Columns 2020
12 / Post-Covid Economics
11 / How China manages bubbles
10 / Bidenomics
09 / Economic prospects after Covid-19
08 / Will the world have two or three superpowers in the future?
07 / Global Public Debt
06 / Europe and China
05 / The Covid-19 Aftermath in Europe
04 / Why invest in poor countries?
03 / Beyond Covid-19
02 / What kind of science is economics?
01 / Are Economic policy instruments obsolete?
Column December 2020
Post-Covid Economics
2021 has begun! Let’s hope it will be a happier year than 2020 was. Covid-19 will be defeated, thanks to vaccines that became available at record time. All attention can now be devoted to repair the economic damage done.
What approaches are on offer by economists? This question is dealt with in this column.
Founder of Modern Economics, is the title of a biography about Economics Nobel Laureate Paul Samuelson (1915-2009). The book makes fascinating reading, as Samuelson translated economics into mathematical terms. In addition, he was the author of Economics, the textbook that instructed generations of economists around the world. What struck me was Samuelson’s quest for clarity and truth in the economic science. He attempted to bring economics as close as possible to the real world. He argued that economic models (he was a fan of Keynes’s General Theory) should explain economic dynamics. But they should also be open to refutation: if they failed to explain or predict future economic development, they ought to be replaced by better models. Indeed, economics is a cumulative science, meaning that fresh insights continue to be developed by new generations of economists helping policymakers in making the right decisions.
Now, economics is not the same as physics or chemistry. As for the latter, the laws of nature are universal. Unfortunately, the environment in which economists operate is in many ways unpredictable. This opened the door for different interpretations of the real world. It was John Maynard Keynes who, in the 1930s, refuted classical economics (based upon its microeconomic foundation). He invented macroeconomics. Keynes presented economic notions like consumption, saving, investment and income in so-called aggregate terms. He pointed to the fact that the cause of the Great Depression was insufficient aggregate demand for goods and services, resulting in massive unemployment.
This insufficiency could not be solved by the market, as classical economists would argue. No, said Keynes, government had to step in to fill
the gap caused by insufficient demand in order to achieve full employment.
Keynes’s insights gained popularity up to the 1970s, when inflation started to run out of hand and unemployment soared. Keynes was discredited and an alternative analysis gained the upper hand, proposed by monetarists led by Milton Friedman. Their analysis was that governments had pressed for full employment too much, leading to a price-wage spiral, triggering runaway inflation. In addition, Friedman observed that there was simply too much money in the economy. To counter inflation, the quantity of money had to be brought down.
New Keynesians and monetarists expanded their inspirators’ insights. While doing so, Keynesians accepted useful insights of monetarists, and the other way around. A synthesis resulted in which the central objective was to maintain stable inflation. Depending on the particular situation at hand, the main instrument was to raise or lower short-term interest rates. This was more effective in managing consumption and investment than manipulating the money supply. In short, again monetary policy had the upper hand, while fiscal policies were side-lined because they were felt to be too sensitive to political influence.
After the outbreak of the 2007/8 financial crisis, and the ensuing Great Recession, tinkering with interest rates proved ineffective, as they had dropped to around zero in countries such as the US, Japan and Europe. Quantitative Easing (QE) was then added to the monetarist toolkit.
The result: weak growth, inflation remained low, but employment improved considerably, also benefitting low-paid workers. But inequality in income and wealth widened. QE is one of the culprits, as it boosted the prices of houses and shares owned by higher income earners.
When covid-19 broke out, aggregate demand dropped while savings increased. The explanation is simple: people could spend less and, being unsure about their future, they saved more. Millions of low-paid workers, typically working in the service sector, lost their job. Given these dramatic developments economists have put full employment as their top priority. This objective was understandably shared by political leaders in many countries. They quickly launched enormous fiscal stimulus packages to save businesses and jobs. This helped: many workers could keep their job, bankruptcy rates were not as bad as expected, and markets calmed. But at a price: a steep increases of public debt.
Now, what should be done to return to where the economies were before the outbreak of covid-19, in terms of growth and employment? There are three schools of thought that each provide a different approach; some inspired by Keynesian and others by monetarist policies.
The first one simply suggests governments to demonstrate more guts. The central bank should continue to print more money to boost economic growth until the targets of full employment and inflation of around 2% are reached. This is what, for example, the European Central Bank (ECB) is doing.
The second school proposes fiscal policies. For some time, central bankers urge governments to take robust fiscal measures to help counter the covid-inspired downturn. So government needs to boost spending (or lower taxes) for as long as needed. The resulting budget deficits will then soak up increased household savings. Alternatively, the central bank can print money to fund fiscal stimulus while ensuring low rates of interest to keep borrowing funds cheap. Afterall, if interest rates remain lower than nominal economic growth , an economy can grow its way out of debt, without even the need to run a budget surplus. But what happens if inflation would start to rise? Most economists assume that inflation is something of the past. But not all of them. They argue that, after covid-19, the world could be confronted with inflation picking up, triggered by pent-up demand, causing inflation to rise. This would be worrying given the enormous stock of debt and swollen central bank balance sheets.
School number three proposes negative interest rates, focussed on the role of central banks. The more QE these banks apply to buy up government bonds, the more cash will be deposited with it. Now, if interest rates rise, so will the central bank’s ’interest on reserves’ bill.
The higher QE as a share of total government debt, the more government is exposed to fluctuations in short-term interest rates.
Since rich countries will in future have to pay more for health care, climate change and pandemics, an increase in government borrowing can only be affordable if interest rates are kept negative.
These are the three policy options; more central bank intervention, more public debt resulting from fiscal stimulus, or negative interest rates. Unfortunately, this is not the end of the story, as the proposed interventions would do little to address interrelated structural problems:
growing inequality, higher debt-to-GDP ratios, and lower interest rates tend to reinforce each other.
In conclusion, now that countries bring covid-19 under control, this offers the opportunity for a reappreciation of economic policies, in that not only a choice can be made between the proposed three policy options, but also provides a golden opportunity to structural problems.
Peter de Haan December 2020
Column December 2020
How China manages bubbles
Sooner or later, economic bubbles burst. But not always. China’s economic development over the past forty years demonstrates that bubbles don’t necessarily pop; they can be sustainable.
The economic science faces three principal challenges. The first one deals with economic growth; i.e., how to get an economy growing, preferably in a sustainable manner. The second challenge is about controlling the business cycle. Economies typically do not evolve in a straight upward direction. They meet ups and downs on the way. The challenge for economists is to develop policies to counter these ups and downs, typically triggered by bubbles. The third challenge, income and wealth distribution, has to do as much with economics as with welfare. The challenge is to limit the gap between rich and poor, in order to maintain a fair and stable society, in which every citizen can lead a decent life.
The question I deal with in this column refers to the second challenge: bubbles. Over the past four decades, China successfully managed to deal with bubbles during its phenomenal economic growth spurt. During this period, one would have expected that China would have undergone several deep economic and financial crises, triggered by bubbles. However, economic policymakers have been quite successful in dealing with them, in that these bubbles did neither burst, nor did they much affect China’s growth trajectory.
