Martin Wolf has an excellent piece in the Financial Times (hat tip: MF). It should be required reading for policy makers around the globe, particularly the architects of the euro zone. I have no illusions that it will be or that its basic message will be heeded.
What is that message?
Well, Wolf makes the case, as he puts it, for getting out of debt by adding to debt. His argument is Keynes’ paradox of thrift – the notion that efforts by all to increase savings to raise future consumption can make all worse off. The reason is that one person’s spending is someone else’s income. And to increase savings, spending must be reduced relative to income. But if all individuals increase savings, they must all be spending less; incomes must be falling. Moreover, with lower incomes, incremental savings must be lower; to save the same desired amount, individuals would have to reduce spending still further. Yet, if all individuals compress spending, incomes fall even more.
You can see where this goes, and how ill-advised efforts to maintain fiscal discipline in adherence to the strictures of the gold standard propagated global economic stagnation in the early 1930s. Unfortunately, as I have previously argued, this is pretty much what Europe is doing through the euro zone. Just as protracted stagnation led to growing social and political cleavages in the 1930s, unemployment rates that in some euro zone countries today rival Great Depression levels is certain to fray the social fabric of these countries. Of course, social programs and unemployment programs attenuate these effects, and account for the widespread observation: “Crisis? What crisis?”
The paradox of thrift is easily grasped in the context of a closed economy where total spending translates into incomes. “But,” say you, “the paradox does not necessarily hold in an open economy, since higher savings in one country relative to its investment needs can be offset by higher spending, or dissaving, in another.” Correct. These differences in savings relative to investment are precisely what current account balances record.
Consider what happens when individuals, corporations and governments in one country all increase their savings in response, say, to a financial crisis that depresses asset prices and forces balance sheet repair. In a closed economy world, the synchronized increase in desired savings would depress consumption and ultimately reduce incomes, as above. In an open economy world, however, that decline in income (wages) would increase the competitiveness of the country’s goods in international markets and lead to an increase in net exports. Production would shift from fulfilling domestic orders to meeting the increased demand from abroad. This effect underscores the importance of the G20 commitment, made at the November 2008 summit in Washington, not to introduce protectionist measures in the midst of the crisis.
But what happens when other countries are also saving more? The danger then is insufficient global aggregate that threatens deflation and protracted global stagnation. In effect, that is the threat stalking the global economy.
If the problem in the global economy is indeed the Keynesian paradox of thrift, there are really only two ways out of the current malaise: governments that can borrow at (near zero) interest rates do so, to offset the impact of higher private sector (households and corporate) savings; countries that are attempting to target continued current account surpluses must accommodate the prolonged, difficult fiscal adjustments that are required in countries that have lost access to bond markets. The absence of both responses could condemn an entire generation of young people around the world to life without meaningful employment, with all the negative consequences this entails.
And, yet, policy makers are reluctant to follow the logic of Keynes and adhere to Wolf’s admonition, fearing the wrath of bond markets. But in the current environment, efforts to outshine others in terms of fiscal probity to impress rating agencies and the bond market are tantamount to being the best looking horse at the glue factory; your relative ranking in a foot race matters very little if the end point of the race is a cliff.
Moreover, countries that have current account surpluses – many of which were scared by the experiences of earlier financial crises – are loathe to give up those surpluses, either because they want to avoid the risk of future crises, or a reluctance to relieve the burden of adjustment on deficit countries that were the authors of their own misfortune through fiscal or private sector profligacy.
The global economy is thus hostage to the prisoner’s dilemma, or a coordination failure. Countries that could undertake fiscal expansion fear that their efforts to stimulate would spillover to others, benefiting those “not doing their share” to pull the global economy out of stagnation. The end result would be a higher debt load, and continued recession at home.
A similar coordination failure – the result of dysfunctional monetary arrangements of the early 1930s – led to the global economic stagnation of the Great Depression. The IMF was created to assist its members resolve such coordination problems and achieve a Pareto improvement in which all are better off; today it remains the most important institution of international cooperation for promoting the public good of international financial stability and growth. It is handicapped, however, by a perceived lack of legitimacy, credibility and effectiveness. And, as a result of its weakened stature, the G20 has created the Mutual Assessment Process to foster the cooperation needed to secure the goal of strong, sustained and balanced growth.
Can the MAP exercise succeed? I hope it will; I fear it will not. But if enough G20 policy makers read Martin Wolf and digest the lessons of the paradox of thrift, success might be possible.
So will Wolf’s message be required reading? I suspect not. Engaging ministers and leaders in a discussion of the paradox of thrift and the potential for Pareto improvements would be widely viewed as “Yes, Minister” courageous.