Over at the New Republic, Bob Solow offers a thoughful review of Sylvia Nasar’s new book, Grand Pursuit: The Story of Genius. Along the way, Solow provides a characteristically clear explanation of what he views as John Maynard Keynes most important contribution:
Back then [in the 1930s], serious thinking about the general state of the economy was dominated by the notion that prices moved, market by market, to make supply equal to demand. Every act of production, anywhere, generates income and potential demand somewhere, and the price system would sort it all out so that supply and demand for every good would balance. Make no mistake: this is a very deep and valuable idea. Many excellent minds have worked to refine it. Much of the time it gives a good account of economic life. But Keynes saw that there would be occasions, in a complicated industrial capitalist economy, when this account of how things work would break down.
The breakdown might come merely because prices in some important markets are too inflexible to do their job adequately; that thought had already occurred to others. It seemed a little implausible that the Great Depression of the 1930s should be explicable along those lines. Or the reason might be more fundamental, and apparently less fixable. To take the most important example: we all know that families (and other institutions) set aside part of their incomes as saving. They do not buy any currently produced goods or services with that part. Something, then, has to replace that missing demand. There is in fact a natural counterpart: saving today presumably implies some intention to spend in the future, so the “missing” demand should come from real capital investment, the building of new productive capacity to satisfy that future spending. But Keynes pointed out that there is no market or other mechanism to express when that future spending will come or what form it will take. Perhaps God has not yet even decided. The prospect of uncertain demand at some unknown time may not be an adequately powerful incentive for businesses to make risky investments today. It is asking too much of the skittery capital market. Keynes was quite aware that occasionally a wave of unbridled optimism might actually be too powerful an incentive, but anyone in 1936 would take the opposite case to be more likely.
So a modern economy can find itself in a situation in which it is held back from full employment and prosperity not by its limited capacity to produce, but by a lack of willing buyers for what it could in fact produce. The result is unemployment and idle factories. Falling prices may not help, because falling prices mean falling incomes and still weaker demand, which is not an atmosphere likely to revive private investment. There are some forces tending to push the economy back to full utilization, but they may sometimes be too weak to do the job in a tolerable interval of time. But if the shortfall of aggregate private demand persists, the government can replace it through direct public spending, or can try to stimulate additional private spending through tax reduction or lower interest rates. (The recipe can be reversed if private demand is excessive, as in wartime.) This was Keynes’s case for conscious corrective fiscal and monetary policy. Its relevance for today should be obvious. It is a vulgar error to characterize Keynes as an advocate of “big government” and a chronic budget deficit. His goal was to stabilize the private economy at a generally prosperous level of activity.
A second characteristically Keynesian theme meshes very well with the first. In a complex economy, many business decisions have to be made in a fog of uncertainty. This is especially true of investment decisions, as already discussed: a lot of money has to be placed at risk today in an enterprise whose future success can only be guessed. (Much the same can be said of consumer purchases of expensive durable goods.) The standard practice is to focus on the uncertainty and think about it in terms of probabilities, which at least allow for an orderly analysis and orderly decision-making. Keynes preferred to focus on the fog. He thought that some of the important uncertainties were essentially incalculable. They would end up being dealt with in practice by a mixture of apprehensiveness, rules of thumb, herd behavior, and what he called “animal spirits.” The point of this distinction is not merely philosophical: it suggests that long-term investment behavior will sometimes be irregular, unstable, and given to doldrums and stampedes. Expectations can be volatile, and transmit their volatility widely. Passive or perverse policy can be dangerous to the economy’s health.
Solow thus credits Keynes with pioneering the “uncertainty” meme, although in a different sense than many commentators invoke it today.
His whole review is well worth a read if you are interested in the history of economic thought, including Fisher, Hayek, and Schumpeter.
P.S. Solow’s comments on Hayek are less enthusiastic than for Keynes, but he does note that “the Mises-Hayek critique of central planning was convincing (and clearly confirmed by subsequent facts).”
If all goes according to plan, the hoopla over the debt limit will soon recede. Policymakers and analysts will move on to the next new thing. And, sadly, some fascinating questions will forever go unanswered. For example, which president would appear on the trillion-dollar coin?
But if you are up for one last article about default, yesterday’s piece by Christophe Chamley at Bloomberg is a good one (ht: Donald M.). Chamley recounts Spain’s intentional bond default way back in 1575:
Spain, at the time, was the world’s sole superpower. Contemporaries described it as an empire “over which the sun never sets.” Yet the king needed the cities’ consent to borrow at a reasonable rate. And he needed it for a reason: The cities collected the taxes.
Each of the 18 main cities of Castile levied a special tax earmarked for long-term debt service. The level of this tax was set every six years through negotiation with the king. Tax collections were used first to pay off local long-term bondholders, with the rest sent to the central government. The local long-term bondholders were, in large part, the elderly living in the area. So local taxpayers realized that if they didn’t pay, their parents would be hurt. Thus, this precursor to Social Security had an effective enforcement mechanism — the ire of the elders.