Before explaining what happened, let me tell you what American economist and Nobel laureate Paul Samuelson wrote about bubbles. He said that if an economy is growing, each generation will have more to spend in an asset, such as a house, than the preceding generation. Upon retirement the home owner will sell his property to the next generation, having a higher income. This will allow the seller to earn a positive return on his or her investment. And if the economy’s growth rate exceeds its interest rate, this return will be higher than what other saving possibilities would offer.
Thomas Orlik, who lived 11 years in China working for Bloomberg, recently published China: The Bubble That Never Pops, in which he describes China’s handling of the economy since 1978. Along the way, the Chinese economy, while undergoing a spectacular structural transformation, now and again became under threat from various imbalances, such as rising local government debt, housing overcapacity, or inefficient state firms. Nonetheless, as Orlik noted, the country never experienced an ‘economy-wide door-shut panic’. Thanks to smart economic handling of these imbalances, prolonged recessions were prevented. The author argued: ‘When problems occurred, China always had the growth momentum,
fiscal- and monetary policy space, as well as political determination to manage through, fending off a hard landing.’
Orlik’s book is littered with examples of China’s policy interventions in problematic situations. Let me give just one telling example. The year 2016 did not start well for the Chinese economy. Real estate developers had huge numbers of unsold apartments and offices; they owed a lot of money to (shadow) banks. The country also suffered from overcapacity in industries such as steel and coal, threatening the economy into a dangerous downward spiral of deflation. Policymakers attacked the problems while applying the so-called 5 r’s : reflating and remixing the economy, as well as refining, rotating and writing off assets and liabilities. This requires a bit of elaboration. In the context of its supply-side reform program, China remixed the composition of economic activity without reducing its pace. Old coal mines and loss making steel plants were closed, more investment went into roads and other infrastructure. Bad physical assets and bad loans were written off, including shadow loans.
Regarding the overheated real estate market, the author tells the following story. In Guiyang, the capital of Guizhou province, as in other cities across the country, slums were cleared. Displaced households were given funds to help buy readily available apartments. These efforts were often financed by targeted low-interest loans from China’s central bank. True, the clearances, closures and write-offs reduced China’s stock of wealth, but it did not interrupt the flow of new economic activities. As a result, the combination of new money injected into the economy and old capacity removed from it, increased prices and promoted further GDP growth. All this restored the gap between higher growth and lower interest rates, thereby making debt levels easier to sustain. This example demonstrates the ability of policymakers to take decisive measures to shift economic aggregates in the right direction while addressing economic problems which could have spun out of control.
Surely, Orlik identifies future economic challenges for China, yet it is no surprise that the author’s final verdict is quite positive. He concluded that bets against China ignore how good the country has been at solving problems. These bets also ignore how successful it has been at creating and seeing opportunities. Having read Orlik’s book, it is difficult to arrive at another conclusion.
Peter de Haan December 2020
Column November 2020
Bidenomics
Joe Biden is America’s President-Elect. This prompts the question what his policies will be for the American economy and the world at large. In particular, what will President Biden’s policies vis-a-vis China be?
A sigh of relief went through the world when on 7 November last not Donald Trump, but his opponent Joe Biden was declared winner of the American presidential elections. Contrary to the erratic, destructive and destabilising Mr. Trump, the President-elect is a pragmatist.
During his entire political career, spanning almost half a century, Mr. Biden has shown to be balanced, even-handed and pragmatic.
In political terms, pragmatism means political philosophy applied with common sense.
President Biden will be facing a number of substantial challenges. Firstly, there is the aftermath of the covid-19 pandemic. The American economy is undergoing the deepest economic recession in living memory. A huge number of workers is unemployed, thousands of firms have closed their doors, and public debt is steeply rising. Income and wealth are distributed in a highly unequal fashion, and America is one of the world’s largest polluters.
Bidenomics: this is how the future president’s economic policy intentions are called. The urgent need to revive the economy is the first priority.
To this end, a Stimulus Bill will be sent to Congress in which workers are to benefit more than America’s rich. There will be more attention for the environment. Probably a somewhat watered-down Green New Deal may be presented to Congress in due time. The role of the State will be enhanced, and an active industrial policy will be pursued, intending to create millions of manufacturing jobs (Mr. Biden is fond of manufacturing), including bringing supply chains back to America. Furthermore, a Buy American government procurement policy will be introduced.
All these policies result in higher public spending, which adds to America’s rapidly growing federal debt. However, the new president does not seem to be much preoccupied about this potential problem.
What about Mr. Biden’s foreign economic policy? He intends to open America’s borders to skilled migrants. What some observers expected, i.e. the US returning to free trade is not on the cards. The new president is expected not to reverse President Trump’s protectionist policies. In fact, not much will change in America’s trade policy, although President Biden’s approach will be more consistent than his predecessor’s.
One of Mr. Biden’s themes is: ‘Economic security is national security’. In this sense, he will restrict imports from China that represent a security threat to the US. Mr. Biden characterised his predecessor’s trade deals with China as ‘empty agreements’. Regarding eventual new trade agreements with China, Mr. Biden said that they could wait after fresh investments in the American economy will have been made. This implies that the tariffs imposed on China, may not be removed for the time being. In due time it may be that these tariff reductions may be used in return for concessions from the Chinese authorities.
In September last, Mr. Biden published a paper entitled Made in America. This sounds familiar, as China already applies its Made in China 2025 policy for some time. Now, what does this Made in America involve? Apart from subsidising manufacturing, the Biden Administration is to invest $300 billion to support research in artificial intelligence, electric cars, and 5G. However, should companies ship jobs overseas, the subsidies they received will have to be reverted to the government. But hang on: subsidising industrial activities is unfair from the point of view of foreign companies wishing to invest in the US. In their eyes it is comparable to applying tariffs. This may lead to international trade tensions. Nonetheless, Mr. Biden has pledged to fight back against countries that undercut American manufacturing using - in his own words - ’unfair subsidies’.
What about Mr. Biden’s stance vis-a-vis the World Trade Organisation (WTO)? The functioning of this multilateral body was already undermined by the establishment of a large number of regional trade agreements. Worse, a global wave of renewed protectionism is also undermining WTO’s role. The Trump Administration had created difficulties for WTO’s system of solving trade disputes. Some time ago, the WTO judged that American tariffs on Chinese imports broke WTO rules. And just recently, the WTO ruled that the European Union was allowed to claim $4 billion from the US, as it illegally subsidised Boeing, an American airplane manufacturer. Both rulings will not prompt the new president to take a fresh, positive stance towards the WTO. Only time will tell whether the US may again warm to the WTO.
President-elect Biden’s intended international trade policy is, as I mentioned, not much different from President Trump’s. Will the US eventually move away from protectionism into the direction of free trade? It depends on many factors. An important one is the successful implementation of Bidenomics. This will, above all, depend on the number of manufacturing jobs Bidenomics will create. However, tariffs instituted by the Trump Administration destroyed American manufacturing jobs. Moreover, they made imported parts more expensive and triggered other countries to charge higher tariffs against American goods, thereby harming both American consumers and economic growth.
