Theorists lose the plot

If poor economic performance produces even worse politicians, the downside risk to living standards is essentially unlimited

By Martin Hutchinson 
Add Milton Friedman to the list of economists whose solutions have come under fire. Predictors - including this column - have been confounded by strange economic behavior in the five years since the 2008 downturn. 

For monetarists, whether Friedmanite or Austrian like me, the strangest feature has been the failure of inflation to re-emerge, in spite of massive overstimulation of the money supply and prolonged negative real interest rates. For others of different persuasions, the Great Recession has surprised by failing to produce results from massive Keynesian stimulus, by the prolonged failure of labor force participation to return to its pre-recession levels and by the persistent decline in real wages even in a time of economic recovery. Existing economic theories of all political shades have failed to predict the course of reality. 

The biggest casualty of the last few years should surely be Friedmanite monetarism. M2 money supply in the United States is currently expanding at 6.5% over the last year and 11% over the past two months, and has been expanding at a steady 7% over the past five years, much faster than nominal GDP. Yet, rising consumer price inflation is nowhere to be seen. 

Add to that Friedman's own apostasy in the last few years of his life, when he praised then Federal Reserve chairman Alan Greenspan's mad expansion of the money supply, at a time when he could really have helped sound-money believers, and the man's credibility is shot. (Maybe not as badly shot as Maynard Keynes's, but dented nevertheless.) 

Friedmanites will make two responses to this. First, they will claim that we should be looking at M4, which has been expanding much more slowly than narrower measures, rather than any of the narrower measures of money supply. While the Fed has been expanding the monetary base like madmen, the banking system has not been making business loans aggressively, but instead has placed over US$1 trillion of extra reserves on deposit with the Fed. 

There is a certain amount of truth to the above claim, but there is a lot more to the Friedmanites' second claim, that inflation has been rampant over the last five years, but has manifested itself in asset prices and (until 2011) commodity prices. 

There is no question US stocks, in particular, are in a major bubble that shows increasing similarities to that of 1997-2000, while the prices of such assets as farmland and collectibles are reaching levels never before dreamed of. But to some extent this isn't a very helpful response; arithmetically, the gigantic money creation has to go somewhere, and it isn't clear at first glance whether rising prices of miscellaneous assets are particularly significant or damaging. 

Friedmanites are not alone in having their favorite nostrums exploded by this downturn. Keynesians too have seen unprecedented budget deficits in many countries, most notably in Japan, where deficits have been continuous for 20 years. Economic growth has been notably lower than in previous decades, when deficits were lower and budget positions sounder. The more extreme Keynesians such as Paul Krugman now claim that the problem is that deficits haven't been large enough. Running twice the deficits would have produced twice the "stimulus", they claim. 

However there's no evidence for this. The countries most enthusiastic about Keynesian spending stimulus such as Spain and Greece have only had to adopt unprecedented levels of austerity as the money ran out. What's more, even within the rapidly growing emerging markets, the countries where deficit spending has been attempted, notably India, Brazil and China, have all seen their economies run into considerable difficulties this year, suggesting that British, Japanese and US deficits have only been sustainable because of those countries' previous stellar credit records. 

The Austrian theory about the global economy's trajectory hasn't been disproved yet, because it hasn't been tried. According to Austrian analysis, very low interest rates should produce a credit bubble and a surge of damaging "malinvestment" - investment ill-targeted to the real needs of the economy and incapable of producing output at an economic cost. The malinvestment then produces a recession, which would be prolonged by further malinvestment such as Keynesian "stimulus" spending. 

There was certainly evidence before 2007 that the low interest rates of that period produced malinvestment in housing, and we got the recession as advertised. However the renewed surge in ultra-cheap money since 2008 has produced first a surge in commodity prices and then a surge in stock prices, but not so far a surge in corporate or private investment (except for a so far mild recovery in housing). 

Austrian theory says the bubble in stock and other asset prices must burst, producing a more severe recession when it does so, but the theory cannot be given credit for a successful prediction before that prediction turns out to be correct. 

Having demolished the analyses deriving from standard economic theories, there are some predictions we can make from first principles. First, it has been clear for a decade that modern communications and the Internet have made it much easier to outsource production worldwide, to countries with labor costs a small fraction of those in the US, Europe or Japan. 

Globalization was celebrated for 20 years until 2008, but even at that time it should have been obvious that its effects on Western living standards were damaging, especially when it was combined with excessive levels of low-skill immigration. 

