Three Issues That Keep Us Up at Night1
Three issues keep us up at night. They are the basis of what we see as fundamental movements in the economic sphere that are being met by policy makers in only a superficial way. Over the last year, we have repeatedly seen that these superficial monetary and fiscal policy moves have been ineffective in dealing with the three issues we will address here. We believe policy is piling on the Band-Aids while the source of the bleeding is left unattended.
Economics: More Than Just the Business Cycle
First, current economic difficulties reflect both cyclical and structural forces. Policy makers emphasize the traditional “Keynesian response” to a sudden drop in aggregate demand. There is an emphasis to getting us back to where we were. However, it is where we were that was out of step with long-run sustainable growth. There simply were too many retail stores, financial services and manufactured goods financed on credit to be sustainable. Going forward, the structural movement toward less-leveraged consumer/housing finance dictates a conflict between policy promises and economic reality. The pace of sustainable economic growth is likely to be lower over the next five years than during the five years prior to the recession. The attempt to “getting us back to where we were” should therefore entail policy actions that would sustain spending above the pace consistent with sustainable long-run trends. This will force spending, employment and fiscal deficits above the long-run equilibrium rate. Pricing and resource allocations are likely to be distorted.
Moreover, extensive promises of macroeconomic growth via stimulus tend to fall prey to the Lucas critique.2 That is, policy advice based on conclusions drawn from large scale macro models fails because the parameters of those models are not structural – that is, not policy invariant. They would necessarily change whenever policy – the rules of the game -- changed. Therefore, policy conclusions based on those models have the potential to be misleading. Instead, parameters must reflect individual behavior. We can then predict what individuals will do by taking into account the change in policy, and then aggregate the individual decisions to calculate the macroeconomic effects of the policy change. These individual predictions must be built upon the micro foundations of individual household and firm behavior.
Yet, while policymakers talk of stimulus, many current policy proposals are anti-stimulus to the extent that they suggest policy actions that are disincentives to growth. Higher taxes, more regulation and greater trade protectionism are not pro-growth policies, and, if enacted, would offset much of the macro stimulus proposals.