This past experience suggests that moving sooner than later into the direction of free trade would be the better bet.
Peter de Haan November 2020
Column September 2020
Economic prospects after Covid-19
After COVID-19 will have been defeated, the world’s economies may return to pre-Covid times.
The question is: will they indeed? And if not, what will probably change?
I am sure all of us are longing for a return to the life we led before the outbreak of Covid-19. As the present economic crisis is not caused by economic-financial factors but by a deadly virus, the first priority is to contain the pandemic and, secondly, to produce a vaccine. Researchers are working round the clock to develop a thoroughly tested and approved vaccine.
Meanwhile, the number of infected people in the world is rising. As I write this column, the World Health Organization (WHO) reported 307,930 new infections - the highest number recorded to date. India scored highest with 94,372 new infections; America and Brazil, put together, registered roughly the same number. The number of new infections in Africa is anybody’s guess. In short, the virus is still very much among us. The hoped-for vaccine of, for example, Oxford-based AstraZeneca is being tested. But testing had to be interrupted twice as some volunteers undergoing the test developed negative side-effects. I fear that testing, approval, and production of the vaccine into the billions (including for the poor), will take time - perhaps more than one year. The International Monetary Fund (IMF) and philanthropist Bill Gates call upon the international community to support funding of vaccine production so that affordable doses become quickly available, not just for the rich but also for the world’s poor.
Most countries instituted lockdowns that caused economic effects - some positive, some negative. Shops, factories, offices, restaurants, theatres, stadiums, you name it, closed their doors. Employees had to work from home, were put on furlough, or lost their job. Governments that could afford it, quickly took financial rescue measures intending to keep businesses afloat. This will continue for some time; but not forever.
Now what has changed since lockdowns and which may become an integral part of the economy once covid-19 is brought under control? Work from home is one offshoot of lockdowns, including meetings and seminars held through skype, Zoom or Loom. Air, rail and road commuting went down, and also - a piece of good news - air pollution. Another piece of good news was that global sales of laptops soared. Work from home was so successful that bosses now toy with the idea of making work from home the norm. After all, it is cheaper: no financial compensation of workers’ travel expenses, and far less office space needed. Skype and Zoom make expensive overseas seminars at attractive locations redundant, perhaps to the regret of those who used to attend them.
Will work from home become the norm? This may not be so. Some firms will continue promoting work from home, but others will want their staff back to the office. Some studies suggest that work from home raises productivity, while others say that work at the office is more productive as it brings people together and ‘promotes behaviour conducive to new ideas’, as one report put it. Many employees were dying to get back to the office after lockdown, as they felt lonely. Some felt that if they were overlooked by bosses, they might not be promoted or, worse, had a higher chance to be sacked. After lockdown, some 80% of French office workers are back at their desks, but less than 40% of British workers are. In short, the Jury is still out on the work from home issue.
The world-wide lockdowns exposed the interconnectedness of production and other economic activities. It appeared that countries had become too dependent on the delivery of strategically important goods (such as medicine and specialised vital equipment) from one or two supplying countries. An example: once the pandemic had broken out, Europe had become totally dependent on the delivery of mouth caps and protective equipment from China. In response, European Commission President Ursula von der Leyen proposed a European Health Union to counter this dependency.
Since lockdowns were instituted, world trade took a nosedive. Last April, outgoing World Trade Organization chief, Roberto Azevedo, projected that this year international trade could drop between 13% and 32%. However, the OECD, a club of mostly rich countries, and the Fed, the American system of central banks, now say that global trade has not done as badly: global trade volumes may drop not by some 30% but by 10% this year. The Economist, a weekly magazine, coined this ‘the 90% economy’. This is triggered by steeply increased sales of laptops and covid-related goods. Lockdowns in Asia were lifted relatively swiftly, which helped large exporting countries, such as China, to reopen their factories and boost output. However, productivity growth may suffer as quite a few firms hesitate to invest.
Given the steep increase in covid-19 infections, a second wave of lockdowns may be in the offing. Add to this the present mood of protectionism, and the conclusion is that international trade may continue to decrease in the coming years. This would have, three major consequences: lower world economic growth, more unemployment, and more expensive consumer goods.
Once state support will come to an end, quite a number of companies have to close down after all. So, the economic pain is not yet over - worse is in store. Workers in the entertainment, transportation, tourism and cultural sector, having no chance of surviving the pandemic, will be laid off. They have to be retrained to qualify for other types of jobs. This will not be easy, as human beings have a limited number of talents which may not match the requirements of available jobs.
The IMF is optimistic, although its projections carry a higher-than-usual uncertainty. For sure, IMF anticipates slower recovery as a result of damage to supply potential, and a hit to productivity as surviving businesses ramp up necessary workplace safety. Nonetheless, IMF’s latest World Economic Outlook projects that in 2021 world output will grow 5.4%. Advanced economies, such as the US, the European Union, Japan and Canada will grow 4.8%, while emerging markets and developing economies (including China, India, ASEAN-5, Russia, Brazil) will register 5.9% growth next year. China’s output alone is expected to grow 8.2% in 2021.
I find this forecast hard to believe, unless one accepts IMF’s assumptions. One is that social distancing will persist (if one takes the slack attitude in my home country Holland as the norm: very unlikely). It is also assumed that financial conditions will remain at current levels, although IMF’s Outlook observes that the recent rebound in financial market sentiment appears disconnected from shifts in underlying economic prospects.
In concluding, it is likely that we have to brace ourselves for difficult economic times ahead.
Peter de Haan September 2020
Will the world have two or three superpowers in the future?
Is China already overtaking America as the world’s largest economy? But what about the European Union (EU)? True, the EU has the largest internal market in the world, but will the Union emerge as the world’s third superpower?
Applying the usual GDP yardstick, in 2019 the American economy produced goods and services worth $21.4 trillion. China produced $14 trillion. But this is not necessarily a fair yardstick. After all, one may think that one dollar in China buys more goods and services than one dollar in the United States. This yardstick is called the Purchasing Power Parity (PPP). When this PPP standard is applied to China, its economy would have produced $26 trillion in 2019. So, China would have surpassed America in PPP terms. However, the PPP yardstick is debated. A reporter at Caixin, a financial magazine, discovered that a number of goods in Hangzhou were more expensive than in Boston. This was picked up by the World Bank. It found that goods were in fact 17% more expensive in China. Yet, the Bank’s estimates suggest that China overtook America’s economy in 2016. However, in GDP terms America is still the world’s largest economy.
Some people say that America is in decline, while China is going strong. Covid-19 did not stop China’s economy from growing, be it at a slower pace than last year. Europe is struggling: the Euro area will shrink some 8% this year, with a possible growth resumption next year. It all depends on the success of keeping covid-19 under control, in the absence of a vaccine.
Productivity matters
What are the ingredients for the promotion of sustained economic growth? A better question is what the factors would be that promote sustained productivity growth? I offer a few key productivity boosters: (i) the number of registered patents, reflective of innovation and research & development, (ii) the quality of academic education, and (iii) the ease of doing business. Surely, other factors also play their part, such as the quality of a country’s infrastructure and its institutions. Nonetheless, I believe that these three boosters influence productivity growth most directly. China, the US and Europe score on them as follows.
