Explaining the government’s response to the financial crisis
Much of the commentary about the financial crisis in the general media is little more than superstition – recommendations like the 14th century efforts to control the Plague by killing dogs (which, of course, made it worse).
Here are two excerpts from the professional economics literature, brief insights into our true situation. Plus two powerful recommendations: sustained fiscal stimulus and global coordination of economic policy. We’re doing the first, on too-small a scale and in a sloppy fashion. We are not doing the second, an error which might undo all the efforts of the world’s governments.
(1) Excerpt from the Drobny Global Monitor, Andres Drobny, 30 November 2009:
Monetary policy should help ensure that liquidity is maintained, and pot holes like Dubai and other busts that are encountered do not spread systemically. Easy money is designed to prevent a cascade of failure sin an environment of falling asset values combined with high private sector debt loads. It may not, however, be at all effective in stimulating additional aggregate demand in such circumstances. When real returns on physical assets are low, easy money can’t really provide much of an incentive to boost physical investment spending. It is thus more of a support package and seems unlikely to provide much of an economic boost.
Fiscal policy, in contrast, can provide a direct boost to spending, making up for deficient spending in the private sector.
(2) “The protectionist temptation: Lessons from the Great Depression for today“, Barry Eichengreen and Douglas Irwin, 17 March 2009 — Excerpt:
This finding has important implications for policy makers responding to the Great Recession of 2009. The message for today would appear to be “to avoid protectionism, stimulate.” But how?
In the 1930s, stimulus meant monetary stimulus. The case for fiscal stimulus was neither well understood nor generally accepted. Monetary stimulus benefited the initiating country but had a negative impact on its trading partners, as shown by Eichengreen and Sachs (1985). The positive impact on its neighbours of the faster growth induced by the shift to “cheap money” was dominated by the negative impact of the tendency for its currency to depreciate when it cut interest rates. Thus, stimulus in one country increased the pressure for its neighbours to respond in protectionist fashion.
Today the problem is different because the policy instruments are different. In addition to monetary stimulus, countries are applying fiscal stimulus to counter the Great Recession. Fiscal stimulus in one country benefits its neighbours as well. The direct impact through faster growth and more import demand is positive, while the indirect impact via upward pressure on world interest rates that crowd out investment at home and abroad is negligible under current conditions. When a country applies fiscal stimulus, other countries are able to export more to it, so they have no reason to respond in a protectionist fashion.
The problem, to the contrary, is that the country applying the stimulus worries that benefits will spill out to its free-riding neighbours. Fiscal stimulus is not costless – it means incurring public debt that will have to be serviced by the children and grandchildren of the citizens of the country initiating the policy. Insofar as more spending includes more spending on imports, there is the temptation for that country to resort to “Buy America” provisions and their foreign equivalents. The protectionist danger is still there, in other words but, insofar as the policy response to this slump is fiscal rather than just monetary, it is the active country, not the passive one, that is subject to the temptation.
But if the details of the problem are different, the solution is the same. Now, as in the 1930s, countries need to coordinate their fiscal and monetary measures. If some do and some don’t, the trade policy consequences could again be most unfortunate.
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To read other articles about these things, see the FM reference page on the right side menu bar. Of esp relevance to this topic:
- about the Financial crisis – what’s happening? how will this end? - esp section 8, about solutions
- about the End of the post-WWII geopolitical regime
- some Good News about America!
Posts on the FM site about economics — theory and practice:
- The greatness of John Maynard Keynes, our only guide in this crisis, 4 December 2008
- About the state of economic science, and advice from a famous economist, 8 December 2008
- “A depression is for capitalism like a good, cold douche.”, 17 December 2008
- Words of wisdom about the global recession, from the greatest economist of our era, 29 December 2008
- A very important article by an expert, discussing the necessary next step to solve the financial crisis, 17 February 2009
- Economic theory as a guiding light for government action in this crisis, 10 March 2009