The Great Uncertainty

Conservative economists believe that the most serious problems facing the economy are budget deficits, the threat of a future inflation, and the government's aggressive economic interventions in the economy, which include the stimulus package, the health care plan, and the takeover of General Motors. Liberal economists believe that the most serious problems facing the economy are that the depression may deepen and that the recovery from it, when it comes, will be shallow and protracted. Some of them believe that there is still a threat, indeed an actuality, of deflation; with the consumer price index flat for the past year, anyone who borrowed money last year when interest rates included an inflation component will find himself repaying the loan this year with dollars that are worth more than he expected.

The strong positive correlation between economic diagnosis and ideological presupposition tells you something about economics, more precisely about the economics of the business cycle. If this branch of economics were scientific, the conclusions of economists would be "observer independent" rather than inflected with each individual economist's political outlook. It is when science and other methods of exact reasoning (such as logic and mathematics) give out that a person's political preconceptions influence his views.

Macroeconomists look at the same evidence, the same phenomena, and see different things. Conservatives see a self-regulating economy, which achieves and maintains equilibrium (or an approximation to it) with minimal government regulation. Liberals see an unstable economy that requires, at times, including the present time, aggressive government action to keep the economy from running off the rails.

Conservatives typically believe in "Say's Law"--that supply creates its own demand. There can never be oversupply, because whatever is produced can be sold at some price; if the demand for some product falls, its price will fall until all of it is sold. Say's Law implicitly describes a barter economy, in which the role of money is incidental. Someone produces one good, and someone else another, and the terms on which the goods are exchanged reflect demand and supply. Ordinarily perhaps one widget is valued at two gidgets, but if demand for widgets falls perhaps the widget producer will have to accept one gidget in exchange for a widget. The "good" may of course be labor, but as long as prices are flexible, there will be no unemployment, just as there will be no excess supply. Of course at some point the price of labor may fall so low that many workers may prefer not to work. But they are not unemployed; they just are substituting one job, paid for in leisure, for another, paid for in other goods.

Keynes, the great denouncer of Say's Law, argued that money shouldn't be regarded as a veil between goods that merely facilitates barter. For when A sells B a good, A may decide not to buy any good or service with the money he receives in the sale, but instead to hold the money in some form. And if enough people do this, there may (depending on the form in which the money is held) be excess supply, contrary to Say's Law,. Producers may not be able to cut prices far enough to restore equilibrium. Instead, as prices fall, consumers and businesses may hoard cash all the more, because as prices continue to fall the purchasing power of cash will rise. With demand below the quantity of goods and services that full employment of the society's labor and other productive resources could supply, the government must have to step in and supply the missing demand, for example through a massive public works program employing workers for whom private producers have no jobs. But to a believer in Say's Law, the only effect of governmental demand is to augment private demand, so that total demand exceeds supply and therefore generates inflation.

There is much more to be said about the rival positions, but my simplified version will give the reader an adequate sense of the basic dispute. Although my own view, which is also that of a majority of economists at the present time, leans toward the second, the Keynesian, position, even if it could be proved correct (or more correct) than Say's Law it would not resolve the debate with which I opened. Keynesians acknowledge that there can be excessive government intervention in the economy, that enormous deficits can give rise to inflation, and that inflation can impose substantial social costs. And some conservative economists will concede, however grudgingly, that a stimulus program (Keynesian deficit spending, as on public works) may be a proper supplement to less intervenionist measures for arresting an economic downturn. Conservatives have generally supported the Federal Reserve's efforts to simulate lending by reducing interest rates and the efforts by the Fed and the Treasury Department to recapitalize banks, because bank lending is essential to production and consumption. But as I keep saying, you can lead a bank to money but you can't make it lend, and the experience since last fall has been that banks, nervous about lending into a depression and facing a reduced demand for loans, are not lending enough to stimulate economic recovrery, but instead are hoarding most of the cash that the government's monetary and bailout policies have given them.

The problem is that the degree of agreement that I have indicated on broad principles does not generate an answer to the question what the government should be doing now. If, as some economists, business forecasters, and government officials believe, the economic downturn has reached or is about to reach bottom and we will soon be on the path to a rapid recovery, there is an argument for shifting focus from stimulation of the economy, whether through deficit spending or the purchase of debt by the Federal Reserve to keep interest rates low, to deficit reduction. If, as others believe, the economy may continue declining for a significant amount of time and, more likely, will whenever the bottom is finally reached stay there, or near there, for a long time, then the danger of inflation is remote and more stimulus is indicated. It is not possible to choose between these beliefs, other than on the basis of temperament (optimism versus pessimism) and politics (belief in weak government versus strong government)--and temperament may be influenced by politics: the liberal may be pessimistic about the economic downturn because he wants the fragility of the economy and the salvationist role of government to be demonstrated, and the conservative may be optimistic about the downturn because he is embarrassed that the economy should fall so far that government has to step in and replace private with public demand for goods and services.

The U.S. economy is so complex, and the susceptibility of an economy to adverse feedback loops is so great, that it just isn't possible to determine objectively where exactly we are today in the business cycle and how long (whether given current policies, or different policies) it will take to get back on the economy's normal growth path. As long as unemployment continues rising, even if at a declining rate, there is a danger of negative feedback: the unemployed suffer a loss in income, and workers who are still employed become more anxious about retaining their jobs the higher the unemployment rate (really, the underemployment rate, which increasingly includes workers on short hours), and so both groups spend less and this leads to reduced sales and therefore reduced employment. As long as housing prices continue falling, people's wealth (heavily invested in housing) falls, and with it their desire to spend rather than save. The personal savings rate is way up, and we not know yet how much of those savings will be put to work as productive investment capital rather than hoarded. At the same time, inventories have declined, and at some point production will have to increase in order to satisfy demand even at its current low level--and that level may rise as consumer durables wear out and need to be replaced, or as reviving consumer confidence induced increased personal consumption expenditures.

When it is not possible to decide between two courses of action--in the present instance, between stepping on the economic brakes and stepping on the economic accelerator--on the basis of which is more likely to yield the greater benefits, it may still be possible to make a rational choice by considering the consequences of error. If mistakenly stepping on the brakes would produce worse consequences than mistakenly stepping on the accelerator, we should step on the accelerator. But that can't be determined. If we step on the brakes, this could precipitate a severe recession, as happened in 1936 when the government, fearing inflation, raised taxes and interest rates and reduced the federal budget deficit, But if we step on the accelerator, the resulting increase in the budget deficit might set the stage for an eventual inflation that could, like the inflation of the 1970s, precipitate a severe recession when, the inflation threatening to get out of hand, the Federal Reserve pushed up interest rates steeply.

There is, however, a third way, and that is to take measures to reduce the deficit without exacerbating the economic downturn. The concern with inflation and related methods, harmful to economic activity, of dealing with a swelling national debt, such as heavy taxation, increased dependence on foreign lenders, and devaluation of the dollar is directed at future government revenues and expenditures more than present ones. Tabling programs, such as health care reform, that do not contribute to recovery from the depression would reduce concern for future inflation, and by doing so reduce interest rates, which would in turn speed recovery.