Flawed diagnosis from the doomsayers

This is my comment from this week’s Fund Strategy.

It is widely accepted that few economists anticipated the economic crisis of the past year. But what about the small minority who predicted imminent doom? Many are being given undue credit for their apparently accurate predictions.

It is easy to forget that until last year the mainstream view was that economics had become “boring”. By this it was meant that the fundamental problems of the market economy had been solved. Central bankers knew how to target interest rates and politicians were wedded to prudence. A Great Moderation of long term stable growth had set in. There would be no return to boom and bust.

It is now clear that the old orthodoxy was wrong. Bust has reappeared with a vengeance. Old rules about fiscal stability have been quietly discarded.

But what about the former doomsayers? There was certainly a minority of economists who long warned of the dangers of rising house prices and expanding household debt. With their reputation enhanced, many are looking to them for future predications.

However, on closer examination they were not really right in the first place. Many of them were predicting imminent doom for years. It was hardly surprising that house prices eventually fell or indeed that the economy dipped into recession.

More importantly, the reasons why they predicted a downturn were wrong. They foresaw a crisis of overconsumption. The build-up of household debt enabled consumers to spend to an unsustainable extent.

But such a view betrays a superficial understanding of the crisis. The surge in debt was itself a result of problems in the productive sphere of the economy. Interest rates were kept relatively low and public spending relatively high to offset crisis tendencies in the economy. There certainly was a boom in household debt but it was largely the unintended consequence of state action to buoy sagging economies.

A flawed diagnosis suggests incorrect solutions. The doomsayers suggest that there needs to be curbs on consumption. They ignore, or at least downplay, the need to revive the productive side of the economy.

Strangely, the doom-mongers and the optimists share a key feature: their overemphasis on the consumption side of the economy. To really understand the current crisis means grappling with the complexities of the real economy.