Thursday, 11 August 2011

Thrift's Paradox or how economics can be made simple

We are all slaves to dead economists, the (late) British economist JM Keynes famously stated. A lot of politicians on both sides of the Atlantic have committed mistakes that indicate that they could need a hefty dose of pre-Keynes thinking. I am talking of the Thrift’s Paradox, first formulated by Mandeville in 1714. Put briefly, it states that if we all save to become richer, we all end up poorer.

It is a brief statement, and to most people without understanding of economics, it seems like simple nonsense. If something works for me (saving to improve my financial situation) it must also work for the government.

It sounds obvious. But it does not make it any more correct. If I save, it means that somebody else’s business will suffer a lack of demand. And if a lot of consumers decide to hold back on consumption, it will mean that a lot of demand disappears. In the end it is felt all the way down to the producers and they will respond by reducing output and laying off staff.

This simple mechanism is one of the most misunderstood issues in economics. It is also one of the most misused. It is easy to make political soundbites by comparing the public sector to a household. It is difficult to catch voters’ attention while trying to explain why it is wrong.

In the current situation, households on both sides of the Atlantic are saving in order to improve their balance sheets. That leads to lower demand. It would only be normal if the government sectors would do the opposite, spend in excess of the revenue, in order to keep the economy going during the transition. The public sectors can then – later – concentrate on improving its balance sheet. Usually, the governments are then also helped by a sprinkling of inflation reducing the real value of the debt.

Because of the suddenness and the depth of the economic setback in 2008/2009, many governments are running sizeable deficits – induced by lower tax revenue and increased spending related to unemployment. Since late 2010 significant efforts have been made to reduce government deficits. That austerity hits us now.

In the US, a weak president has left the field open to voodoo economics espoused by an uncompromising Tea Party. In Europe, the strongest economy, Germany, is also the one least inclined to add stimulus. And Germany will not “save Europe” until Europe’s institutions have been reformed – which is being blocked by France.

Central banks are the only ones left holding the rope. They do not have an awful lot of rope to give. Economic growth estimates will be adjusted downwards in the near future. A period of slow growth seemingly lies ahead. A lot of it caused by a wrong policy reaction, caused by the wrong political philosophy at the wrong time.

For once I will quote from the Economist's Free Exchange Blog. (Article from 28 July 2011). It reads:

“The challenges facing Europe and America are big, but they're not mysterious. In Europe, the issues are sovereign debt, vulnerable banks, and a poorly designed currency area. It's not tricky to see what must be done. Peripheral debts should be addressed through austerity, sure. But unsustainable debt loads need to be written down. Banks should be recapitalised to prevent trouble in financial markets. Emergency funds should be bolstered to fight sovereign and banking contagion. And substantial fiscal integration must take place, including fiscal transfers to support peripheral economies while they get their budgets in order. The central bank should also stop fighting the phantom of accelerating inflation.(...) 
“Again, it's not like the correct policy path is incredibly complicated. Here, I'll sum it up in three quick steps:

Don't cause a major crisis.
Do spend more and tax less for the next year or so.
Do spend less and tax more after that.”

Wonder how far stock markets will have to fall and unemployment will have to increase before politicians get it. If they don’t, well...

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