Thought du Jour

Jean-Claude Trichet, president of the European Central Bank, made a predictable (and dull) call for austerity in his invited contribution to the FT debate on this subject. Deficit spending, he concedes, was necessary to avert “a financial meltdown and a second Great Depression”, but enough of that. Now it is time to restore fiscal balance and concentrate on ensuring price stability:

The ECB, which acted at the very start of the financial turmoil on August 9 2007, will contribute to consolidate a confident economic environment by ensuring price stability in the euro area as we have done for more than a decade. We expect governments to confirm their determination to consolidate their public finances.

Jean-Claude Trichet, “Stimulate no more – it is now time for all to tighten”, Financial Times, 23 July 2010.

Berkeley economist Brad DeLong responds to Trichet in the FT weekend edition, with prose that is lively and entertaining.

What lessons does history have to teach us about Jean-Claude Trichet’s call for immediate, rapid, and substantial fiscal and monetary retrenchment and austerity–about his full-throated endorsement of the agenda of the Pain Caucus?

Well, history tells us that there are times and circumstances when countries’ refusal to listen to calls for retrenchment and austerity has led to economic disaster. Times when a country’s supply of savings is inelastic and more government borrowing leads to sharp rises in and high real interest rates are times in which government budget deficits have drained the pool of savings, reduced private investment, and slowed growth–as they did in the U.S. in the second Reagan and the first Bush administration. Times when monetary and fiscal laxity leads to an expectation that government debt will be monetized and to rapid rises in inflation expectations are times in which policy has made a deep recession to restore price stability inevitable–as happened in the U.S. in the Nixon, Ford, and Carter administrations. And times when irrational exuberance on the part of foreign investors leads a country’s public or private sector to borrow heavily in foreign currency, it needs to pre-emptively retrench before foreign investor exuberance wears off, or else–as happened to East Asia in 1997-8, to Mexico in 1994-5, or to Argentina innumerable times since 1890.

Brad DeLong,  “Trichet rejects the counsels of history”, Financial Times, 24 July 2010.

You can access the rest of the statement at ft.com, or view an ungated version at Brad DeLong’s blog, where he complains that the Financial Times deleted the first two paragraphs. Here are the deleted paragraphs:

One of the embarrassing dirty little secrets of economics is that there is no such thing as economic theory properly so-called. There is simply no set of foundational bedrock principles on which one can base calculations that illuminate situations in the real world. Biologists know that every cell runs off instructions for protein synthesis encoded in its DNA. Chemists start with what the Heisenberg and Pauli principles plus the three-dimensionality of space tell us about stable electron configurations. Physicists start with the four fundamental forces of nature. Economists have none of that. The “economic principles” underpinning their theories are a fraud–not bedrock truths but mere knobs twiddled and tunes so that the right conclusions come out of the analysis.

What are the “right” conclusions? It depends on what type of economist you are, for there are two types. One type chooses, for non-economic and non-scientific reasons, a political stance and a political set of allies, and twiddles and tunes their assumptions until they come out with conclusions that please their allies and their stance. The other type takes the carcass of history, throws it into the pot, turns up the heat, and boils it down, hoping that the bones and the skeleton that emerge will teach lessons and suggest principles that will be useful to voters, bureaucrats, and politicians as they try to guide our civilization as it slouches toward utopia. (You will not be surprised to learn that I think that only this second kind of economist has any use at all.)

Brad DeLong, “Jean-Claude Trichet Rejects the Counsels of History”, Grasping Reality with Both Hands, 23 July 2010.

Why were these paragraphs deleted? FT editors would no doubt argue that space constraints required it. This was the argument of OECD editors who, a decade ago, deleted all negative references to the World Bank from their published version of my contribution to a Prague conference. (You can download the unedited version of my essay here.) I was naturally upset with the OECD, but fortunately my employer at the time (the UN Secretariat) did not censor my private writings, and allowed me to circulate the piece as a UN discussion paper. Writers ought to welcome censorship, as this brings them publicity and, in the end, more readers!

