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The Limits of Stimulus

August 23, 2010

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.

12 Comments leave one →
  1. regularreader permalink
    August 24, 2010 1:50 am

    Dr. P. As a reader like this blog. I suggest you delete the chiang speech, it can be interpreted in too many ways. It can be offensive and cause trouble to the access of this blog. Just my two cents. Thank

    • prchovanec permalink*
      August 24, 2010 10:37 am

      Thanks so much for your advice, which I know is well meant. The Chiang quote is going to stay, for a couple reasons:

      1) The horse is out of the barn. My blog is republished on several sites, and I’m sure it’s already out there by now, so if people are going to misinterpret my use of that quote, the damage is already done.

      2) It’s a very famous historical quote, one that I’ve even heard the Chiang character say in Chinese-made movies and TV series depicting that period. Everybody in China knows he said it and what he meant, from his own point of view.

      3) It’s true that Chiang’s original quote raises complex historical issues. Was he right or wrong? Most Chinese at the time, and most Chinese today, believe he was wrong, and see his statement as rather unpatriotic. His position led directly to his kidnapping in the Xi’an incident, in which he was forced by his own generals to form a “united front” with the Communists against the Japanese. The subsequent behavior of the Japanese, in the Nanjing Massacre and elsewhere, make it hard to diminish the awfulness of the Japanese threat. So yes, in its original context, the quote is problematic.

      4) Nevertheless, I have confidence in my readers that they will be able to understand that I am lifting this famous quote from its original historical context and applying the distinction Chiang was drawing to an entirely different set of circumstances. In much the same way, I can quote Mao observing that “political power grows out the barrel of a gun,” and recognize the value and relevance of this insight, without siding with Mao or endorsing the actual argument he was making at the time.

      5) Like many Chinese phrases (“as close as lips and teeth”), Chiang’s expression is well known in China, but unknown to most of my readers outside of China. If I were writing for a Chinese audience, I could just say “demand is a disease of the skin, supply is a disease of the heart,” never mention Chiang, and everyone would know what I’m saying and nobody would read anything political into it. But for a non-Chinese readership, I have to explain the original of the phrase, or nobody will have any idea what I mean by it.

      6) I’m just not going to start self-censoring myself to please the CPC and prevent them from blocking my blog. If I go down that path, I’m going to start second-guessing everything I think of saying, which is exactly what people in China have become trained to do these days. I don’t mean to give offense, and I don’t think my use of Chiang’s quote really should give offense to anyone who thinks seriously about the real point I’m trying to make. But at the end of the day, I’m an American, and I get to say what I want. I’m not going to start playing the self-censorship game here or anywhere else.

      But your two cents are appreciated, really.

  2. Dean Jackson permalink
    August 24, 2010 2:11 am

    Great Piece. Thanks.

  3. Hua Qiao permalink
    August 24, 2010 8:24 am

    Nicely stated. Thanks.

  4. Park permalink
    August 24, 2010 10:12 am

    Nice Post. I really like your last line.

  5. jomiku permalink
    August 24, 2010 10:58 am

    I suspect that your actual position today would be more similar to Krugman. Do you support raising the key US interest rates with unemployment very high, bond yields touching 0%, disinflation (with the spectre of deflation), state and local governments contracting spending and the chance of recession reoccurring? Do you support reducing federal spending now? Do you believe in what Krugman rightly calls the “invisible bond vigilantes” or in austerity without any evidence of inflation?

    Krugman argues – correctly – that the deficit is largely structural, is largely related to entitlements and military related spending and that addressing these concerns is the only way to reduce the structural deficit over time. That and sensible tax increases on the wealthy. The obsession with minor bits of spending – a few million here, a billion here – when tax cuts cost $1.6T is absurd.

    You speak of Keynesian easy money but the easy money of the housing bubble wasn’t Keynesian but was a weird hybrid of a strange belief in the perfection of markets (with an over-emphasis on the good they make while ignoring their destructive powers). It was policy but to call that Keynesian beggars the label and would mean that any policy can be labeled “Keynesian” if one chooses to disagree with it.

