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The long term has arrived


The long term has arrived

Whoever grasps the causes of the world financial crisis, of which repercussions we continue to witness, does not look in awe to the latest developments in Europe. In 2008/09, in response to the supposedly eminent collapse of the global economy, several countries in the developed world embarked on unprecedented fiscal expansion. Given the exhaustion of monetary policy, it was left to the governments to roll up the sleeves and spend. Spend heavy and fast. It was the return of the master Keynes and his cure: fiscal stimuli.           

Why fiscal stimulus is not the answer

Also referred to as contracyclical policies, other synonyms for fiscal stimulus are: budgetary impulse or expansion, deficit spending, among others. In simple language: additional government expenditure financed with borrowed money. By definition a stimulus is something that rouses or incites activity. It is something that has an impact, impulse, or influence on a system. If an object needs stimulation, it follows that it is simply not responding in accordance to its normal functioning. If stimulation is needed in an economy, one infers it is not responding the way it should, prompting action by government. The economy is lethargic. So goes the traditional thinking.

One of the main flaws in Keynesian and mainstream economics is their inadequacy to understand what is causing an economy to be in such a mode. In absence of a correct and sound theory, the answers never point to the appropriate solution. Actually, not only are the wrong answers put forth, but irrelevant questions are also raised.

Why is consumption falling? Neglected attention to this answer begging question, focus is instead turned toward the prescription. Government must step in to revive total aggregate demand in support of a falling private demand. So advise the Keynesian experts.

Contracyclical policy means policy aimed at countering the cycle. Keynesian and mainstream economists alike do recognize that there is a business cycle. They fail to understand, however, why there is a cycle. And this is a key point. It is as if business cycles were a given in Keynesian theory. They simply exist. It is hardly surprising that the prescriptions focus on the symptoms rather than in the underlying causes, reinforcing the problems instead of alleviating them.

Credit expansion not backed by a commensurate increase in real savings sends false signals to entrepreneurs who are misled to embark in investment projects as if the necessary resources were actually available for their completion. Consumption patterns have not changed, that is, time preference has not been altered, but credit creation masks precisely this fact. Fiduciary media have increased, while the pool of loanable funds remains unchanged.

This phenomenon causes an inflationary boom which brings about large scale malinvestments, since all projects cannot come to fruition due to insufficient resources. Eventually, unviable businesses will have to be liquidated, turning the previous boom into the inevitable recession.

During this phase, all unprofitable ventures are liquidated so the economy can reassign the resources to viable businesses once again. Although the public at large would like to avoid unwanted suffering, the inescapable outcome of an unsustainable boom is malinvestment, that means, businesses which should not have been even initiated. Therefore, redundancies and bankrupt firms are inherent to a boom and bust cycle. Allowing for a process as frictionless as possible is all that is required from governments, as it will accelerate the profitable reallocation of resources, ensuring a solid and sustainable recovery.

The conventional wisdom sees the recession as the stage of the business cycle where all the misfortune takes place: lay-offs, bankruptcies, debt defaults, among others. Depressions are inherent to the market economy, Keynesian economists contend. Governments are supposedly responsible for restoring "economic stability". This is where monetary policy and fiscal policy should intervene and guarantee economy activity do not recede.

Considering the theoretical background explained above, one can already sense how deficit spending may in fact only worsen the predicament, as we will attempt to demonstrate below.

If governments are only able to employ resources previously appropriated from the private sector (via taxation or borrowing) it is simply not possible to invest without divesting from somewhere else in the economy. Public investment necessarily entails private divestiture. Consequently, the much sought after "increase in aggregate demand" is nothing but a misconceived notion, as Eggers[1] explains:

"Aggregate demand is an unintended result of individuals' actions and has no causal role in determining them. But if aggregate demand is irrelevant to action and has no meaning in an analysis of the functioning of a market system, there can be no standard for determining that it falls short of some ideal, and there can be no such thing as unemployment caused specifically by this shortfall."

Entrepreneurship and profits have no place in Keynes' economic theory. As the title of his notorious work denotes, his main concern is employment. Thus, it is of little significance, according to Keynes, if public investment is in fact productive and resources are efficiently utilized. What matters first and foremost is whether people are employed.

As Egger succinctly clarified, it is essential to understand that "all unemployment is caused by mispricing, and none by insufficient aggregate demand". Profits arise from the differential between revenue and costs. Entrepreneurs are concerned with the differentials in relative prices and not with an increase or fall in the general level of prices. Any attempt to expand the money supply by means of extra Central Bank liquidity will only aggravate the distortions, preventing companies from adjusting their businesses and correcting the aforementioned mispricing. "This, in turn, implies that a policy designed to reduce unemployment by bringing aggregate demand closer to its ideal is fundamentally misconceived from the start. The result is typical of well-intentioned efforts to solve problems that do not exist: the problems that do exist are made worse[2]".

