Nobody Knows

“Nobody really knows.” This is a phrase we should use more often, yet it’s guaranteed to send producers at CNBC running for the hills. If you want coverage, whether in the Financial Times or Bloomberg, you better pick a side. “Austerity will unleash a boom.” “Austerity will cause a depression.” Pick one of the above, but whatever you do, don’t sit on the fence.

Well, I happen to like fences. Despite the claims of Keynesian economists like Paul Krugman, the truth is that nobody really knew, in 2010, how austerity would affect Greece. It could’ve unleashed Greek animal spirits, so that the rise in private demand would’ve offset the reduction in public demand. Or it could’ve crushed those same animal spirits and exacerbated the malaise. Both of these outcomes were theoretically possible. To claim we knew the outcome with certainty is equivalent to saying that we can omnisciently predict the behaviour of tens of millions of individuals, or that we have such rich historical datasets that we can forecast with absolute confidence that austerity in Greece will always trigger a depression. But the truth is, none of us are prophets, and despite some anecdotal evidence from the Great Depression, our historical data is pretty patchy. Even today, when it might seem painfully obvious that austerity is behind Greece’s unconscionable levels of unemployment, can anyone empirically prove that the real problem is not inadequate structural reform? Or too tepid austerity?

To be clear, I’m personally more attuned to the Keynesian argument. I find the economic logic coming out of Berlin implausible, but this doesn’t mean it’s impossible. Perhaps in some universe, in some time, with some combination of human behavior, it’s possible that an austerity-led boom would’ve come to pass. I take the same view in regards to the Neo-Fisher claims that a hike in interest rates will unleash an economic boom. It’s implausible, but it’s not impossible. Theoretically, it’s possible that the prospect of higher rates will encourage borrowers to speed up their investments, or that it reduces the rate of savings by giving savers more interest on their income. Implausible, but not impossible.

And this is the fundamental problem with our economy: we have no idea how private-sector demand will react to a certain event or a certain policy. The variables are simply too many, the feedback loops too complex.

Perhaps one day, after decades of morally dubious social experiments on countries like Greece (austerity) and Japan (mind-boggling QE), our statisticians will have accrued enough data to give weight to our predictions. Maybe then, with absolute (statistical) certainty, we’ll be able to say: QE works in this situation, but government stimulus is needed in that one. Or: a stimulus of 5% of GDP is sensible, but 10% is dangerous. But even then, will we believe such economic pronouncements as we do the law of gravity? All it takes is for one poorly calibrated stimulus to trigger inflation and the tub-thumping deficit hawks will drive us back to the drawing board.

This problem — “nobody knows” — is a big part of the reason why we need to adopt a neutral monetary system. In the crudest sense, neutral money fixes demand at the level needed for full employment. It’s really that simple. So however happy or sad consumers may feel, however bullish or bearish the stock market, demand doesn’t change. Spending may shift from one industry to another, or from the public sector to the private sector, but it can never shrink below the level needed for full employment. As anyone who reads my book will discover, the changes are drastic. But, sadly, I don’t see any other sustainable option. With secular stagnation lurking on the horizon, the time for drastic thinking is now.

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[…] The problem, as with most economic theories, is the lack of empirical certainty. Although a lot of evidence supports my view, it is ultimately impossible to say for certain whether the structural decline in workforce growth is the prime culprit. The participation rate is simply influenced by too many factors—from cyclical issues like depressed expectations to structural ones like women entering the workforce or people returning to college. Once we start asking questions like: are more people studying for second degrees because of an increased interest in education or a weak job market? we enter the ambiguous realm of “Nobody Knows”. […]

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