    I enjoy your blog but I think you’re emphasizing your intellectual distinctions. Most everyone finds the idea that one can manipulate the economy or markets to make them work “better” less than appealing. But I’ve yet to hear Krugman or others on his side of the argument say that. They argue, instead, that in a 0% environment when the Taylor rule says rates should be way negative, with disinflation, with deflation looming, with a deficit that’s structural, then the proper role of government in society is to act to stimulate the economy.

    A year ago the argument was advanced – by many well known people – that the stimulus bills would merely displace private investment. That hasn’t happened and I haven’t even heard that argument for many months because the idea isn’t defensible. I heard that inflation was now a huge risk and yet bond yields have been falling since. I’m hearing now that there’s a “bubble” in Treasuries but that would require a safer asset to which funds could move and no such animal exists. One may exist some years from now. One likely will at some point in the future. But I’ve never even heard anyone making this point carry it through to argue that a safer alternative exists now or will in the next year or the year after. When they can’t even finish the thought, that’s a sign that the worry is more the inability to accept what the evidence says is real.

    So, look at Krugman’s actual positions about what should be done. I don’t agree with him on many points – mostly on pragmatic grounds – but I don’t mischaracterize his actual suggestions to avoid labeling myself Keynesian. Note for example that Reinhardt and Rogoff have both said they favor immediate action to stimulate demand even though their paper is now cited by austerity hawks.

    • Park permalink
      August 24, 2010 12:23 pm

      You don’t really counter Chovanec’s main point that stimulus does not enhance real wealth. I don’t think you can easily dismiss it as indefensible. Have you heard of the term “guo jin min tui(國進民退)” in China? Or have you seen you Japanese government credit grew in the place of private credit? Or do you see real wealth growth in Japan after two decades of fiscal stimulus?

      Of course in Japan’s case you can argue, as Richard Koo has, that government credit was neccesary to replace private deleveraging. On the other hand, you can also argue that if it weren’t for government credit (neccesary for fiscal stimulus) Japan would have recovered already, though it could have suffered from a sharp recession, or perhaps even a depression.

  6. Greg Ludvigsen permalink
    August 24, 2010 4:12 pm

    Great post. Always great insights. Thanks for the clear and informed observations and sound analysis of the observations.

  7. Jay permalink
    August 25, 2010 12:31 am

    Is the New Deal a wasted effort then?

    So you support liquidationism which caused the great depression.

    Have you ever read Richard Koo? He will be viewed as the greatest economist of our times once everything is said and done, that’s my prediction.

    I don’t like Krugman, at all, but he is right in the solution of the bubble bursting, a Japanese style mild deflation is far better than a great depression.

  8. charles permalink
    August 25, 2010 1:23 am

    The wise Nessim Taleb likened it a few months ago to the medecine killing the patient 🙂

  9. Karen permalink
    August 31, 2010 1:03 am

    I agree with much of what you say, particularly that governments’ and central banks’ “cures” are not the panacea some think they are.

    But as far as which is the “disease of the heart,” I think that is the worldwide failure of demand. Yes, some countries (Greece?) may have forgotten how to produce real value at reasonable cost and may suffer because of it, but on a global scale I have the sense that producers are very ready to ramp up, if only they could find more consumers for their products. And it is now clear that, at least in the U.S.A., high consumption over the past two decades or more was an artificial creation of very loose credit conditions, so the failure of demand has actually been around a lot longer than we realized.

    I think maybe the Marxists are right that unrestrained capitalism (and also political favoritism/corruption) has generated great income inequality which has led to the concentration of wealth in the hands of a small minority whose personal needs cannot begin to stretch far enough to match their resources. Not wanting to give it up but not knowing what to do with it, these people just “invest” their money, which these days amounts to sitting on it, since productive investment opportunities are few due to the demand problem.

    I would lump in with this phenomenon the excess cash being sat upon by publicly-traded corporations in the West, since those who make the decisions about what to do with that corporate money are part of the wealthy class, and leaving it in the corporate accounts preserves their ability to steer much of it to themselves over time, something that is not true of paying it out in dividends.


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