The recession since 2008 has brought the decline in Western living standards into clear focus. It is not clear how much further that decline must go, but the signs of inflation and labor unrest in China should be very encouraging to those Westerners seeking to make a semi-skilled or unskilled living. Outsourcing has now spread beyond China to countries with even lower wages, and back to some middle-income countries like Mexico where the logistics are favorable. 

But if markets are allowed to take their course, it would appear that we are much nearer the end of telecom-sourced outsourcing than the beginning. We can thus rejoice for those in China, India and especially Africa whose living standards have been improved, while breathing a sigh of relief at the lessening of the threat to our own. 

For US and European employment to recover, however, costs - especially those imposed by the public sector - must be reduced, and for the last five years the tendency has been to increase them. 

Second, there was a surge in 2007-09 in belief in global warming, which produced a surge in subsidies to "green" energy projects, regulations affecting existing energy, state investments in "new energy" and taxes on disfavored energy sources. 

You only have to look at Germany to see that this has seriously affected economic output. In that country, in 2011 electricity cost 70% more than in Britain and three times the US cost. Naturally, energy-intensive industries such as steel have been badly hit while Germany's traditional power companies are heavily loss-making. 

In the US, the most obviously costly "green" legislation is the subsidy to growers of cellulosic ethanol, which isn't even climate-friendly. However, there's also the massive investments in hopeless projects such as Solyndra, Fisker and the California High-Speed Rail project (which fortunately seems likely to be cancelled after absorbing only some $5 billion of our money rather than the $80 billion it was scheduled to waste.) 

However, if this wasn't enough, you must count the cost of the tightened CAFE (corporate average fuel emission) standards, which will make it almost impossible to manufacture petrol-driven automobiles with an acceptable degree of safety by 2025, and are already imposing huge conversion costs on manufacturers selling into the US market. 

This is all "malinvestment" in the Austrian sense, but it has been caused not by the global recession nor by global monetary policy but by foolish, politically motivated regulation and subsidy. To the regulations outlined above, you must add the regulations the US Environmental Protection Agency will shortly impose on coal-fired power stations, which over a period will have the effect of shutting down the coal-fired power sector at a cost of some $27 billion annually, the current difference between coal-generated and gas-generated electricity. 

You must also add the refusal to build the Keystone pipeline, which has imposed costs of some $10 billion annually, albeit most of them falling on unfortunate Canadian oil producers through lower prices. 

Combine this politically directed malinvestment with the inevitable malinvestment resulting from budget deficits, which result in resources being redirected to the wasteful public sector from the private sector, where they are optimally allocated by the price mechanism, and you have a reasonably convincing explanation for the growth sluggishness of the last five years. 

The precise mixture varies from country to country. In the United States, Britain and Germany, investment in and subsidies for misguided greenery is probably the most important component of growth's failure. 

In Japan, where growth has lagged for 20 years, the lag appears to be caused by continual budget deficits and now the gigantic debt, funded by diverting Japan's private savings into politically managed operations like the postal savings bank and the state pension fund. 

Here some of Prime Minister Shinzo Abe's initiatives, like the devaluation of the yen (which works, albeit on a beggar-my-neighbor basis) and the encouragement of pension fund investment into the equity markets, seem likely to produce somewhat better growth, but his continual deficit spending will do no such thing and may well make the entire operation un-financeable at some point, causing outright economic collapse. 

In summary, therefore, there are a number of changes we need to make to standard economic models. We need to recognize that money supply growth does not necessarily cause inflation, especially if resources in much of the economy are being allocated by political means. We need to recognize that deficit spending, if it becomes ingrained, may itself produce long-term economic sluggishness because resources are being allocated sub-optimally. 

Finally, we need to recognize that malinvestment takes many forms, and if it is distributed throughout the economy may take a long time to produce an economic downturn, merely being reflected in sluggish growth and higher unemployment than normal. 

The most serious economic implication of prolonged sluggishness, however, comes from Public Choice Theory. As politicians persistently fail to produce decent economic results, the electorate becomes disillusioned with traditional politicians and their economic policies and seeks solutions among new faces with new economic ideas, however economically spurious. 

In the 1930s, this brought the rise of Nazism, democratically elected in Germany. This time, it has already resulted in greater success for fringe parties throughout Europe, both of the left and the right. Even in the United States, traditional constitutional checks like the filibuster are being abandoned, and the probability of an extremist success in 2016, most likely from the left, is much higher than it was. 

Needless to say, if poor economic performance produces even worse politicians, the downside risk to living standards is essentially unlimited.