austerity | This is Ashok.

Brad DeLong summarizes the emerging case for monetary and fiscal austerity:

And so right now the austerians are deploying three arguments:

The longer zero-interest-rate and quantitative easing policies continue, the more likely it is that banks somehow reach for yield in ways that will require another rescue–and this time to rescue the banks and so prevent total economic meltdown will be politically impossible.

In any event, policies of extraordinary monetary ease are certain to fail because central banks cannot credibly promise to be incredibly irresponsible over the long-term.

Further expansionary policies are unwise because our Keynesian short-run is going to be followed by a classical long run, and entering that long run with too high a debt to annual GDP ratio will cause the economy a world of hurt–although precisely how appears to be one of those pesky “unknown unknowns”.

How much substantive theoretical, empirical, and policy meat is there, really, on top of dry bones in these three arguments the Napoleons of austerity have now marshaled?

I seem to be somewhat out of harmony, in that I think that there may well be at least some meat here.

Except “summarizes” is the wrong word, implying there’s something more substantive. That’s all there is, the bones that DeLong tosses are the whole case for austerity, there is no “meat” to the story. In other words, it’s vegetarian-friendly. We can show that (1), (2), and (3) do not support either monetary or fiscal austerity. More importantly, we can show that (1), (2), and (3) are internally inconsistent with each other. But before we take a detailed look at why the three points fail to hold water, it is important to note that the new austerians purport to present a case against both monetary and fiscal stimulus. That is, they either represent the Bank of International Settlements or write for the Wall Street Journal editorial page. (Strike zero).

The “reaching for yield” argument has run its course. For one, it is only an argument against monetary – not fiscal – stimulus. Regardless, we can’t judge monetary policy on bad credit dynamics. Plenty of us have offered fair alternatives to bypass the credit system altogether. To the extent these are politically infeasible, it is cruel and moralistic to subject many to long-term unemployment because the government cannot adequately regulate financial markets.

Indeed, whatever risks are a generated as a byproduct of easier monetary policy can be amended with sound regulation: equity requirements and transparent exchanges come to mind. Furthermore proponents of this theory must somehow sustain that the expected loss from a future recession that is causally-related to easy money today is equal to or greater than the loss from continually anemic growth and hysteresis effects thereof.

To the extent they are making an intellectual, and not practical, argument, they must include in the costs of this recession the counterfactual that the Fed had pursed an “easy” policy at the time of recession; for example a nominal income level target. Indeed, if nominal income had not crashed – either due to monetary expectations or fiscal stimulus – and our unemployment rate was at 5% there would be a guaranteed counterfactual benefit equivalent to .02*.70*315000000*25000*3.

These same arguments must be further sealed with either the guarantee that sound regulatory institutions will not emerge as a result of smart governance or not only is easy money increasing risks by creating a reach for yield, but that it is fundamentally altering the financial landscape inter alia.

In the former case, proponents of the “reach for yield” thesis must tell moral philosophers why they are wasting their time arguing for policies that hurt the poor and stunt economic growth in service of a fixable risk instead of furthering the case for sound regulation that is Pareto-superior. They must also tell us why they do not support a stronger fiscal policy which is devoid of such risks.

Therefore, the argument for proposition (1) rests on an inordinate set of assumptions that only holds sway because a group of very smart academics believes it to be true. Whether such conviction, rather than hard fact, is enough to drive policy is a normative question beyond my pay grade.

DeLong’s second proposed case for austerity is actually just an argument for fiscal policy. Furthermore “it might fail so we should do nothing” is a terrible form of argument. There are ways to credibly commit to irresponsibility. Proponents of this view tend to lack imagination and hence cannot be trusted to give full view to the arsenal of monetary strength. Paul Krugman is not one such person, he just believes – like me – that serious policymakers lack the imagination for good monetary policy and hence supports fiscal policy as a less imaginative guarantee.

More importantly, let’s note that there is significant overlap between those making each of the above three arguments. Therefore there is significant overlap between those making the former two arguments. The reach for yield crowd secretly wants higher interest rates, not just a tapering of asset purchases. Therefore the zero lower bound critique is nonexistent, because in the world that such austerians live, a higher interest rate supports the all-noble saver and discourages profligacy by increasing rates on Treasuries. Therefore, the two arguments are intellectually inconsistent, and are yet submitted by the same people.

