The thing about beliefs is that they are difficult to argue about. One of the reasons is that it is hard to paint a counterfactual scenario. Let us take a simple example: someone is going through a difficult time and he consults an astrologer. The astrologer prescribes some remedial actions. The anxious client performs those actions. There is no improvement. Do we conclude that the astrologer was wrong? It is a plausible explanation, but it is equally possible that but for those remedial actions the client might have had a more difficult time. It is not possible for the astrologer to prove that nor is it possible for the client to refute that. Arguments over beliefs are fruitless and often counterproductive.
Economics is, for the most part, a belief system. Let me rephrase it. Economic theories are mostly beliefs. They are points of departure, at best. At worst, they are plainly wrong. Economics is a social science that influences and is influenced by human behaviour, which is predictable and consistent only over a long period. In the short term, specific stimuli, including the context and other irrational factors, determine individual responses. That is why economic theories work in certain places and at certain times, but not always.
Also read | V Anantha Nageswaran’s previous columns
Most economists seem to be oblivious of this. They are conducting the debate over whether the US should be pursuing more economic and monetary stimulus in a deterministic fashion. The most recent target of their ire is Bank for International Settlements (BIS) that suggested that much of the economic growth potential might have been destroyed in the wake of the financial crisis. That is, the output gap might be a lot less negative than is assumed. Therefore, real interest rates might not have to become more negative or remain negative for long.
Now, output gaps are notoriously difficult to estimate. More so in economies that have seen their manufacturing sectors diminish progressively in importance. But since most of what the financial sector “produced” was self-serving leverage and the consequent bloated executive compensation, it is reasonable to assume that the overarching contribution of the financial sector in recent years to economic growth was to boost demand while doing very little to boost potential growth.
Therefore, the point made by BIS in its Annual Report for 2011 is neither trivial nor silly. As pointed out by Bare Talk last week, the decision to go for release of crude oil from the Strategic Petroleum Reserves is a tacit acknowledgement of the costs of unbridled and endless loose monetary policy.
Some of the apostles of expansionary policy point to the fact that financial markets are willing to accept a low rate of interest on the US debt and hence, the US government should make use of the opportunity to borrow and to maintain economic growth rate. It is not as though the US deficit is a low 1-3% of gross domestic product (GDP). It is around 10% of GDP. The US government has not been exactly squeamish about spreading its largesse around. The problem lies more with the intended targets of the government spending rather than with the quantum of spending itself.
Second, the stimulus-champions want to have it both ways when it comes to financial market efficiency. When it suited them, they argued that China distorted the US treasury market with its investment in US treasuries. That helped to keep the interest rate lower than it should have been. Thus, China encouraged Americans to engage in unhealthy borrowing habits and thus was chiefly responsible for the American housing boom and bust.
Now, neither China nor other central banks of the world have stopped buying US treasuries. Global reserve managers and sovereign wealth managers are thus still distorting asset prices with their investments. Hence, there is little reason to believe that US treasury yields reveal the collective preference of millions of anonymous buyers and sellers who are individually incapable of influencing prices. Just as the yields on Greek debt, until recently, did not reflect the true risk of lending to Greece and the yield on the Japanese government debt does not, even now, reflect the risk of lending to a country whose debt-to-GDP ratio is approaching 300%.
Financial markets, inebriated with liquidity, addicted to zero cost of funds and manipulated by sovereign investors, have become utterly incapable of valuing assets correctly. Hence, economists who wish to make their case for more government spending should do a lot better than rely on financial market prices to make their case.
Responsible governments must provide relief to the poor and the unemployed in difficult times. But they should do so without saddling future generations with too much of debt. It is not easy and judgements can differ. The debate needs to be conducted with a lot of humility and awareness of the limitations of our knowledge and ignorance.
PS: If economists stop behaving like fundamentalists, then we could consider labelling it a social science.
V. Anantha Nageswaran is chief investment officer for an international wealth manager. These are his personal views. Your comments are welcome firstname.lastname@example.org