the point.

You are right. I didn't grasp that subtlety.

Is this at all addressed by Bush's plan to accelerate the out-year tax cuts? Or is that move already included in your critique?

If yes, would you then advocate *deeper* structural tax cuts that would have a more immediate shock value?

Posted by: Bucky Dent on January 26, 2003 02:48 PM

Now, Bill Gates and Warren Buffett have pointed to.....

I think you mean Bill Gates, Sr., actually.

And the Dems (and Paul Krugman) have offered him, on a sliver platter, the opportunity to end Social Security As We Know It; all in the name of "stimulus".

Do elaborate.

Posted by: Jason McCullough on January 26, 2003 04:19 PM

Am a very novice economist, but why is a scenario of falling pices ad increasing AD, being greeted with so much trepidation.

Most firms (notably in the IT/Hi Tech) industry have coped with this issue by shortening new product and innovation cycles, to maintain prices. Other industries such as Autos are earning how to execute these strategies - anyone interested should track the emergence of flexible production lines over the last decade in autos.

Pure commodity firms are not facing this issue - look at any commodity price index or check rental movement in the aea you live.

AD is growing, investment demand is low because capacity utilization is low for now.

So why are we so worried?

Peeyoosh

Posted by: Peeyoosh Chadda on January 26, 2003 07:50 PM