Patents: The 2018 World Intellectual Property Indicators reported that China came first with 432,147 patents. The US occupied second place with 307,759 patents. After Japan (194,525 patents) came the European Patent Office reporting 126,603 patents. As for companies, Huawei tops the list. Qualcomm, an American company, occupies the fourth slot on the top-ten companies list (by the way, Huawei is Qualcomm largest client). Ericsson (Sweden) took the 7th and Bosch (Germany) the ninth position on the companies list.
Quality of academic education: This is best reflected in the list of the world’s best universities. Of the top-10 on QS’s World University Rating List 2020, five are American universities. European universities occupy the other 5 slots on QS’s top-ten list. Regarding China, Tsinghua University, occupies slot 15 on QS’ top-twenty universities.
Ease of doing business: The US occupies number 6 on the 2019 World Bank’s Ease of Doing Business rankings. China takes up a lower position: slot 31. However, China’s ranking is the result of the scores of 30 large cities on mainland China, in that some cities do very well in one or more aspects of the ease of doing business, while other cities do less well. The list does not include a ranking of the EU as such. Among the EU member-countries, Denmark scores best (slot 4), followed by Norway (9) and Sweden (10). Germany, the EU’s largest economy, is number 22 on the list, while France occupies number 32.
Challenges
Based upon the productivity boosters I proposed, China, the US, and EU each have strong points but also weak ones in their pursuit of sustained productivity growth. Strictly based on these boosters, economic policymakers would advise the US to ramp up its research and development (R&D) in order to increase innovation and, thus, the number of patents. Their high-quality universities can certainly provide the right inputs in this realm. The EU is weak on patents and, so, weak on R&D. The high level of European universities may help boost its R&D. China has a lot of ground to cover regarding the quality of its universities. To temporarily cover the gap, Statista reported that in 2018 more than 662,000 Chinese students followed courses at prestigious universities overseas. They will bring their knowledge back to China.
The US scores best in the ease of doing business. The EU and China can do better, given their lower scores. The World Bank recently reported that China is, indeed, making progress in, for example, limiting the time it takes to establish a business.
The European Union in more detail
Towards the end of July, European leaders met in Brussels, to agree on EU’s 2021-2027 budget of €1074.3 billion, plus a €750 billion rescue project to pay for the economic damage done by the covid-19 pandemic. At the end of long deliberations all leaders agreed. The rescue project was approved, underscoring solidarity among the EU membership. A second inspiring aspect was that the European Commission, EU’s executive body, will borrow the project’s funds on behalf of all member states. The Commission will also be allowed, for the first time, to raise EU-wide taxes, among others to be able to repay the loan. This is an important step in the direction of EU’s fiscal integration. But not all is well. EU members critical of the rescue project, were granted rebates on their contribution to the EU budget at the detriment of budget items such as the European Defence Fund (39% less) and EU’s R&D budget (30% less).
If the EU wants to become the third global superpower, more than having a huge internal market is required. Regarding strategic sectors such as ’big tech’, the EU has lost out to China and the US; both are way ahead and it will be very hard for the EU to close the gap. Slashing EU’s R&D budget was the wrong thing to do in this context. The EU lacks a unified economic strategy, such as China’s Made in China 2025. It also lacks a unified geopolitical and foreign policy; often member states deploy their own diplomats, while a unified approach would be more effective. Nor has it one unified EU defence force. As noted, cuts on defence spending were made. – again, the wrong budget to slash in pursuit of a superpower status.
Conclusion
In GDP terms, China will soon eclipse the US as the world’s economic hegemon unless the Americans reinvent their proverbial economic resilience before it is too late. The EU may remain a strong economic powerhouse, but I don’t expect the EU becoming the third superpower on the world stage.
Peter de Haan August 2020
Global Debt
Many covid-19 affected countries have taken the right measures to prop up their economies through unprecedented fiscal and monetary injections. So far, this prevented their economies from sinking into a deep depression. However, more fiscal and monetary support may result in unsustainable debt levels. This column looks into the matter with a special concern for poor countries
How large is the world’s public debt? The Economist Intelligence Unit runs a so-called public debt clock which provides an up-to-date figure of debt incurred by governments. As you look it up, you can see that the world’s public debt is increasing while watching it. Given the very large covid-19 inspired fiscal and monetary rescue measures, this is not surprising. When I recently looked the public debt clock up, total global public debt was more than $59 trillion (i.e., 59 plus 12 zero’s). And surely, this figure will further increase this year. Even more impressive is the total global debt figure, so, including private debt. The Institute of International Finance’s website says that pandemic-driven recovery measures pushed global debt-to-GDP to a new record of $ 258 trillion – the equivalent of 331% of Global Domestic Product. These are sobering, near-incomprehensible figures, putting sustainability of debt levels of some countries in jeopardy.
But let us look at the other side of the equation: savings. Unlike public debt, savings are mainly accumulated by persons, not governments. Some influential economists, such as Harvard’s Larry Summers, talk of a savings glut; that is saving more than investing, resulting in an ever larger mountain of savings. What do global saving figures tell us? It is hard to find an exact amount of global savings; the latest estimate I came across stood at $ 250 trillion.
A simple conclusion would be that the accumulated debt to date could more or less be covered by the accumulated amount of savings. But this conclusion is -of course – incorrect. After all not all savings are kept in a savings account. Most savings are held in two forms: real estate and in pension portfolios. In addition, people who save will only part from their savings if they expect to earn an income from it. Investing one’s savings in e.g. bonds of governments with a questionable reputation of repaying loans (as some poor or poorly governed countries), will obviously not take place. These countries must rely on soft loans issued by development banks, such as the World Bank, or from bilateral donor countries, including China. In case of a sudden balance-of-payments crisis, the International Monetary Fund (IMF) will provide credits to help restore order in the country’s finances in the short term. Countries needing more time, such as many African countries during the 1980s and 1990s, could apply for IMF stabilisation credits of a longer duration. By the way, IMF’s short-term credits are not limited to developing countries. In the 1970s for example, the United Kingdom had to call in IMF’s help. More recently, Greece had to be assisted by the IMF, together with loans from the European Central Bank and the European Stability Mechanism.
Running a debt is not worrisome as long as the creditor trusts that the debtor will pay back the principal plus interest. For most rich countries this is not a problem; their credibility is confirmed by credit rating agencies such as Moody’s or Fitch. Two examples. My home country, the Netherlands enjoys a triple-A status by these agencies. The other day our Minister of Finance auctioned Dutch Treasury Certificates worth Euros 1.4 billion. Within four minutes(!) all certificates had been bought up. Then, Japan. The country enjoys an A+ rating, despite the fact that the country is running a huge government debt of more than 240% if its GDP. Financial markets do not get nervous of Japan’s huge debt.