But the king could only exploit this confluence of interests so far. The Cortes set the earmarked tax rate by majority rule, and that limited the king’s issuance of what were, in effect, his AAA securities. The king also issued other bonds secured by other, non-earmarked revenue. These securities were of a lower grade and sold at lower price.
Thanks to Philip’s expensive military adventures in the Netherlands and the Mediterranean, Spain’s debt had reached half of gross domestic product by 1573. At that point, the cities balked at paying higher taxes. For the next two years, they refused to budge in their confrontation with the king.
Finally, in September 1575, Philip took a circuitous route to outmaneuver the Cortes. He suspended payments not on the long-term debt, but on the short-term debt, which was owed primarily to Genoese bankers. The people cheered. Resentment against bankers ran as high then as now — perhaps higher, because the bankers were foreigners. The upshot, however, was default and a full-blown credit crisis.
And then what? Well, as Chamley recounts, it wasn’t pretty.
To what extent do natural environments explain political development? A lot, according to a recent paper by Stephen Haber and Victor Menaldo. They find that rainfall and democracy go together like porridge and Goldilocks – to get democracy to flourish, it shouldn’t be too wet or too dry:
Why are some societies characterized by enduring democracy while other societies are persistently autocratic? We show that there is a systematic, non-linear relationship between rainfall levels and regime types in the post-World War II world: stable democracies overwhelmingly cluster in a band of moderate rainfall (550 to 1300 mm of precipitation per year); persistent autocracies overwhelmingly cluster in deserts and semi-arid environments (0 to 550 mm per year) and in the tropics (above 1300 mm per year). We also show that rainfall does not work on regime types directly, but does so through the its impact on the level and distribution of human capital. Specifically, crops that are both easily storable and exhibit modest economies of scale in production grow well under moderate amounts of rainfall. The modal production unit is a family farm that can accumulate surpluses. In such an economy there are incentives to make intergenerational investments in human capital. A high level and broad distribution of human capital makes democratic consolidation more likely.
ht: Roger K., who referred me to a recent Amity Shlaes column that cites this research.
Read aloud by the announcers on NPR.
My favorite part? The concluding lines:
And for the support of this Declaration, with a firm reliance on the protection of divine Providence, we mutually pledge to each other our Lives, our Fortunes and our sacred Honor.
As I noted a few days ago, some nations have managed even larger budget adjustments than the one that Greece faces today. Several commenters rightly noted, however, that this slim reed of hope becomes even slimmer when you consider other factors such as the pace of adjustment (Greece would have to cut very quickly) and its inability to devalue its currency (unless it leaves the eurozone).
Michael Cembalest of JP Morgan put together a sobering chart that highlights how severe Greece’s challenges are compared to other nations that have accomplished major budget adjustments in the past (hat tip: Paul Kedrosky at Infectious Greed):
Today Greece finds itself high on the vertical (i.e., needing a very rapid fiscal adjustment) with minimal growth prospects and no ability to devalue.
Greece needs money fast. The International Monetary Fund (IMF) and members of the Euro-zone have that money. But before they lend it to Greece (at very favorable interest rates), they are demanding that Greece get its fiscal house in order.
As a result, Greece is proposing an austerity plan that would reduce its out-of-control budget deficits (currently standing at more than 13% of GDP) by at least 10-11% of GDP.
You might wonder whether that’s possible. History suggests the answer is yes, at least in principle. Indeed, several countries have achieved even larger deficit reductions.
According to an IMF study that I discussed a few months ago, the past three decades have witnessed at least nine instances in which developed nations have cut their structural deficits by at least 10% of GDP:
This list demonstrates that large-scale budget improvements are possible. But they don’t always stick. Sweden, for example, makes two appearances in the top nine. Its gains in the 1980s were undone in the financial crisis of the early 1990s, so it had to undertake a second round of austerity. And Greece itself is a repeat offender, as its gains from the early 1990s have all been lost.
Greece faces enormous practical and political challenges in its austerity efforts, and success is hardly guaranteed. The nation can take some encouragement, however, from the fact that other nations have addressed even larger budget holes.
With some hard work and luck, perhaps Greece will join Sweden as a two-time member of the Large Deficit Reduction Club.
Several colleagues recently suggested that now is a propitious time to read (or re-read) Paul Blustein’s “The Chastening.” The book recounts how the International Monetary Fund (IMF) and the G-7 nations struggled to combat the Asian, Russian, and Latin American economic crises of the late 1990s.
Having read the book while flying back and forth across the nation, I heartily agree. The Chastening is a great read if you want to get up to speed on many of the issues now posed by the “PIIGS” (Portugal, Ireland, Italy, Greece, and Spain).