Additionally, government expenditure and investment contributions to society are at the very least highly questionable, since there is no rational way for governments to base their investment decisions. Moreover, the whole process tends to be excessively politicized[3]. Lacking the profit-motive, government employment of resources is inefficient by definition.

The only viable contracyclical policy is to refrain from monetary expansion at the outset. All other attempts will only attenuate the crisis, attacking symptoms but not the root cause of economic cycles. Notwithstanding, once the artificial boom has been engendered and the recession arrived, let us leave the market (entrepreneurs, consumers, producers, savers, investors, etc.) in charge of rebuilding the economy.

Today it is Greece. Who is next?

Before the 2008 crisis several European Union countries were already in breach of the Maastricht Treaty clauses, showing worrying budget deficit and debt ratios. Nevertheless, in order to avoid the collapse of the world economy the consensus pushed for heavy monetary and fiscal artillery.

Under the title of European Economic Recovery Plan[4], EU member countries were encouraged to expand its budgets, incurring deficits on the short term, so as to prevent "aggregate demand" from falling, but always conditioned to structure reforms and actions aiming at long term fiscal solvency. In other words, spend now and deal with deficits later. The majority complied.

The sovereign debt crisis that Europe now faces, was intensified, and, perhaps, even accelerated by the fiscal stimulus packages adopted by several EU countries. Through desperate policies and lacking a reliable yardstick whether such measures would be effective, the majority embarked on a very short term spending spree, worsening an already dire fiscal situation.

The theoretical basis supporting fiscal expansion on the short term and fiscal consolidation on the longer term was that the Keynes' multiplier would soon take effect, resulting in higher economic growth, thus higher tax receipts, automatically lowering the budget deficits ratios to more sustainable levels over time.          

However, at some point, the long term must arrive. And it has indeed arrived. Unexpectedly (for politicians) the fiscal stimuli were not only useless and harmful, in the sense of ameliorating the economy, but also precipitated the chaos in the EU public finances. What will happen cannot be known, since the decisions will be political and not based on economics. Will the Euro be inflated to save spendthrift countries? Will governments be obliged to balance its budgets? Will they accept the demands? Or will they leave the monetary union and devalue its new national currency?

It is in fact impossible to guess. We must bear in mind, though, that the crisis is far from over. Now it is Greece's turn, and as it appears, Portugal too. This very week the ECB started buying Spanish and Italian bonds on the open market. How much and for how long they will purchase is yet unknown. What is certain is that we shall still face a few storms. Curiously, a few weeks ago many commentators still spoke of "contagion risk". Well, indebted and running continuous deficits, they all were. There was nothing more to contaminate. Debt is the disease. It was a mere question of time for the financial markets to deal with each country.

Let us not forget the USA, which too belong to this domino. Although S&P has (finally) had the courage to downgrade the American rating, investors are illogically turning to treasuries as a safe haven. Let us not forget the charade the debt ceiling deal was. If everything goes according to official estimates, the US federal government will have to pile on over US$ 6 trillion in additional debt in ten years. One cannot claim the deal has in fact solved the problem. The can has been kicked one more time.  

What is indeed close to its fateful end is the viability of the welfare state. Not that it has ever been viable. But more than never, the evidences are clear and impossible to deny. Especially when one realizes that the unfunded liabilities (Social Security and other programs like Medicaid and Medicare in the US) are not being taken into account either in the deficit ratios or in the efforts to balance the budget.

Deficits and indebtedness measured by traditional indicators lack a highly important quality, they are not forward-looking. Unfunded liabilities like pension schemes are not reflected in the commonly used indicators, such as budget deficits (overall, primary and structural), gross debt, and even public sector financial net worth. Demographics will weigh heavily in EU member states which have not yet engaged in structural reforms, increasing their long-term fiscal gap. Consequently, while countries may be embarking on budget constraints on the short-term, their efforts might not be sufficient to meet liabilities over longer horizons. It is hard to picture how society will react once the time to solve this equation comes.

In summary, there is no room left for recommendations such as "spend now and deal with deficits later", even though some people continue to live in denial[5]. Under the pretext of solving the greatest crisis since 1929, governments unloaded all the monetary and fiscal ammunition a modern Central Bank has. They have tried everything, when, paradoxically, no further meddling was all the economy needed. The long term has never been so short. It is long past time we put the fiscal house in order.

[1] Skousen, Mark (ed) (1992), Dissent on Keynes: a critical appraisal of Keynesian, p.42

[2] Ibid. p. 43.

[3] Rothbard, Murray N. (2009), Man, Economy, and State with Power and Market, Auburn, AL, US: Ludwig von Mises Institute, p. 938.


[5] It is laughable that there are some people who, in all earnest, still cling to this policy recommendation

Sobre o autor

Fernando Ulrich

Fernando Ulrich é mestre em Economia da Escola Austríaca, com experiência mundial na indústria de elevadores e nos mercados financeiro e imobiliário brasileiros. é conselheiro do Instituto Mises Brasil, estudioso de teoria monetária.

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