The Week of October 11th: The Great Divide

Adam Smith published the book that started economics 'An Inquiry Into the Nature and Causes of the Wealth of Nations' in 1776, which by any measure, was a fair while back. Why is it then, that human beings, who have gone to the moon in 1969, have still not come to a broad consensus about how to run economies in trouble? The answer perhaps lies in a place that is not extremely comfortable for an economist to look into; the gut!

The gut tells us that beyond all the hubris of bell curves and complicated  mathematical expectation based modelling, the subject matter rests upon one big fault: the need for specific assumptions. There is no way that one theory of unemployment and search frictions which won Pissaredes and co. the Nobel prize for Economics this year, can capture the interactions in the labour market in every country accurately. There is no way that the growth models of Solow and Ramsey can be used as a generalized input output models for every country in the world. We as human beings, have the innate tendency to prefer extremes in theories; whether about religion, philosophy or science. The middle path seems almost invisible to the naked eye, and hence we have the great divide.

The events of the past week have served to increase and solidify the differences in approaches to tackle this monster of a global recession. The Eurozone is hell bent for austerity; a word that provides warmth and comfort to every German citizen unlucky enough to live through the great hyperinflation era in the 1920s. The British, fired up with the exuberance of a coalition government, and some time off from Gordon Brown, have also accepted that life is not going to be easy for a few years, and it is a sacrifice worth making. The increased VAT will hit the consumers in February, and even University professors from  Oxford etc are going to take a 1.6 billion pound hit on their payrolls.  On Thursday this week, BOE MPC members De Anne Julius and Rachel Lomax said explicitly that a further stimulus programme would be a wrong move. Eurozone inflation reports also came out this week, and the numbers held with analyst predictions at a lowly 0.2% y/y. 

The Americans, stand on the other side of the fence, and believe that further stimulus is imperative to recovery. This week, Ben Bernanke gave a speech at the Boston Fed, stating very clearly, that in all likelihood we are going to see at least another 500 billion dollars if not a trillion, injected into the American economy in November. As I argued last week, the markets had already priced in a further stimulus, as the Dow and S&P 500 hovered around the previous week levels. If Bernanke had said anything indicative of an indecision about further stimuli, markets would have taken a big tumble accelerated by the release of poor economic data yesterday. The University of Michigan Consumer Confidence index, which is an important indicator for the markets, fell to 67.9 against analyst expectations of 68.9. However, the retail sales numbers were good, rising 0.6 percent. Retail sales make up about 70% of purchases by consumers in the American Economy. However, inflation numbers remain low and this is a good excuse for the Fed to justify further stimulus even on the back of a worse than expected trade balance number clocking in at -46.3 billion m/m. 

The Americans, have a ponzi scheme running with the dollar. Their total debt to GDP ratio (60% or thereabouts) is still not at a place that would cause concern to people like Paul Krugman, who have been actively campaigning for stimuli since the crisis began. And it is definitely true that without the injections of artificial demand in the economy, the unemployment numbers would be comfortably in double digits. The question that does not have any definite answers though is this: If the Fed believes that more stimulus is needed and its been two years since the recovery process was initiated, how long will the markets be fooled into believing that they should go up and not down on the back of further stimulus as its an indication of a more chronic problem in the economy than was initially thought? The answer probably is that at some point in time, they will stop believing that more and more intervention is good for them. However when that time arrives is not certain in any way. When the endemic nature of the problem surfaces, the deficit hawks might have the last laugh. It is not wise to  count out the nature and impact of self fulfilling prophecies, but having said that, it is not wise to bet against the American economy either. As long as people around the world believe in the American Economy's total supremacy, and productivity increases like the ones we have seen over the last two years continue to happen, the tide would continue to work in America's favour. After all, no country with a sovereign currency has had a default problem like Greece and Ireland, so another 10 years of trade deficits would not be completely unacceptable from an economist's perspective. Furthermore, with American consumers saving higher amounts of money than ever (the recession has indeed managed to scare the indomitable American consumer), there does not seem to be much of an option presented to the Fed.

The great debate about stimulus vs austerity is not a debate after all. And there is no panacea for the state of the developed world right now. The trick is to know when to stop with the stimulus and when to ease off the austerity; the trick is to know your people. For Example, German consumers can endure a lot more fiscal prudence than the American consumer; and with these two countries being at the polar opposite ends of this debate, it seems only reasonable that they act according to what is feasible rather than what is ideal.