Flawed model masks nub of economic woe

In: Uncategorized

12 Jan 2009

The following comment by me appeared in the latest Fund Strategy (12 January).

There is no doubting the theme of last week’s economics discussions: how can economies be boosted to offset the effects of the downturn? Such a limited outlook overlooks practical and more fundamental problems.

In Britain the focus was on the Bank of England lowering base rates to their lowest levels ever. There is also talk of “quantitative easing” – printing money – if lowering base rates does not ease the credit crunch.

In America the debate has centred on the fiscal stimulus. Barack Obama has proposed a $775 billion (£530 billion) package of which $300 billion will be in tax cuts. Meanwhile, the Congressional Budget Office (CBO) has forecast that the fiscal deficit will hit $1.2 trillion, or 8.3% of GDP, this year.

Yet just as America needs to borrow more it is likely to find it harder to raise funds. China will be increasingly reluctant to fund American consumption as it needs resources for its own fiscal expansion.

Much of the discussion of stimulus packages, both fiscal and monetary, is open to such practical objections. Another is that the economic boost could stoke inflation.

Although such objections are important they do not get to the nub of the problem. They are based, implicitly if not explicitly, on an underconsumptionist model of the downturn. In other words they assume the problem is that the economy is facing insufficient demand. Paul Krugman, whose latest book is reviewed in this issue, is a leading exponent of this outlook.

Unfortunately, such a model cannot be taken as given. Those who assume that the problem is lack of demand will propose an economic stimulus as a solution. But such a premise has to be proved rather than assumed.

There is good reason to suggest the economic downturn has more fundamental causes that the underconsumptionists suggest. Developed economies have experienced relatively sluggish growth since the early 1970s. Indeed the enormous expansion of credit was largely an attempt to offset this tendency.

In more recent times the trend towards “green capitalism” has compounded the problem of slow growth. Economic growth is increasingly stigmatised as leading to environmental disaster and misery.

If the underconsumptionists are wrong in their diagnosis of the economic woes their solutions are also likely to be flawed.

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