The outlook for most poor developing countries is quite different. During the G-20 meeting, held last April, a Debt Service Suspension Initiative (DSSI) was launched for them. This could free up more than $20 billion for 73 poorest debtor countries by suspending repayments on loans from G-20 governments. One G-20 member is China – and a formidable lender at that! Its loans include soft loans from the government, semi-soft loans from so-called policy banks and profit-seeking loans from state-owned commercial lenders. China accounts for 20% of the total foreign debt by these 73 - in particular African - countries (and 30% of their debt service this year). That is more than all of the Paris Club lenders, including the US, Britain and Japan. Particularly serious is Djibouti’s situation: 40% of its total debt is owed to China.
There is talk of debt forgiveness, taking into consideration the weak financial position of most poor developing countries plus the extra investments they have to do in countering the covid-19 pandemic. Uganda, for instance, spends more on servicing its debt than it can spend on providing health services. However, most poor countries hesitate to ask for debt forgiveness as it will negatively affect their international credit rating; which in turn will limit their access to the international bond market.
It is yet early days to tell how DSSI will work out in practice. The only conclusion that can be drawn now is that debt forgiveness for the poorest countries is a likely scenario.
Peter de Haan July 2020
Europe’s and China’s response to the outbreak of Covid-19
China and the European Union reacted swiftly to the economic fallout caused by Covid-19, as their economies came to a near standstill. Negative economic growth projections of the IMF, World Bank, and OECD send shivers down politicians and business leaders’ spine. This column deals with the question what measures have been taken to dampen the economic crisis and how fears of inflation are perceived.
Monetary and fiscal measures are taken to counter economic depressions. Monetary measures (lowering the interest and/or buying up bonds) are the central bank’s domain, while fiscal measures (lowering taxes, investing in social services and public works through deficit spending) are government’s responsibility. In short, a good-old Keynesian approach, invented by the great British economist John Maynard Keynes, later elaborated by Milton Friedman.
Previous depressions had financial-economic origins. The present one is caused by Covid-19. So, countering the deep worldwide depression depends not just on the effectiveness of monetary and fiscal stimulus, but also on the time it takes to develop a vaccine against the deadly virus, or a medicine to mitigate its impact. In most countries the spread of the virus seems to be under control. However, renewed outbreaks of Covid-19 in various countries, if not effectively contained, will be disastrous for any economy, as monetary and fiscal stimulus cannot go on forever.
Keynes and Friedman’s lessons have been taken to heart by Chinese and European authorities. As for Europe, soon after the outbreak of covid-19, the European Central Bank (ECB) bought up Euro’s 750 billion sovereign- and company bonds to increase the money supply. At the beginning of June last, ECB bought up another Euros 600 billion. So, ECB’s total monetary injection was Euros 1,350 billion - an enormous amount of money. Its immediate effect is that interest rates are kept low and the threat of deflation is averted. ECB’s President, Christine Lagarde, explained that ECB took the measures to prevent fragmentation of the European Union.
Regarding fiscal measures, not the Union but individual member states took them, totalling around Euros 2.2 trillion; again, an enormous sum. Some members, such as Germany and Holland, have deep pockets and a low level of sovereign debt, so they could support workers and businesses lavishly. Some even introduced a basic income for their most vulnerable citizens. But heavily covid-19 affected - and indebted countries, such as Spain and Italy, could not do so. They asked for help in the form of grants from richer fellow Union members. This was not acceptable for Austria, Denmark, Holland, and Sweden (the ‘Frugal Four’). They argued that, as a condition for help, these indebted member states should put order in their financial house to improve their international financial credibility. In response, Italy, Portugal, and Spain were furious; Italy even threatened leaving the Union. Germany’s Chancellor, Angela Merkel, got nervous and joined France in proposing a temporary Euros 500 billion multiannual financial framework (MFF); from which most-affected member states and regions would receive grants. Again, the Frugal Four were not amused. The European Commission, EU’s executive body, is now working on a Euros 750 billion rescue plan - incorporating the French-German proposal - that partly consists of grants and partly of loans - a typical compromise proposal. This rescue plan is to especially help southern European countries in co-funding their health sectors and their economies to prevent the Union’s members drifting apart.
Regarding China, the picture is different. In the past China has not hesitated in pumping large sums of money into the economy. And in 2008-2009 it worked, after the Great Recession had broken out. But now that China is facing a deeper economic depression, there is a fear among influential economists that lavish rescue policies may trigger inflation, asset bubbles, and a loss of confidence in sovereign credit. The fear of inflation is understandable: during the middle of the 1990s China’s inflation rate ran as high as 28%.
China’s Ministry of Finance announced that this year the central and provincial governments would, together, issue Yuan 8.5 trillion in new bonds. A think tank proposed that the Peoples Bank of China monetise the fiscal deficit – in effect printing money to buy and hold new government bonds. Contrary to the situation in Europe and Japan, China still has space to cut interest rates. So, critics wonder: why not cut interest rates rather than taking an inflationary road of bond buying? This concern was picked up by Prime Minster Li Keqiang, who, during the recent National People’s Congress, announced that official interest rates would be cut. He also said that banks’ required reserves would be reduced to expand money supply. He did not mention any bond purchases.
Is the concern about inflation justified? Economics textbooks say that a large infusion of money into an economy, if not leading to an equal increase in the value of goods and services, triggers inflation. But in Japan and in Eurozone countries, where huge sums of money have been pumped into the economy, inflation remains low. How come? Japan provides an explanation.
For decades, Japan has been trying to cure the economy from low inflation, sluggish growth and close to zero interest rates. Well before the covid-19 outbreak, the government had already pumped trillions of yens into the economy, with little success. Last April, the Abe administration announced extra spending plus guarantees equal to 20% of GDP. And last May, the government announced spending plans involving fiscal support, including guarantees, equal to 40% of GDP. Meanwhile, the Bank of Japan bought up roughly $600 billion in assets, pushing its already bloated balance sheet to over 110% of GDP. Japan’s government debt is now well above 240% of GDP. In response to these huge infusion of money, and piling up of debt, financial markets have not shown signs of uneasiness. Share prices increased, benefitting from the central bank’s large purchases of exchange traded funds. Apparently, the limits of Japan’s extreme monetary and fiscal policies are farther away than economists had thought.
There are no worries about Japan’s fiscal sustainability, let alone the risk of inflation. One reason why Japan has been able to borrow so much is because the rest of the economy does not spend enough: higher saving than investment is Japan’s problem. This is partly caused by the population’s composition. Japan’s population is aging; those close to retirement save more and consume less. Aggregate demand declines, installed capacity is not used fully, and investments go down. Economic growth is the result of population - plus productivity growth. So the way forward for the Japanese is to have more children or, politically less attractive, to promote immigration.
Peter de Haan June 2020
The Covid-19 Aftermath and Europe
What started as a health crisis turned into a global economic depression. Two questions are dealt with in this column (i) how does the present depression compare to previous ones, and (ii) what were the European Union’s challenges and responses?
The International Monetary Fund (IMF) characterised the present sharp financial and economic downturn as The Great Lockdown. It is the worst crisis since the Great Depression of the 1930s. The Great Recession, which started in 2008, was a mild crisis compared to the present one. While the Great Recession was largely limited to the Western world, the present one is a deep global downturn.