The third argument is more curious still. It first requires that fiscal policies be purely demand side. However, smart job training programs, investment in education or infrastructure, financing of basic research, deployment of a smart grid, and building a large green energy program not only increase immediate aggregate demand (when aggregate supply is elastic) but also right-shift the long-run aggregate supply curve. Therefore, potential growth can be linked with smart fiscal policy today. Austerians somehow reject this.

The next implicit assumption by the classical crowd suggests that it is better for a large number of poorer Americans to remain unemployed for now, and hence forever, than for future debt to be financed by earnings from those with a high marginal propensity to save. Indeed, even if one accepts Ricardian equivalence (which we perhaps must in the longest of runs) he must still make a welfare judgement that the tax rate on the top 1% in the next generation is of more importance than the employment and poverty condition of the bottom 20% today. I reject this judgement.

But the assumptions do not end there. This future-classicist must believe that the jump from a Keynesian short-run to a classical long-run is abrupt. He must believe that interest rates will suddenly jump making it difficult to service American debt, without accepting that such optimism implies a higher tax revenue and lower safety net outlay. He must believe the long-run demand curve has a sharp curvature with a nonexistent medium run, that is it becomes perfectly inelastic, rapidly. He must reject any significant cost of hysteresis because of long-run labor competitiveness.

He must reject path dependency of structural and cyclical growth rates, and thereby somehow cede that the debt-GDP ratio in the classical long run is unaffected by GDP today. This is a strong assumption.

Finally, because the new austerian suggests a policy against both monetary and fiscal austerity, he must accept either (1) and (3) or (2) and (3) together. (1) and (3) cannot coexist because a classical long-run at the zero lower bound is an economic future with wildly different implications (the government can run debts and never pay them back, for example). (1) and (2) cannot coexist because you cannot both argue that “we should have above-zero interest rates but tight monetary policy” and that “monetary policy is only useful at above-zero interest rates”. Not with a straight face, at least.

Therefore, the chance that this new argument is correct falls from p = [(1 | 2) & 3] to p = 2 & 3. However, (2) and (3) cannot coexist, either. Think about it, (2) believes that monetary policy cannot gain traction in a liquidity trap and fiscal expansion is necessary to succeed. (3) believes that we should not enter the long-run with a higher debt-GDP ratio. If ZIRP and non-inflationary policy is the symptom of Keynesian short-runs, that (3) submits we will one day be in a classical long-run implies that fiscal policy was used.

See that? (3) is internally inconsistent with either (1) or (2). Therefore, the new austerian is compelled to pick one, and only one, of {1, 2, 3}. None of these on their own justify both fiscal and monetary stimulus. And if you agree with the thrust of my argument above, none on its own justifies either fiscal or monetary stimulus.

Without R-R or A-A there is no case for the new austerians, other than a tricky morality play or a huge prior that a future financial calamity is both imminent, not solvable by regulation, endogenous to easy money, and worse than that in which we exist today. There is no meat on the argument, only the very seductive illusion thereof. Anyone who bites in hard will break his teeth on the bone.

P.S. I was going to say vegetarians have a second case for austerity. An unemployed poor means less people can buy expensive meats and will have to succumb to the damned vegetables for their meal. Then I realized I live in India and we’re talking about America where a healthy living and vegetarianism are more expensive than McDonald’s or Tyson meats. Oh well.

Update: I accidentally said my right-axis was growth acceleration when it was rate, please forgive the mistake: it doesn’t change my point. At this point after a recession we should be seeing much more robust growth. Tabarrok rightly notes growth is persistent, but that’s not good enough after a terrible demand shock.

Alex Tabarrok has a post, American Austerity (and Growth). As you can see, I couldn’t think of a better title so I went with a permutation thereof. Read it. Also, read Brad DeLong on why our short-run a) isn’t as short as it used to be, and b) sucks. Now, my turn.