I particularly enjoyed (if that’s the right word) the number of characters, familiar from today’s Greece debacle, that appear in the book. For example:
* The government that used derivatives to hide its perilous financial situation (Thailand)
* The German leaders who denounced the moral hazard created by sovereign bailouts (most notably Hans Tietmeyer)
* The policymakers facing doubts (often well-founded) about whether assistance packages could really help or were just postponing the inevitable (and, in the meantime, bailing out some unsympathetic creditors).
With the benefit of ten years more hindsight, readers can also enjoy a certain “you ain’t seen nothing yet” thrill from passages about how scary the financial world looked during the crises of the late 1990s.
[Alan Greenspan the] Fed chief told the G-7 that in almost 50 years of watching the U.S. economy, he had never witnessed anything like the drying up of markets in the previous days and weeks. (p. 334)
Unfortunately, we were all in for even worse in less than a decade. And now Greece is following in many of the steps of Korea, Thailand, Indonesia, Russia, and Brazil.
A couple weeks ago, I highlighted an IMF report that compared the fiscal challenges facing developed economies. Not surprisingly, the IMF concludes that the United States has one of the largest structural deficits. To get our national debt back down to 2007 levels (relative to the economy), the IMF believes that we need to undertake a major fiscal adjustment–equivalent to a whopping 8.8% of GDP.
I have some quibbles about that figure, not least because the United States could avoid a fiscal crisis without getting the gross government debt all the way back to 2007 levels. But the basic message is sound: we face an enormous fiscal challenge.
However, we should not give up hope. As I discuss in a new piece over at e21, the IMF report also provides some reason for optimism: history provides numerous examples of developed economies that have successfully undertaken major fiscal adjustments. Indeed, the IMF finds 30 instances during the past three decades in which countries made adjustments of at least 5% of GDP, and nine cases in which the adjustments were even larger than the IMF currently prescribes for the United States:
The United States itself makes the list, with a fiscal adjustment (i.e., reduction in the cyclically-adjusted primary budget deficit) of 5.7% back in the 1990s.
Looking through the list, you will notice that many of these large adjustments occurred, at least in part, during the economic boom of the late 1990s. That isn’t surprising: fiscal adjustment is much easier if strong economic growth reinforces responsible fiscal policies.
The fiscal outlook for the United States is grim. This year’s deficit will be around $1.4 trillion, about 10% of GDP, and the Obama Administration projects that deficits in the next ten years will total about $9 billion. Under those projections, the ratio of publicly held debt to GDP will be approaching 77% by the end of 2019, up from 41% just a year ago.
Those figures are daunting. We are in a deep fiscal hole. But we shouldn’t give up hope just yet.
As the Committee for a Responsible Federal Budget notes in a new report, numerous countries have faced gigantic deficits and found the political will to change course. A few examples:
Finland (1992–2000): Following a major banking crisis, Finland faced large deficits (around 8 percent of GDP) and a rapidly rising debt (58 percent of GDP). Prior to the crisis, Finland was running surpluses of around 6 percent of GDP. Motivated by strong political support to get its house in order to qualify for eurozone participation and by the need to address external financing concerns, the government pursued a fiscal consolidation program. A medium-term budget framework, entitlement reforms, spending cuts and tax reform were part of the program. By 2000, the debt/GDP ratio was under 45 percent. The cyclically adjusted primary fiscal balance improved cumulatively by 10 percent of GDP from 1992.
Spain (1993–97): Spain’s fiscal position had been deteriorating since the late 1980s. By 1995, its fiscal deficit exceeded 7 percent of GDP. Its public debt exceeded 70 percent of GDP. Facing external financing concerns and strong public support to adopt fiscal disciplinary measures to prepare for euro area membership, the government adopted a fiscal consolidation plan that emphasized spending (including cuts in social transfers, government wages and health care spending) but also included tax reform. Fiscal balances improved, cumulatively by around 4 percent of GDP since 1993.
Sweden (1994–2000): Sweden’s fiscal situation deteriorated severely in the early 1990s as a result of a banking and economic crisis. In the midst of a recession, the government adopted a fiscal consolidation program to achieve fiscal balance through a tightening up on household transfer payments and an increase in various taxes. As a result of its fiscal consolidation efforts, the fiscal position shifted from a deficit of over 11 percent of GDP to a surplus of 5 percent of GDP and the debt/GDP ratio was reduced from 72 percent to 55 percent in 2000.
The CRFB report draws some interesting lessons from these episodes (e.g., Lesson 6: “It is preferable to make fiscal adjustments on your own terms before they are forced upon you by creditors.”)
But my point today is much simpler: Just as we were hardly the first developed economy to face a major financial crisis, we also are not the first to face a looming fiscal crisis. Indeed, as the examples of Finland and Sweden show, we aren’t even the first developed economy to face a potential fiscal crisis in the aftermath of a financial crisis.
As we prepare (I hope) to address our looming deficits, we can take heart from the fact that some other nations have successfully faced similar challenges.