Extreme mixing of economic policies
More than a quarter century ago, while studying macroeconomics, I examined the tools and options a government had at its disposal to influence growth, employment and inflation, and the world looked easy. At the time, there were two competing schools of thought regarding these options: the “do something” school, or Keynesian tradition, and the “do no harm” school, or monetarist tradition.
According to the Keynesians - I’ll risk oversimplifying their thinking here - recessions are caused by a lack of demand. By either increasing spending or reducing taxes, a government can boost a faltering economy, as can a central bank by cutting interest rates. Countercyclical economic policy was the name of the game in the 1950s and 1960s, to the extent that US President Richard Nixon is supposed to have said: “We are all Keynesians now.”
A major flaw in the Keynesian conception is that politicians are eager to spend money in times of recession but reluctant to follow its other prescription: saving money during boom times. In practice, Keynesianism became more an asymmetric than a countercyclical policy. Moreover, countercyclical policies tend to be ill timed. Due to lags, they often reach maximum impact when the economy is already recovering, leading to overheating and inflationary pressures. Therefore, the monetarists, led by Milton Friedman, advised governments to avoid countercyclical policies altogether under the Hippocratic principle: “Do no harm!”
The world has obviously evolved since the heyday of Keynesianism, which a large part of the economics profession considered obsolete after the Great Inflation of the late 1970s. However, with the onset of the financial crisis and the Great Recession, macroeconomic policies that help smooth or mitigate downturns came into fashion again, although not everywhere alike. We have to differentiate here between US activism, Eurozone restrictivism and a rather strange Japanese mix.
Former US Federal Reserve Chairman Ben Bernanke once joked: “The problem with [quantitative easing] is that it works in practice, but it doesn’t work in theory.” However, what the US embarked on at the end of 2008 was nothing short of a kind of Über-Keynesianism. The government and Fed fired all possible expansionary guns, almost doubling the public debt-to-GDP ratio and ultimately increasing the monetary base fivefold. Economists are currently debating what the long-term consequences of such extreme anti-cyclical policy will be. But we shouldn’t be surprised that, for now, the US is posting very strong growth rates.
The economic policy practiced by the Eurozone during and after the Great Recession is more difficult to read. While at first Eurozone monetary policy was expansive, if in a rather shy way relative to the US’s, it became de facto restrictive by October 2012, when the European Central Bank’s (ECB) balance sheet started to shrink by roughly one trillion euros. At least until last September’s ECB announcements, one can safely state that the overall policy mix was restrictive and pro-cyclical. In hindsight, this mix explains the Eurozone’s double-dip recession in 2012-13, its current flirtation with deflation, and the strength of its currency until March 2014. While the issue of countercyclical policies is debatable, it is worth noting that no economists are arguing in favor of pro-cyclical ones.
Japan, with its Abenomics, has adopted the strangest of all policy mixes. Its monetary policy is extremely expansive. The new measures announced by the Bank of Japan will expand the monetary base at a pace equivalent to USD 5,600 per person per year, compared with the USD 3,200 per person per year at which the US monetary base rose during the peak of QE3. At the same time, its fiscal policy, still expansive in 2013, has become ultra-restrictive in the wake of a 3% VAT increase this spring, with another 2% rise planned for 2015. Abenomics looks, on a macroeconomic scale, like a psychotropic drug experiment in which a person receives a shot of amphetamine (monetary policy) followed by a shot of barbiturate (fiscal policy). It has markedly increased the volatility of Japanese GDP, which posted 6% annualized growth in 1Q14 followed by a 7.2% annualized contraction in 2Q14. The experiment is ongoing so it is difficult to assess whether the Abenomic shock therapy will finally defibrillate the Japanese economy or send it into definitive cardiac arrest.
In my view, the fact that all three major industrialized economies have pursued individual and internationally uncoordinated macroeconomic policies is likely to have been counterproductive. However, there is an upside. A quarter century from now, macroeconomists will be able to refine their policy tools with all the experience being currently accumulated.