Zombie Economics: Financial crisis fails to kill discredited theories

Mark Blyth, Guest Blogger

As George Soros noted in his recent NY Review of Books piece, before the recent G20 meeting in Toronto, Germany’s deflationist stance was the minority position. By the end of the meeting the American reflationary stance was the minority position. Abruptly, and against the apparent ‘we are all Keynesians now (again)’ love-fest of 2008-2009, the G20 signed up to halve their budget deficits by 2013. Government spending, it seems, has to stop.

Now the G20 does have a point. There is too much debt in the system, from consumers, to corporations, banks, and sovereigns. But as I blogged in a recent piece for Foreign Affairs, the G20’s endorsement of “growth friendly fiscal consolidation” relies on the same fallacy of composition that brought on the banking crisis. Back in the glow of the ‘Great Moderation’ regulators assumed that by making individual banks safe you make the system as a whole safe. Unfortunately, as the world discovered through learning terms like ‘CDS daisy-chains’ and ‘serial correlation,’ that turned out to be a really bad assumption. Now, in a re-run worthy of Nick-at-Night, we are about to simultaneously retrench in the middle of a recession in order to restore growth.

Those who warn of the dangers of debt argue that ‘normal service has been resumed.’ For all the Keynesian ferment the simple fact remains that markets react to bad policy, and bloating government debt to prevent a normal market correction was bad policy.

While appealing in a ‘bulimia bad/dieting good’ moralizing sense, such a view ignores that, according to the IMF, of the 39.1 percent (average) increase in government debt across the OECD only 12 percent of that increase was discretionary. The rest was a direct result of bailing out the banks. So it’s more than a little ironic to note that what the G20 are responding to – Eurobond market pressures – are coming from the same banks that used those bailout funds to buy super-cheap underwater assets while short-selling the government debt generated in the process of saving their assets.

But, irony apart, there is a bigger intellectual puzzle here. Why do some economic ideas refuse to die despite the stunning lack of evidence for their veracity? For the arguments used to justify retrenchment really don’t stand up to much scrutiny.

The first such idea is the consistent denial by deficit hawks of fallacies of composition: that the whole is hardly ever reducible to the sum of its parts. Due in part to the insistence on micro-foundations for everything in mainstream economics (thereby ignoring such processes as emergence, recombination, evolution) the same thinking that saw moral hazard as the only conceivable problem in banking (whoops!) now see debt as the only thing holding back recovery.

The second originates with Ricardo, was formalized by Barro, and ends up driving the 2010 June ECB report (the Summa Theologica of the orthodox) which lays out the rationale for retrenchment. That is, consumers are said to operate with ‘Ricardian equivalence’ regarding their balance sheets and will discount fiscal stimulus as future debt. As such, only fiscal consolidation, not fiscal stimulus, will produce growth if “the share of consumers discounting the future effects of fiscal retrenchment (i.e. so called ‘Ricardian’ consumers) is high.”

So how do we know this is the case? Well according to the ECB report a bunch of small countries (Ireland, Finland, Denmark) non-simultaneously reduced debt and still grew during the global asset and export boom in the 1990 and 2000s. So that clearly applies to all states facing a global recession today. But more fundamentally, there is an asymmetry in this argument that is also swept aside. Why are these Ricardian consumers, at least in the US, who always vote for tax cuts (which should auger future tax rises and should be discounted) and happily spend themselves into oblivion, are presumed to behave quite differently regarding government debt?

Third, lurking in the background is that pièce de résistance of 18^th Century thinking: crowding out. If you ignore the whole/parts distinction, and you do think that consumers are rational expectations zombies as regards government debt, then it follows that if you cut debt growth must reappear automatically – right? The ECB seem to think so since they argue that once government spending is reduced this will result in “the freeing up of revenues to finance more productive expenditure or growth-enhancing tax cuts.”

But all of this rests on a rather strong counterfactual. That the only thing holding back a huge investment spurt isn’t uncertainty over the future, or the fact that major indices are heading in the wrong direction, or that investing heavily in a middle of a recession is not seen as good management: its simply government ‘getting in the way.’ OK, let’s have a look at places where government didn’t get in the way, like Eastern Europe. Take Latvia for example, where the reward for eschewing debt was a fall in fourth quarter GDP in 2009 of 17.7 percent, a rise in unemployment to 16.6 percent, and a collapse of government finances, the theoretical beneficiary of this belt-tightening, because of falling tax receipts. Yeah – that worked.

As John Quiggin points out in his forthcoming book, Zombie Economics, some economic ideas are like zombies: they never die. And like Zombies they persist by eating the flesh of the living. When retrenchment starts to bite here, and not in Latvia, you’ll see what I mean.

Mark Blyth is Professor of International Political Economy at Brown University.