During the Great Depression, unemployment rose not as fast as it does now, especially in America where over just a few months’ time unemployment shot up from 3.5% to some 15%. In Europe the unemployment rate is (still) far less because governments subsidise firms’ wages, to prevent unemployment from rising. The ones who lost their job receive unemployment benefits. Nonetheless, worse is yet to come, in that unemployment will rise and so will bankruptcies.
The response to the Great Depression was protectionism, deflationary economic policies, and drying up of bank loans, resulting in massive unemployment, plummeting industrial production and dramatically shrinking GDPs. For example, between 1929 and 1933, America’s GDP fell by 25%.
It was John Maynard Keynes who in 1936 presented economic policies to redress the situation. His analysis was that aggregate demand had to be boosted through government investments, lowering interest rates, and pumping money into the banking system, in order to get the economy going again. It worked – consumers started to spend and Investors to invest again, inspired by their ‘animal spirits’, as Keynes called it.
The present unprecedented sharp economic downturn is not caused by financial-economic factors. It was the covid-19 virus that did it. So, the duration of the depression will largely depend on the time needed to develop a vaccine and to produce it in huge numbers. Meanwhile, governments will have to continue supporting economic actors. Public debt will further rise which could lead to unsustainable debt levels for some countries. Given this gloomy perspective, it is not helpful that protectionism was already on the rise and will continue rising. Roberto Azevedo, outgoing World Trade Organisation (WTO) chief, warned that this year international trade could drop between 13% and 32% as a result of a combination of protectionism and the outbreak of the covid-19.
The European Union , home to the world’s largest single market, acted swiftly in dampening the crisis. Indeed, the lessons of Keynes, and later those of monetarist Milton Friedman, have been learned. On the monetary front, the European Central Bank (ECB) was quick to respond in a massive way to counter the economic consequences of the covid-19 lockdown across Europe. The ECB bought up euro-zone governments’ debts to the tune of €750 billion, to give countries like Italy and Spain easy access to loan funds in the open market. Regarding fiscal policies, European governments followed suit in pumping €1.9 trillion into their economies to subsidise wages, help self-employed people, invest in health facilities, what have you. Yet, the IMF projects that this year the economies of the European Union (EU) will shrink on average by 7.5% (in 2009 it was only 4.3%); the economies of Spain, Italy, and Greece will contract by more than 9%.
Not for the first time in EU’s history, the economic burden falls heavily on those least able to bear it. Most affected countries want a €1.5 trillion recovery fund paid for with debt, backed collectively by the EU as a whole. This proposal is not liked by Northern European countries, including my home country Holland; they want to have a say how recipient governments would spend the funds. Germany and France want to ease the tension between North and South Europe by proposing a recovery fund of €500 billion, from which countries that need help can receive grants. The fund is to be created by loans from the capital market, which the EU as a whole, will pay back in due time.
In short, what started as a health crisis became an economic crisis, then a financial crisis, and almost a political crisis. It may even run into a constitutional crisis, prompted by Germany’s Constitutional Court questioning ECB’s €750 billion debt-buying program, thereby implicitly criticizing EU’s highest judicial body, the European Court of Justice (ECJ), for not doing so. One analyst even argued that if the stresses of the covid-19 pandemic weaken the ECJ’s foundations, the entire EU may shake. Or will the EU continue to muddle through, as it did in the past when addressing crises?
Despite its economic prowess, the EU has not become a third superpower between the US and China. This would, to my mind, be a welcome addition now that the US is withdrawing from its traditional global leadership role. This is the more regrettable, as developing a vaccine against covid-19, overcoming the present global depression, and rearranging a global free trade system, all require a global effort. The European Commission took a commendable small step in the direction of global leadership in organising a successful global fundraising drive for the development of a vaccine, but much more is required. Dreams of the EU as a superpower require deeper economic and political integration as well as strategic unity which, at the moment, is simply not there among the 27EU member countries.
Peter de Haan May 2020
Why invest in poor countries?
In normal times the best recipe for a country‘s development is self-help. At present the times are not normal - all countries, rich and poor, are facing a pandemic. For low-income countries self-help is now not an option; they need help.
Over the past forty years, many low-income developing countries have done pretty well. They have been able to leave poverty behind and joined the ranks of middle-income countries. Some of them even managed to join the growing group of high-income countries (see bar chart). I will soon publish a book about this inspiring development, entitled Whatever Happened to the Third World. Never in the world’s history have we witnessed such a rapid and widespread economic growth of low-income countries.
Source: Whatever Happened to the Third World
So, it is no surprise that my book radiates an optimistic spirit. However, not all is well. There are still low-income countries having difficulties shedding poverty. And, more troubling, there is an increasing number of so-called failing or failed states where there is hardly or no central authority left, leaving them open to terrorist groups, drug cartels, and criminal organisations, whose destabilising and brutal actions spill over to other countries.
Since we live in a globalised world, what happens in low-income countries -and in failed states for that matter - is of concern to us all. The corona pandemic provides a worrying example. It has affected high-income and low-income countries alike. The former have the financial means and health facilities to counter the pandemic, but low-income countries don’t. If left to themselves these countries are unable to stem the pandemic, wiping out what had been achieved by them in income and social welfare terms. No help would also pose a renewed corona threat to rich countries that thought they had slain the pandemic.
In 2002, the Global Fund was established to help low-income countries with funds and technical personnel to counter malaria, tuberculosis and AIDS. Rich countries and philanthropists who funded the Global Fund can rightly claim that the Fund’s co-ordinated global effort contributed to the containment of these killer diseases. This applies in particular to AIDS, having greatly limited its spread from low-income to - in particular - rich donor countries. In short, a fine example of altruism combined with self-interest.
Let us take sub-Saharan Africa - home to most of the world’s low-income countries - to demonstrate the effects of the coronavirus. So far, more than 20,000 infections have been reported, and the number of new infections is rapidly rising. If measures such as social distancing and lockdowns will not work, between 25% and 80% of a typical Africa population will be infected. Roughly 5% of infected Africans need intensive care, which simply is not available. For example, Uganda has more government ministers than intensive-care beds. And regarding ventilators, counties like Mali and Mozambique have only one ventilator per one million people. In addition, lockdowns won’t work, nor social distancing in slums where the poor live. Most people depend on daily labour to survive. If they cannot work, they can’t eat. As one prime minister sadly observed: ‘If we shut down the cities, we will save people from corona at one end, but they will die from hunger’. So, they must go out to work for their survival. If this is prevented, riots may ensue. South Africa deployed the army to enforce the lockdown there.
The economic fall-out in African countries will be disastrous. They don’t have the funds to invest in social safety nets or in unemployment payments, let alone in stimulating the economy after the pandemic will have been brought under control. African exports are down, as international demand for them is all but gone. Needless to say that tourism, a major source of income, is down as well. Foreign investors are rapidly pulling out from developing countries, including Africa. International investors have already pulled $90 billion out of Africa.
Remittances, far more important than foreign investments for many African countries, are drying up as migrant workers in rich countries are losing their job. The result: balance-of-payments problems and a dramatic decrease in African governments’ tax income. It is precisely this income that is needed to invest more in the health sector, social safety nets, and in cash transfers to the poor. Out of a total of 1.3 billion Africans, 400 million live on less than $1,90 per day, and 80% of Africa’s workers don’t receive a regular wage; they try to make a living in the informal sector.
If low-income African countries are not assisted now, all previous economic gains in poverty alleviation, economic growth, schooling and health care will be lost. The result: poverty will deepen; political stability will be under threat, and the coronavirus (and other vices for that matter) will spread from these countries to other continents. So, it is in everybody’s interest to help. To start with, $150 billion is urgently needed to boost health spending, to strengthen financial reserves and fund social safety nets. In early April the IMF has enlarged its lending capacity with $ 1 trillion to help counter the financial costs of the pandemic. The World Bank is releasing $160 billion of emergency and medium-term support to affected developing countries. Also individual countries and philanthropists respond. For example, China is donating millions of test kits to many countries, along with technical advice on how to control the pandemic. Then, take Alibaba’s Jack Ma. He donated 20,000 test kits and 100,000 face masks plus 1,000 protective suits to each African country. Huawei donated many face masks, even to my home country Holland (unfortunately, some did not meet our safety requirements). All this is welcome and very necessary. But we are still in the first, emergency, phase. After the pandemic will be brought under control, more financial help will be needed to help low-income countries recover their economies. The recent G-20, including China, agreed to let indebted nations suspend debt payments to G-20 members for eight months. Given the bleak economic prospects for indebted low-income countries I fear that a new round of debt forgiveness will have to follow. As in past crises, a united global response is the most appropriate. Traditionally, America led the way in addressing global crises. However, the Trump Administration is pulling away from global responsibilities. America even suspended funding the World Health Organisation. Will China take up this global challenge? Or will it be a small group of nations determined to preserve multilateralism and magnanimity which has benefited the world much since the end of World War II? The future will tell.
Peter de Haan April 2020
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Beyond Covid-19
By the time you read this column the coronavirus pandemic is probably under control in China. In Europe the pandemic is still raging. The question is what the worldwide economic fall-out will be.
Throughout Europe, entire cities, provinces, and countries are locked down. There are no mass events like football games; restaurants and bars are closed, and so are schools. Initially, the government of my home country, Holland, took a step-by-step approach. First, the province of Brabant was locked down, as the virus first appeared there. As further spreading of the virus could not be contained, harsher measures were taken: no more sport events, and museums and theatres were closed. And two days later, the government decoded to close schools, colleges and universities for three weeks.
The world is undergoing a global health crisis and an economic crisis. Now, how do economists look at the economic impact of Covd-19? Some compared it with the financial crisis of 2008 when the American investment bank Lehman Brothers collapsed, ushering in a near meltdown of the international financial system and, subsequently, the Great Recession.
Over the past few weeks stock exchanges across the world registered colossal losses as a result of panic; the price of oil plunged, and firms and workers suffered lockdowns. Yet, it is too early to tell whether the world is facing another deep recession. The IMF, World Bank, and the Global Fund quickly made available billions of dollars to counter the pandemic. In addition, the immediate response of central banks like the FED, the American central bank, and the ECB, its European colleague, and those of China, Japan, Australia, Britain, plus other countries was robust: interest rates were slashed and huge sums of money were pumped into the economy to prevent the crisis from deteriorating into a full-blown recession. This was a quick and necessary action to calm financial markets and to provide cash for them. But, as central bank Presidents reiterated, their ammunition is limited; more needs to be done by others to counter the crisis. They urged governments to take their responsibility in countering the consequences of Covid-19. Let me explain. To ease the financial pain of lockdowns, governments should implement fiscal policies (such as tax cuts and wage subsidies) to alleviate financial damage done to firms and self-employed workers. Moreover, governments should financially help the ones who lost their job. Also uninsured people should be helped by footing their health bill. Some economists even advocated cash handouts, also known as helicopter money, to help those without any source of income and to boost demand. This is exactly what most governments did: they made large sums of money available. This was easier for surplus countries such as Germany and Holland, yet other countries with fewer financial reserves took bold financial measures. After all, any government wants to prevent recessions and unemployment.
One economist observed that the consequences of the coronavirus had entered into ‘the arteries of the globalised world’. This very good metaphor is reflective of the complex interdependency of the global economy. However, the present crisis is atypical in that it is caused by the corona pandemic and by its financial-economic fall-out. To make matters even more complex, we are not dealing with a dramatic drop in aggregate demand (such as during the Great Depression of the 1930s) or a drop in supply (during the recession of the late 1970s). This time, a simultaneous fall in supply and demand is on hand. Supply chains are no longer a national phenomenon; they are globalised. So, when the supply of one essential part is held up as a result of a Covid-19 inspired lockdown, it affects the production of the final product. For example, Peugeot, BMW, and Jaguar/Range Rover closed their plants as a result. As for demand, people earn less or no income at all during a lockdown. Demand is also affected by the fact that people simply cannot spend on eating outside, going to sport events, concerts or to a movie.
Economic think tanks estimate that this year’s global economic growth may be the lowest since 2009. The hope is that growth will resume later this year, but nobody knows for sure; it depends on the duration of the pandemic and on the speed with which the economy can bounce back.
Another question is whether countries may not retreat from globalisation altogether and move towards autarky. Some European countries already talk about producing medicines themselves again rather than depending on imported drugs from China or India. Others are toying with the idea of embarking on a policy of protectionism. This would be bad news for international trade and development.
Are there signs of hope? I believe there are. At this time of writing, China appears to have been able to curb the spread of the virus in a very short period of time indeed. Now, if other affected countries would be able to also contain the pandemic in a relatively short time, production and other economic activities can be resumed and financial and consumer confidence can be restored. Second, there will be pent-up demand at the end of a period of lockdown, in that people will be willing to spend more than in normal times, which will contribute to the resumption of economic growth.
Peter de Haan March 2020
The philosophy of economics
Economics is the only social science recognised by the Nobel committee of Sweden‘s Central Bank. Each year one or more economists receive the Nobel Prize for economics. Yet, economics is quite different from the natural sciences, such as physics and chemistry; both based upon the laws of nature. This raises the question on what basis economics rests?
When I studied economics, little attention was paid to the philosophy of the subject matter. We were instructed to understand the dynamics of supply and demand, and their respective influence on the formation of prices. We learned what measurements there were on the distribution of income and wealth. And, regarding business economics, we learned how to distinguish between cost- and sales price, and by which methods machines and other capital goods could be depreciated.
But we learned nothing about what was behind all these models and notions. In other words: on which philosophy is economics based? Why, for example, pay attention to economic growth? After all, growth is a means to an end; the end being better welfare, more stability and happiness of a society; that - in the end- is what economics should be about.
Now that I have studied economics a bit deeper, I discovered a few things which I did not learn in college. For example, Adam Smith, the father of economics, was not an economist; he was a philosopher. Apart from his Wealth of Nations (1776), Smith is also famous for having written The Theory of Moral Sentiments, which he published way back in 1759. This book provided the moral basis for the Wealth of Nations. Its message was that people, through serving their own economic interest, also serve society at large.
It struck me that especially after anomalies or economic downturns, economists published books that were critical of the prevailing economic system. Karl Marx comes to mind. He criticised the exploitative nature of ruthless capitalists during the Industrial Revolution’s heyday. He predicted that capitalism would collapse. After the Great Depression of the 1930s, Joseph Schumpeter published Capitalism, Socialism and Democracy (1942). Although certainly not a Marxist, Schumpeter argued that it would be quite possible that capitalism would collapse and be replaced by socialism. After all, capitalism had failed miserably during the Great Depression, as millions of people lost their jobs, poverty was rife, and there seemed no end to the misery.
I find John Maynard Keynes more interesting than Marx and Schumpeter. He was not after the collapse of the capitalist system. Keynes intended to save capitalism from its downfall. However, he was very critical of capitalism’s perverse aspects. For example, he writes in The General Theory of Employment, Interest and Money (1936), that lowering of interest rates would mean the ‘euthanasia of the cumulative oppressive power of the capitalist to exploit the scarcity value of capital’. True, even Marx could have observed this. But Keynes – unlike Marx - was not in favour of killing capitalism. His aim was to rid capitalism of its faults in order to ensure full employment, and a more equitable distribution of wealth and incomes.
Keynes proposed fiscal and monetary instruments applied by governments to effectively counter the Great Depression. So, he developed the economic means to achieve the ends which he clearly had in mind: full employment and, indeed, a more equitable distribution of income and wealth. Once these were secured, Keynes added, communism and fascism would lose their appeal.
All economists I just mentioned analysed the economy based on their particular political philosophy. Hence it depends of the philosophy of the economist concerned how economic problems are perceived and what solutions are offered. While Keynes accorded a prominent role for government to counter a recession, Milton Friedman, by contrast, argued in Capitalism and Freedom (1962) that governments are doing more harm than good to the economy. He strongly felt that the market should be counted on to, for example, counter depressions. Friedman believed that only the market system was able to restore equilibrium in the economy. More recently, Thomas Piketty criticised in Capital in the Twenty-fist Century (2014) modern capitalism for widening the gap between the haves and havenots, triggering social and political instability.
By and large, mainstream economists can be divided in neo-Keynesians and supporters of Friedman’s neoclassical economic philosophy. They used to have one thing in common: a disdain for their opponents’ views. Keynes once characterised his opponents as ‘incompetent bunglers’. But nowadays economists are gradually acknowledging useful elements in each other’s theories. So there is progress.
However, economics still differs from the natural sciences. Physics and chemistry base their analyses on the same unchanging laws of nature. By contrast, economies are unpredictable, as more than only purely economic influences are at play, ranging from political and demographic developments to climate change. My advice to the reader is to take this difference into consideration when listening to what economists propose.
Peter de Haan February 2020
Are economic policy instruments obsolote?
Economists were confident that fiscal and monetary policies on politicians would help redress macroeconomic and monetary imbalances. But it appears that economies now behave different from the past. It is time for adjustments.
Governments have an important role to play in keeping their economies on a balanced growth path. In economic terms this implies: price stability, full employment and decent social welfare. Now, how were these objectives achieved and by whom exactly?
Let us start with monetary policy. It has a short term horizon, as it is supposed to counter business cycles. The prime task of ensuring price stability is bestowed upon the central bank. In most countries the central bank is an independent institution, run by technocrats. Politicians are not interfering in what central banks decide. Price stability is achieved when inflation and deflation are kept under control. For example, when aggregate demand is overshooting aggregate supply, inflation is the result. The central bank will then raise the interest rate to discourage investment and encourage saving. The central bank can also limit the money supply to stem inflationary tendencies. In the early 1980s the late American Fed Chairman Paul Volcker limited the money supply to counter runaway inflation. The initial result was that investment fell dramatically and unemployment increased. But after two years, the American economy resumed growth, and employment increased again.
Fiscal policy is in the hands of the country’s political leadership. It involves, simply put, pumping money into the economy, in order to stimulate aggregate demand. During the Great Depression of the 1930s, John Maynard Keynes was the great promotor of this policy. He argued that when aggregate demand fell short of achieving full employment, the government had to fill the demand gap through cutting taxes or through (deficit) financing. A recent example of successful fiscal policy was China’s infusion of $ 586 billion into the economy during the Great Recession which broke out in 2008. As a result, after two years of slow growth, the Chinese economy resumed growth at more than 10% per year.
The principal difference between monetary and fiscal policy is that the latter is applied by political leaders who are accountable to parliament and the electorate, while monetary policy as noted, is applied by technocrats who do not render account to both.
Now, what is different from the past? In the old days, we saw that when inflation rose, employment fell; and -the other way around- when inflation was low, employment increased. This inverse relationship is no longer there. What we witness in America for example, is near full employment combined with very low inflation. There are various explanations for this phenomenon. Now there is jobless growth (jobs are being taken over by cheaper robots and automation), and global supply chains do not reflect local labour market conditions, i.e., a lot of parts of a product are now produced in countries where labour is cheap. Another difference is that there is more global saving than global investment (some talk of a savings glut) pushing interest rates down.
What are the consequences of these developments? Let’s take monetary policy. The economies of America, Britain, the Euro-area, and Japan, were not only hit hard by the Great Recession but also suffer from a deflationary tendency. This means slow growth, low interest rates, low inflation, and insufficient investment. In order to prevent the recession from deepening and to stimulate the affected economies, central banks initially lowered their interest rates. But the economies did not respond sufficiently, enhancing the fear of deflationary tendencies. The interest rates were further pushed down to 0 (zero) or even lower. This means that, should a new recession break out, the interest rate instrument does not work since the rate cannot fall any further.
Central banks invented a new instrument: quantitative easing (QE). The American Fed and the European Central Bank (ECB), for example, bought up trillions of government bonds in the hope that with this huge financial infusion, investment and consumer demand would rise and, consequently, inflation would pick up again. The idea being that a small dose of inflation of around 2%, is enough to stave off deflation. But QE was not successful in boosting inflation: the American inflation rate is only 1.4%; the Euro area’s rate is around 1%; hence well below the 2% target. This suggests that QE would not work should a new recession break out.
Time and again, central banks urged governments to do their share in countering the recession and deflation. Most of the fiscal policies applied during the Great Recession, particularly by Euro-area governments, were insufficient and of too short duration.
Monetary policies alone cannot pull the economy out of a future recession. More is needed. Robust fiscal policy measures will have to be taken with more impact and staying power. This would be facilitated by the current very low interest rates, as governments can borrow very cheaply and invest the funds in projects that enhance the economy’s growth and productivity. Countries, like Germany, have to overcome their fear of runaway inflation, and invest their huge current account surpluses in public works such as roads and bridges.
There is also a proposal to give central banks some fiscal policy instruments. I do not think this is a good idea. First of all, it lowers politicians’ responsibility to act. Secondly, fiscal policy should remain within the domain of politicians, as central banks are not designed to take political decisions around questions like how much of fiscal stimulus should be handed to the poor or what type of investments should be made? These issues need to be decided by parliaments, which - in the end - render account of their decisions to their electorate.
Peter de Haan January 2020