America has recently been breaking many economic records since September 15, 2008, when Lehman Brothers, its fourth-largest investment bank, collapsed and “officially” triggered the global economic slump. Unemployment figures (at ten percent) have been rising to historic heights as stocks plunge to historic depths. At 12 percent of GDP, the government deficit (what it has to spend over what it earns) is the highest in peace time (it grew to 100 percent during the Second World War). Under the Troubled Asset Relief Programme (TARP), $700 billion of state funds are being used to stimulate the flow of credit through the financial system. An additional $787 billion in government spending (on infrastructure, renewable energy, tax relief) is aimed at stimulating economic activities and consumer spending.
These are extraordinary times. Government actions have become central to creating jobs and driving growth. But the economics is pretty mundane. In the Third World and, to an extent, Europe, many see the crisis as proof of the severe limitations of free-market economics. The argument is more sharply drawn in America where monetarists (led by the Harvard economic historian, Niall Ferguson) are pitted against resurgent Keynesians (led by Paul Krugman, the 2008 Nobel Economics Laureate). The debate is affecting the response of the Obama administration to the crisis and hence, the course and pace of economic recovery internationally. It also provides a thought-provoking crash course on the impact of the government’s policy levers everywhere.
Monetarists claim that the size of the government deficit threatens future economic growth because the government is storing up inflation. Its fiscal policies (flushing all that $787 billion through the economy) contradict the policy of the Federal Reserve (the American Central Bank) to stimulate the flow of credit through low-interest rates. As more money is pushed into the economy and prices rise, the Fed would have to raise interest rates to curb inflation, thus hurting private sector borrowers. As more people (domestic investors in bonds and the Chinese government, a big buyer of American bonds) begin to doubt the ability of the American government to pay back, the interest rate on bonds rises as the risk of default is factored in. The American government’s ability to pay depends on how fast the economy starts to grow and how fast it can cream off more income and corporate taxes.
The monetarists think they have seen inflationary wolves and they are crying. The interest rate on 10-year treasury bonds rose from 2.07 percent in December 2008 to 3.715 percent, a 79 percent hike, in June 2009. The market is charging Uncle Sam more for the money it is lending him because it is beginning to doubt his ability to pay.
Paul Krugman’s camp sees “nothing to fear but the fear of inflation itself”, to use the words of a BBC economics commentator. In the Keynesian view of the economic world, there is an excess of desired savings over willing investment in the economy. Consumers who have borrowed too much during the credit boom are now saving rather than spending. Companies cannot access credit because banks have to conserve capital which has been depleted by bad lending decisions so they cannot invest. Companies who have capital also cannot invest because consumers want to save. No investment, no growth, no jobs. The only economic actor that can inject demand into the economy is the government. To Keynesians, inflation is a long-term worry if it is at all. Inflation will be dampened by the low prices of eager Chinese exports and the high rate of unemployment which will keep wages low. The fund manager, George Soros, thinks there is a threat of a recovery being choked off as policy makers raise interest rates to curb the inflation that exists only in their heads. In fact, Keynesians see the rise in bond rates as evidence of “green shoots”; panicked investors who could only put their money in “safe” American government bonds in the last quarter of 2008 are now confident enough to buy stocks and other assets. There are fewer takers of the bonds.
Behind these positions are a range of “principled biases” about how an economy should run. Monetarists firmly believe all the government should do to stimulate growth is aid private decisions i.e cut interest rates to make firms borrow and invest and cut taxes to help citizens spend on services and products. Keynesians believe that the government should do much more, especially in a recession. They accuse monetarists of not seeing inflationary potentials in George Bush’s tax cuts.
Abimbola Agboluaje is Managing Director of WNT Capitas.
(This is the first of a three-part series which examines arguments for and against the fiscal stimulus of the Barack Obama Presidency that was first published in July 2009 in BusinessDay. As the world deploys another round of fiscal stimulus to fight the economic fallouts of the COVID-19 pandemic, arguments about the appropriate objectives, limitations, and consequences of government fiscal interventions will be revived. The second part of the series, Why FDR is Popular Again, will be published on Monday 6 April 2020)