The old joke — ‘what happens when you put 10 economists in a room together? You end up with 10 different views about what’s wrong with the economy and how to fix it’ — was never truer. As doubts about the strength and durability of the US economic recovery have intensified, so too has the debate over the right response.
Nobel laureate Paul Krugman, a professor of economics at Princeton University, is urging the US government to increase spending in order to prevent the global economy plunging into a third depression. “This third depression,” he wrote in a recent column in the New York Times, “will be primarily a failure of policy. Around the world … governments are obsessing about inflation when the real threat is deflation, preaching the need for belt-tightening when the real problem is inadequate spending.”
Other economists believe Krugman’s policy prescriptions are premature. Harvard University professor, and former chief economist of the International Fund, Kenneth Rogoff argues that Krugman’s warnings are over-stated. He argues that following a financial crisis, the economic recovery is typically subdued.
“The fact that we’re not growing super fast doesn’t necessarily say, well, therefore we’re about to enter something worse,” he said in a recent interview on Bloomberg television.
In his latest weekly letter, John Hussman of Hussman Funds argues the US government’s stimulus measures failed to translate into a rebound in private sector activity. Now that the effects of the stimulus are wearing off, the US economy is most probably headed into a second leg of recession.
And while the present mood in Washington is in favour of austerity and reducing government deficits, Hussman points out that this will likely turn around quickly as soon as strains build in US housing, credit and employment markets. “We have yet to see a case where fiscal responsibility trumps perceived crisis,” he notes.
The question then becomes whether the inevitable new stimulus policies can be designed to achieve socially useful outcomes, rather than ensuring that bond holders of the banks, and the GSEs such as Fannie Mae and Freddie Mac, are fully repaid.
He argues that future stimulus packages should favour projects that enhance the economy’s future productivity. “Various forms of public infrastructure, particularly those that increase the efficiency of large numbers of individuals (roadways, telecommunications) have been shown to have a good payoff over time in terms of output, relative to the cost of those investments,” he says.
In addition, there’s an argument for spreading the spending over a larger number of moderate projects in areas such as infrastructure, research and alternative energy. And with US unemployment likely to climb to close to 12%, he argues there’s a case for extending unemployment compensation benefits as a necessary ‘counter-cyclical’ element of fiscal policy.
Hussman says it’s crucial to stop thinking of government spending as brute stimulus, and to realise that it consists of different projects, with different effects on long-term productivity. “If we abandon all of that subtlety and simply call for government to spend, we can be certain that the spending will benefit those who are best connected to the policy makers doing the spending,” he writes.
In particular, he says, future government stimulus should not be directed to bailing out the shareholders and bondholders of banks and GSEs: “Basic ethical principle dictates that policy makers should not burden ordinary Americans to pay the losses that well-informed bondholders voluntarily took when they lent money to failing institutions.”
Hussman also warns the US sharemarket could be on the brink of a slide as investors realise that the US economic recovery — and corporate earnings — are going to fail to meet optimistic expectations: “The overwhelming risk at present is that we are in what I’ve called the ‘recognition phase’ where economic reality and earnings guidance deviates substantially form the expectations that have been priced into stocks. Two phases of a market downturn are generally the most hostile. The recognition phase and the capitulation (or ‘revulsion’) phase.”