COLUMN-Counterintuitive economics can help politicians

Thu Dec 6, 2012 10:53am EST

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By Anatole Kaletsky

NEW YORK Dec 6 (Reuters) - Absurd wishful thinking. This is how most finance ministers describe criticism of their tough budget policies designed to control government debt and reduce borrowing. Britain, even more than Germany, has been in the vanguard of this austerity movement, as Chancellor of the Exchequer George Osborne demonstrated again in this week's budget statement:

"Confronted with tough economic conditions, some say we should abandon our deficit plans, and try to borrow more - they think that by borrowing more, they can borrow less."

For Osborne , this reductio ad absurdum seemed so conclusive that there was no need to justify his controversial economic beliefs.

To claim that a government should borrow more when its debts are already too high is ridiculous - as ridiculous as suggesting in the 16th century that the earth moves around the sun or that humans evolved from monkeys.

While economics does not deserve to be called a science on par with physics or biology, it is supposed to be a systematic and objective analysis of empirical evidence about the way the world works. The goal of such rigorous analysis is to find insights that are not obvious, and may sometimes even seem ridiculous to casual observers.

Several counterintuitive insights are now nearly universally accepted among economists - for example, that a country can usually gain more wealth by reducing trade tariffs than by increasing them. Others are still very much in dispute. Perhaps the most important of these, especially in the present global context, concerns public borrowing. Should governments try to reduce borrowing during an economic slowdown, or should governments borrow more or less without limit until economic activity revives and full employment is restored?

This is a complex and subtle question on which opinions among serious economists can reasonably differ and change over time. What cannot be described as reasonable, much less as serious economics, is the claim routinely made by politicians, including finance ministers and central bankers who ought to know better, that this is a simple question to be answered with the commonsense aphorisms beloved by Osborne and his counterparts in the German government and the U.S. Tea Party: "You can't cure debt with more debt."

This may seem obvious. But isn't it equally obvious from our perspective that the earth is flat? There is a parallel between the debt cliche and the flat-earth cliche. Both seem obvious at close quarters but break down when the world, whether economic or geographic, is viewed as a whole.

The world economy is very different from an individual company or a household. When individuals spend less than they earn, the savings they put aside give them a claim on the incomes of other people, allowing them to hire workers and make businesses grow, and this makes them richer.

But this cannot be true of the world as a whole. The world cannot spend less than it earns, because one country's spending is another country's income. So if the whole world tries to spend less than it earns, the result is not an increase in savings but rather a reduction in total income.

To make matters worse, the world as a whole cannot lay claim to anyone else's income, unless extraterrestrial workers arrive from Mars. The only way to increase global prosperity is by investing in technology and management. But businesses are reluctant to make new investments when they see consumer spending in decline.

The upshot of these arguments and others like them is the central conclusion of Keynesian economics: If private businesses and households collectively are determined to spend less than they earn, then government must spend more than it collects from taxes to make up the difference. If government instead tries to do the opposite, reducing its debts at the same time as the private sector, incomes will collapse - and government borrowing will paradoxically go up.

There are, of course, many caveats. One country can spend less than it earns if others do the opposite and spend more than they earn, thereby increasing their trade deficits.

Alternatively, government austerity can reduce interest rates and boost confidence, prompting more consumption and investment.

Such arguments justify genuine debate about how governments should respond to economic weakness - and serious economists reach different conclusions depending on the the conditions.

In 2010, Britain's incoming conservative government believed it could boost confidence by accelerating the budget consolidation that the previous Labour government had begun. Two years later it is clear that this bet did not pay off. Growth and deficit reduction have both been deeply disappointing, especially in comparison with the U.S., despite much bigger tax increases and spending cuts. In fact, there would be almost no reduction in Britain's deficits over three years - last year (121 billion pounds), this year (120 billion pounds) and next year (112 billion pounds) - if it were not for the new gimmick of transferring Bank of England profits to the Treasury at exactly the rate required to keep apparent deficits on a downward path.

Can the additional austerity imposed by the Conservatives in 2010 be blamed for this grim performance? Maybe not. But in 2010 the economy hovered between recovery and relapse into recession.

As with a finely balanced seesaw, where a small amount of pressure has a big effect, economics becomes a path-dependent process, with outcomes even harder than usual to predict.

In such circumstances, governments are bound to keep missing economic forecasts and targets. But they could try to limit the risks by basing policies on serious economic analysis, not oversimplified cliches and appeals to common sense that are just plain wrong.

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