Tabarrok cites this graph to show why austerity isn’t bad:

This graph is clipped at 1990, so we get to see the pattern only after three recessions. Here’s the same graph with a little more scope and where the right-axis has the acceleration of growth from the ’70s:

It kinda looks the same. But suddenly it’s a lot more sobering. After a bad recession, the growth rate should accelerate to close the output gap. Quarterly growth hits (roughly) 8%, 7%, 5%, 8%, 5%, 5% after every recession. It barely ever falls below 4% except during a recession (and this is expected). This is also proportional to the depth of a recession. But after this one it has barely hit 2%. In fact, eyeballing it, the red and green lines are pretty well correlated except during the ’90s. This was an exception. We had great supply-side stuff going on with trade, but I’ll get back to that.

It has barely hit a non-recession trough. That means growth is picking up slower today than it did during the dot-com bust. And growth deceleration was never as bad as -4% since the Great Depression. Standard models say it should act like a rubber band, and the hard shock would be followed by steady growth. But Brad DeLong is right, the short-run really sucks.

Tabarrok’s graph is selective. The human eye can’t really tell what growth should look like with such a noisy line. But if we look at the flatlined growth it is pretty clear current growth isn’t enough.

But the comparison Tabarrok makes with Bill Clinton forgets some important differences:

I assume that by very bad policy what Krugman means is a policy that is likely to have very bad effects. Hence, I have added to Krugman’s graph the growth rate of real gdp (annual rate). I don’t see the very bad effects. In the 1990s growth was strong even while “austerity” was increasing (falling red line). More recently, we have seen a big increase in austerity according to Krugman and his measure but although there has been no boom, growth has remained modest.

Ok, so here are a few reasons why the ’90s are different from today:

Huge free lunch from NAFTA and Rubinism in general.
The employment-population ratio was 10% higher than it is.
The cost of capital was actually high.
Long-term unemployment was not a problem.
People had the balls to predict “Dow 36,000” despite crappy interest rates. (By which I mean high).

Today, long-term growth expectations are abysmal. And if people look at my modification of Tabarrok’s graph it’s not hard to see why. If the economy after a bad recession can’t perform as well as it did heading into its last recession something is seriously wrong. And whatever it is, austerity is not helping. Citing Scott Sumner’s post isn’t any help because he doesn’t even consider the counterfactual with more stimulus. It’s a meaningless statement – except those conditioned that austerity isn’t too bad.

But now consider DeLong’s post. A glass of red wine will do:

I think it is a safe bet that our government will and should spend a greater share of national income in the future. We have a “mixed economy”–neither overwhelmingly private nor overwhelmingly government, but a balance. In six areas government appears to do a better job than private–in defense, in basic research, in infrastructure, in education, in health insurance, and in old age pensions. There are also compelling reasons for government to redistribute income to compensate for the very important role that luck plays–most especially the luck in choosing the right parents–in determining lifetime income.

But he’s being nice. The situation is a lot worse than he paints it out to be. I’ll take an example today’s market monetarists will love. They rightly blame inflation targeting regimes understanding the endogenous fragility to supply-shocks. If we’re targeting inflation at 2% aggregate supply collapses, we have to deflate something else to maintain the inflation, that is tolerate a demand shock.

Now consider what DeLong thinks is the government’s comparative advantage: defense, education, health insurance, and pensions. What do we know about the first three. Inflation is above trend for each. This means, if the government keeps its proportional spending constant, it gets relatively less each year. So by “targeting” a level of government spending, we’re forced to “deflate” the real output of government.

But here’s something worse. Not only is government spending not growing, it’s declining as a percent of GDP. If your Econ 101 teacher ever told you “cost-push inflation is bad”, now is the time to remember that. Because prices are increasing and output is falling.

I’m also tired of the Keynesians who talk about the sequester in terms of multipliers. That isn’t even the big problem. It’s the immediate effect of not spending that money. Cancer patients without care. Children without daycare. Single parents without food. ~~Oh, and, did you hear? Congressmen without airplanes.~~

As the FAA fix taught us all, this is about one thing only: the fundamental dismantling of the welfare state. This is a supply-side problem. There’s huge human capital deprecation as the baby boomers retire. The gap between our net and gross incomes will grow as the state of our students deteriorates, as our roads get crappier. This is the time for a supply-side revolution if there ever was one. Ronald Reagan would agree.

Edit: Here’s Justin Wolfers with some jolly good news: