The Limits of Stimulus
I was cited in an op-ed in Saturday’s Wall Street Journal, on “China’s looming real estate bubble,” which you can check out here (if you get the access-restricted version using this link, try Googling the title, I found the Google link goes to a non-restricted page).
It’s clear that the article, by Shikha Dalmia and Anthony Randazzo, isn’t just about China. The lessons they’re drawing, about the limits of stimulus, are obviously meant to be applied to the U.S., and could be applied with equal validity to Europe, Japan, or any other country faced with overcoming an economic slowdown. About a week ago, I was on China Radio International (CRI) talking about the challenges currently confronting the U.S. economy (which you can listen to here). Later that day, I appeared on two segments on CCTV News BizAsia, discussing inflation and lending policy in China (you can watch those two short interviews here and here). I was really struck by the similarity in themes between the two discussions, despite the fact that the U.S. and Chinese economies seem, at first glance, to be in such very different places. Both must weigh the same issue: the desire stimulate growth, on the one hand, with concerns over debt and inflation, on the other.
To a large degree, the debate reflects a deep philosophical divide in the study of economics, one cleverly captured in the Keynes-Hayek rap video I posted a few months ago. On the one side are the Keynesians, represented most vocally these days by Paul Krugman, who believe most problems in the economy stem from misalignments in demand. Too little demand, you get unemployment; too much, you get inflation. Take stems to adjust demand to the appropriate level — by raising or lowering net government spending, or by increasing or restricting access to money — and you’ve solved the economic problem.
Their critics, on the other hand, are more concerned with how value (i.e., wealth) is created in an economy, and the role prices play in signaling value to market participants and shaping their behavior. Because of their focus on the productive, supply side of the economic equation, this camp came to be known in the U.S. as “supply siders.” But the same concerns figure prominently in the writings of the Monetarists (the Chicago School, led by Milton Friedman) and the Austrian School (represented by Hayek). All of them share a deep skepticism in the ability of politicians to “fine tune” the economy, as Keynes and his followers proposed, without causing side effects that are worse than the problem they seek to cure.
Anyone who regularly reads, watches, or listens to my commentary knows that my concerns and philosophy tend to mirror the latter camp, the supply siders. It’s not that I don’t understand Keynes, or appreciate what he is saying. Demand can get systemically out of whack, and fiscal and monetary stimulus can be an appropriate, effective policy response. Juicing the economy with artificial injections of cash can help compensate for acute shortfalls in demand, pull the economy out of a negative spiral, and “jump start” the resumption of more sustainable economic activity. But it’s also important to recognize, as some Keynesians seem to ignore, that deficit spending and easy money also have a cost. Politically-driven government spending often ends up wasted, “invested” in unproductive projects that generate little or no return, while the debt taken on to finance such projects still must be repaid. Artificially low interest rates can have a similar effect, distorting private investment decisions and fueling the formation of unsustainable asset bubbles. “Quantitative easing” — printing more money — might correct for a liquidity crunch, but if the money supply expands faster than the real economy, the result will be inflation.
All of these factors — inflation, unproductive investment, excessive debt — create the temporary appearance of prosperity, because there’s lots of money sloshing around, but they actually undermine growth; that is, real wealth creation. In the end, there are limits to how much debt, inefficiency, and inflation an economy can support before people start losing confidence in its prospects. At that point, policies designed to stimulate the economy actually end up driving it into the ground, and the only way to re-establish any credibility is to adopt austerity measures that actually deepen the downward cycle. That’s where Greece, Spain, and Portugal are now, and where Japan may be soon. They’re not adopting anti-stimulus belt-tightening measures because they want to, but because their stimulus card has reached its maximum limit and they have no other choice left.
Economic stimulus is, in a sense, like a narcotic drug. A little bit can be a life-saver, when you’re in extreme pain. But it’s also a poison, and if you keep using, you’ll end up strung out and addicted like Dr. House on Vicodin. (Paul Krugman argues that this analysis is comparable to saying the economy must be “punished” for its excesses, which he finds both callous and ridiculous. In fact, I’m not saying we should ban all painkillers because they’re potentially addictive and dangerous, which would be foolish and cruel indeed. What I am saying is that, when taking painkillers, you ignore their very real dangers at your peril — just because they make you feel good doesn’t mean they’re good for you. Whereas Krugman and his fellow Keynesians, to carry the analogy one step further, seem to advise popping economic painkillers as though they were candy).
One more medical analogy may drive home my point, and my preoccupation with the dangers of economic stimulus. In the 1930s, China faced gradual encroachment by the Japanese, who had already annexed Manchuria. Despite this threat, and popular demands for national unity to resist the Japanese, the Nationalist leader, Chiang Kai-shek, insisted on pressing home his campaign to crush his main domestic rivals, the Communists. “The Japanese,” he said, “are a disease of the skin, whereas the Communists are a disease of the heart.” What he meant was, the Japanese, as terribly destructive as they were, could occupy China for a year or a hundred years, but ultimately they would go home and China would still be China. Whereas if he lost to the Communists, their victory would redefine China forever.
I respect Keynes’ insights, and his follower’s zeal in trying to mitigate the excessive swings of the business cycle. But in my view, the problems of the demand side are a disease of the skin. The problems of the supply side — the productive health of the economy, its capacity to produce real wealth — are a disease of the heart. Fail to treat the former, and you get a recession. Ignore the latter, and you impoverish your economy. The former is a dip in the trend line, the latter is the trend line.