The causes of our present difficulties

There's nothing mysterious about the economic circumstances we find ourselves in. It's all easily understood in light of standard economic models that would be familiar to people like Keynes, Hicks and Friedman. Brad DeLong has articulated this view well in a number of posts and so I'll more or less summarize his analysis.

The economy is organized around three markets: the market for goods and services ("goods"), the market for safe assets in which to store wealth ("money," but I include U.S. Treasury securities in my definition), and the market for risky assets that generate an expected positive rate of return on wealth such as stocks or corporate bonds ("risky assets"). The economy as a whole is in equilibrium when each of these markets is in equilibrium. The economy is in a full employment equilibrium when demand in the goods market is high enough to generate employment for everyone who wants to work (accounting for labor market frictions, this means an unemployment rate of about 5 percent).

The proximate cause of the recession (depression?) of 2008-???? was a flight to safety on the part of first the financial sector, then businesses and households. What this means is that in the panicky environment that prevailed in late 2008, institutions felt compelled to shy away from all risky activities and hoard risk-free assets. In other words, the demand for stocks and other risky assets fell, as did demand for goods and services, while demand for risk-free assets rose. In real life, this process took the form of: a crash in the stock market, freezing of credit markets, shutdown of bank lending as financial market participants sought to shed risk; contraction of consumer spending and business investment, mass layoffs of workers as businesses and households sought to shed risk; and massive purchases of US Treasury securities which drove their prices up and yields down, even below zero for a brief time at the end of 2008.

We have not fully recovered from this economic meltdown. Interest rates on US Treasury securities are still extraordinarily low, unemployment is still extraordinarily high. Ordinarily there are a number of things that can happen to push the economy back to a full employment equilibrium. First and foremost, the Federal Reserve can reduce interest rates. This punishes people who store their wealth in safe assets and pushes them to buy risky assets or purchase goods and services instead. The Fed did indeed do this, but after short-term interest rates hit zero percent in December 2008 this mechanism could no longer do the job. There may be automatic adjustment mechanisms brought about by falling prices that can push the economy to full employment without any government action. But as Keynes argued (General Theory, Chapter 19) these mechanisms are very weak, especially when interest rates have hit zero, and offset by effects on expectations and wealth. Consequently, getting us out of the recession requires government action. Our government did two things in 2009 that were perfectly sensible and almost certainly prevented utter catastrophe:

1) Quantitative easing and "credit easing". The Federal Reserve bought long-term government bonds and risky assets of all sorts. The idea: if our problems are caused by excess supply of risky assets and excess demand for money, then the solution is for the Fed to buy risky assets to extinguish the excess supply and in the process create money to satisfy the excess demand.

2) Fiscal stimulus. The government passed the ARRA in 2009 that increased spending and cut taxes to the tune of about $900 billion over a three year period, and followed this up with a number of other stimulative efforts such as the 2010 budget deal that extended the Bush tax cuts. The idea: if our problem is excess supply of goods and excess demand for risk-free assets, then the solution is for the Treasury to issue a bunch of risk-free assets (i.e. run deficits that it finances by borrowing), thereby extinguishing the excess demand for risk-free assets, and spend the proceeds (or give the money through tax cuts and subsidies to people who will spend it), thereby extinguishing the excess supply for goods.

Although the government's efforts saved the economy from catastrophe, they did not restore the economy to full employment. The most likely reason for this is that the government did not do enough. Quantitative easing should have been more aggressive: the Fed should have announced an open-ended commitment to buy long-term and risky assets in whatever quantities and for however long it took to restore growth to a healthy rate. Fiscal policy should have been more aggressive and better structured: more money for things like infrastructure investment, less for tax breaks to corporations and wealthy people, less to Congress' pet projects (though I think the scale of the spending boondoggles is smaller than critics would have us believe). But the government did not act aggressively enough, and now here we are and the political dynamic dictates a reversal rather than a doubling down of these actions. The Federal Reserve is ending it's second round of quantitative easing and Congress and the President are negotiating large cuts in spending rather than increases.

Critics of the government's policies since 2008 argue that retrenchment can stimulate the economy. How might this happen? Well, if it is to happen it has to work through the process described above: it must somehow increase demand for goods and reduce demand or increase supply of risk-free assets. The critics' argument is that this will happen through "confidence": if the Federal Reserve swears fealty to "sound money" and if Congress demonstrates maturity by reining in spending, then businesses and financial markets will have greater confidence in the future. They will once again be willing to take on risk, meaning they will lend more, invest more, employ more. Demand for risk-free assets falls, demand for risky assets and goods rises, and the economy heads down the path to full employment.

There are a number of problems with this way of thinking. First there are the facts: there is no evidence, based on the interest rates the government is currently paying on its debt, that financial market participants are at all concerned about the government's solvency (would you accept a 3% rate of return on 30-year government debt if you thought the government was on the verge of default?). Therefore it's hard to imagine that solving the solvency "crisis" will have any impact on financial markets. In surveys small business owners say that the main reason they are not expanding is the lack of demand for their products, not budget deficits, regulation, taxes, or the other things that critics claim are impeding growth. Businesses are in fact investing at a healthy rate; the thing holding the economy back is consumer spending and home building, and this is due largely to the continuing decline in house prices (one of Keynes', or more accurately Irving Fisher's, offsetting factors to the natural adjustment process).

But the big conceptual problem with this analysis is that it relies on magical thinking. Why does the government's tightening of belts and the Fed's announcement of a "sound money" policy restore business confidence rather than, say, a commitment by the government and the Fed to fight the recession directly? There's really no theory that relates this kind of measure to business confidence, it's just wishful thinking. The claim puts a tremendous amount of faith in the effect of austerity on "confidence," especially since austerity involves doing things (reducing the supply of the risk-free assets that are in excess demand, reducing the demand for goods and services that are in excess supply) whose direct effect is to harm the economy.

Proponents of austerity argue that we might as well try sound money and budget cutting because the previous policies did not work. That's about as sensible as saying that because the two aspirins I just took didn't cure my headache I should hit myself in the head with a mallet (as opposed to, say, taking two more). It's important to note (and this is something that Paul Krugman has been harping on for some time) that the analysis I've presented above is perfectly conventional. No exotic untested theory, no magic asterisks or bells and whistles, just plain old conventional textbook economics. It's the proponents of austerity who are peddling the exotic theories. Once again, as in the Reagan and Bush II years (not to mention 1929-33), political gain seems to have been found in bad economics.