Among their most prominent thinkers, there is no consensus as to how – or whether – governments in advanced countries can improve lackluster recoveries. All in all, the situation recalls a cruel joke:
How many economists does it take to change a light bulb? None. When the one they used in graduate school goes out, they sit in the dark.
Recently, economists at the Organisation for Economic Cooperation and Development (OECD) published a retrospective study of its economic forecasts. This qualifies as an act of bureaucratic courage, because the record was predictably dismal. Not only did the OECD miss the 2008/09 financial crisis, but it routinely over-predicted the recovery’s strength. In May 2010, for example, the OECD forecast that the US economy would grow 3.2 per cent in 2011. Actual growth was 1.7 per cent. This is a huge error, and there were larger misses for some European economie as well.
The OECD wasn’t alone. As the study notes, ‘groupthink’ is endemic among forecasters. The International Monetary Fund, private economists and government agencies — including the Federal Reserve and Congressional Budget Office — all committed similar mistakes.
In explaining its poor performance, the OECD cites three under-appreciated forces.
First, globalisation: The weaknesses of some economies, especially the United States’, depressed other economies through reduced trade and greater financial strains.
Second, fragile banks: Countries with undercapitalised banks fared especially poorly, presumably because the banks lent less.
And finally, economic regulation: Highly regulated societies had a harder time adjusting to adversity than more flexible societies.
All these underestimated factors made forecasts too upbeat, says the OECD. Interestingly, one item not on the list is “too much austerity.” The OECD economists found that they generally hadn’t underestimated the effects of spending cuts and tax increases intended to shrink budget deficits in Spain, Italy, Ireland, Portugal and elsewhere. Greece was a conspicuous exception.
This conclusion is surely controversial because many economists attribute the weak recovery to misguided austerity, especially in Europe. Just follow the advice of John Maynard Keynes (1883-1946), they say. When the economy suffers a massive drop in private spending, government should offset the loss by increasing its budget deficits. Europe’s budget cuts were too aggressive, they say, while US “stimulus” policies were not aggressive enough.
Perhaps history will vindicate this appeal to Keynesianism. Or perhaps not. The fact is that the United States did respond aggressively under both George W. Bush and Barack Obama. It certainly didn’t embrace austerity. Federal budgets ran massive deficits — $6.2 trillion worth from 2008 to 2013, averaging 6.4 per cent of the economy (gross domestic product). Nothing like this had occurred since World War 2. Yet, the economy limped along. Why wasn’t this enough?
It’s not just Keynesianism that’s under a cloud. The same fate has befallen monetarism — the doctrine that stable growth in the money supply can promote a more stable economy. Since 2008, the Federal Reserve has poured more than $US3.2 trillion into the economy to keep interest rates low and accelerate economic growth. By monetarist reasoning, so much money pumped out so quickly should spawn higher inflation. Some economists predicted as much; it hasn’t happened yet. Consumer prices today are up a mere 1.5 per cent from a year earlier.
If you add the last six years of US budget deficits and the Fed’s injection of cash into the economy, the total is approaching $US10 trillion. It’s hard to believe that all this stimulus didn’t aid the recovery, but the fact that it resulted in only modest growth has created an identity crisis for economists. The promise they held out was that, through suitable economic policies, they could produce long periods of stable growth and – just as important – avoid prolonged slumps and lengthy periods of substandard growth. Clearly, they aren’t delivering on this promise.
The Great Recession and financial crisis changed behaviour in fundamental ways that economists have yet to incorporate fully into their models or theories. The widespread faith that modern societies were sheltered from deep and sustained economic setbacks has been shattered, causing consumers, business managers and bankers to be more cautious in borrowing and spending. Economic stimulus may offset this caution, but if it signals that the economy is weaker than expected, it may also further depress private spending. There are countervailing tendencies.
The faith in economics was, in many ways, the underlying cause of both the financial crisis and Great Recession — it made people overconfident and careless during the boom — and the basic explanation for the weak recovery, as stubborn caution displaced stubborn complacency. To regain relevancy, economists are searching for a new light bulb — or better use of the old one. Meanwhile, most are still sitting in the dark.