I have work to do – running some regressions on Chinese migration data – but I can’t resist the temptation to read the always interesting blog of Scott Sumner. He admits that he is depressed by the rantings of supposed  monetary experts like Bernanke, but can’t help but write about it, just as the rest of us cannot help but read about it, I suppose. Anyway, this passage caught my eye:

Here’s what [Fed Chairman Ben] Bernanke says about the prospects for reaching their [the Federal Reserve's] goals:

The unemployment rate is expected to decline to between 7 and 7-1/2 percent by the end of 2012. Most participants viewed uncertainty about the outlook for growth and unemployment as greater than normal, and the majority saw the risks to growth as weighted to the downside. Most participants projected that inflation will average only about 1 percent in 2010 and that it will remain low during 2011 and 2012, with the risks to the inflation outlook roughly balanced.

Bernanke’s lucky that Congress doesn’t have a clue as to how to interpret Fed-speak, because he is basically saying the following:

1.  The Fed has reduced its implicit inflation target below 2%, indeed below even 1.5%.

2.  The Fed sees more downside risk on jobs, but puts a zero weight on jobs in its policy deliberations.

Scott Sumner. “No We Can’t”, The Money Illusion, 21 July 2010.

Economists really do seem to struggle with history – and sometimes geography, too. Brad DeLong needs to remember that the Financial Times is published in London. As far as most combatants were concerned, the second world war broke out in September 1939. So when I wrote “The federal debt burden [in the United States] rose only slightly – from 40-45 per cent of GDP – prior to the outbreak of the second world war”, I was referring to the increase between 1933 and 1939.

[...]

The current [US] debt explosion relies heavily on foreign capital. Note to the compulsive stimulators: according to the latest Treasury International Capital data, China – the federal government’s single biggest foreign creditor – has quietly reduced its holdings of US Treasuries by $72bn since last July, from 13 per cent of the total debt in public hands to just 10 per cent.

In common with other stimulators, Prof De Long is confident that the day when “government action begins to crack the status of the US Treasury bond as a safe asset” will “probably not” come soon. The gentlemen in Beijing may be less sanguine.

Niall Ferguson, “1939 and all that …”, Financial Times, 21 July 2010.

Brad DeLong may be an economist, but he is also a skilled historian who does not “struggle with history”. Although World War II formally began in September 1939, when German troops invaded Poland, the US entered only after the bombing of Pearl Harbor on December 7th 1941. The second date is the relevant one for the United States.

Also in the FT today, there are contributions to the austerity debate from Ken Rogoff (“No need for a panicked fiscal surge”) and Tim Harford (“A sunlit Keynesian paradise awaits our grandchildren”).

Harvard economist Kenneth Rogoff is co-author (with Carmen Reinhart) of “This Time is Different: Eight Centuries of Financial Folly”, published last year by Princeton University Press. Economist and FT journalist Tim Harford is author of a popular book, “The Undercover Economist”.

The debate rages on at the Financial Times. Berkeley economic historian Brad DeLong today takes the stimulus side, and Harvard historian Niall Ferguson defends austerity. Neither disappoints.

It was said of the Bourbons that they forgot nothing and learned nothing. The same could easily be said of some of today’s latter-day Keynesians. They cannot and never will forget the policy errors made in the US in the 1930s. But they appear to have learned nothing from all that has happened in economic theory since the publication of their bible, John Maynard Keynes’s The General Theory of Employment, Interest and Money, in 1936.

In its caricature form, the debate goes like this. The Keynesians, haunted by the spectre of Herbert Hoover, warn that the US in still teetering on the brink of another Depression. Nothing is more likely to bring this about, they argue, than a premature tightening of fiscal policy. This was the mistake Franklin Roosevelt made after the 1936 election. Instead, we need further fiscal stimulus.

Niall Ferguson, “Today’s Keynesians have learnt nothing”, Financial Times, 20 July 2010.

Brad DeLong’s counterblast:

In 1942 the US ran a federal budget deficit of 14.8 per cent of GDP; in 1943 30.8 per cent; in 1944 23.3 per cent; and in 1945 22.0 per cent – a four-year average deficit of 22.7 per cent of GDP.

Today, in 2010, the US is running a federal budget deficit that the CBO estimates at 10.3 per cent of GDP. Its score of Obama’s budget proposals has that deficit falling next year to 8.9 per cent of GDP, then over the next two years to 4.5 per cent of GDP, and remaining in the 4-5 per cent of GDP range for the rest of this decade – for an average CBO-scored Obama policy deficit of 5.3 per cent over the next eight years.

Brad DeLong, “Deficit data and the fog of war”, Financial Times, 21 July 2010.

See also Brad DeLong’s original post, “It is far too soon to end expansion”, Financial Times, 20 July 2010.