Enlightened Economics

By Ron Robins. First published June 3, 2010, in his weekly economics and finance column at alrroya.com

While visiting the London School of Economics in the autumn of 2008, Her Majesty Queen Elizabeth asked Professor Luis Garicano a straightforward question. Quoting the Financial Times, from November 4, 2008, “if these things [causing the financial meltdown] were so large, how come everyone missed them? Prof Garicano apparently replied, ’someone was relying on somebody else and everyone thought they were doing the right thing.’”

I have some other views. Economics as practiced is still the ‘dismal science.’ Most economists rely on economic modelling for forecasting. It rarely works. Economists ignore key relevant data. Fearing for their jobs they stick with the comfortable view. Massaged government statistics also lead them astray. Furthermore, complicit media rarely question prevailing economic orthodoxies or the ‘adjusted’ government data, adding to delusional thinking. Economists’ reliance on Keynesian economic theory is likely to lead them off course and to miss the next, potentially more disastrous, downturn. Now let me flesh out the details of these points.

Reliance on faulty models and statistics
No economic model can account for sudden changes in consciousness, individual preferences, or exogenous factors. As Alan Greenspan, former head of the U.S. Federal Reserve said in March 2008, “the essential problem is that our models – both risk models and econometric models – as complex as they have become, are still too simple to capture the full array of governing variables that drive global economic reality.”

Before the meltdown, economists completely ignored voluminous data pertaining to excessive debt growth and leverage. In the U.S. and similarly in other developed countries, between the early 1980s and until the financial meltdown, annual consumer and private debt growth often greatly exceeded income and GDP gains by 100 to 200 per cent. U.S. data showed that in “2006 it took $6.32 of new debt to produce one dollar of national income.” Yet mainstream economists either did not know, or totally ignored this rapid accumulation of excessive debt and negative debt productivity with their potential for creating a devastating negative economic shock.

Even if most economists glimpsed the possibility of a forthcoming meltdown, many preferred to say nothing about it. What bank economist would want to tell his management to halt lending while every other bank is massively expanding it? A fall in the bank’s stock price could follow such an announcement and the economist would either have to retract his words or possibly be asked to leave.

Statistics that economists rely on, most especially in the U.S., have been so modified over the past three decades that comparisons with prior periods or with other countries is almost impossible. They also make the U.S. economy look better than it really is. I suggest readers go to www.shadowstats.com for an understanding of how U.S. governments’ statistics have been changed. Relying on debatably biased statistics provides cover for politicians and compliant economists to project rosier views of the world than might really be the case.

The potential of faltering consumer demand should have been obvious to economists by 2007. In the U.S., savings rates (whose statistics were again revised and look ‘better’ than they used to be) dropped to all time lows hovering in the -2 to 0 per cent range of after-tax disposable income. This was while debt service levels were at all time highs. These extremes demonstrated that consumers could retrench in their spending at any moment. Yet mainstream economists never sounded the warning!

Complicit, non-analytical media fed economic illusion
The media were at fault too. Facing deadlines and wanting ‘reputable’ quotes, they inevitably interviewed economists from major financial institutions who had a vested interest in not rocking the boat. A few years ago a top Canadian journalist, when asked why he primarily quoted bank economists on the economy, replied that they were always available, whereas economists in academia – who might give a more independent view -were not.

Keynes theory inappropriate today
Most economists follow Lord Keynes’ economic theories. A principal concern of his was what he called the ‘output gap’—the difference between an economy’s potential output versus its present performance. If the economy was underperforming, Keynes advocated the government spend and borrow more to close the gap. Of course, this is what governments are doing today, spending and borrowing anywhere from 3 to 16 per cent of their GDP as private consumer demand for goods and services has fallen precipitously.

Keynes also indicated that in good economic times governments should tax more and run surpluses to offset the deficits of bad times. However, I have not seen any large developed country government or international economic agency project surpluses in the decade ahead. Thus, Keynes’ theory relating to eliminating government deficits will not work today. His current day followers conveniently neglect this aspect of his theory. Thus, huge debt accumulation with no offsets is facing developed countries.

Debt growth to depress economic activity
Now with developed countries’ government debt expanding rapidly, a limit to their bond issuance might be reached.

In a major report last March, the Bank for International Settlements (BIS)—the ‘central bank of central banks’—studied government debt trends in twelve countries including the U.S, U.K., Germany, France and Japan. The Bank said that, “drastic measures [bold added] are necessary to check the rapid growth of current and future liabilities of governments and reduce their adverse consequences for long-term growth and monetary stability.” Drastic measures means big government program cuts and higher taxes, which create slow or declining economic growth.

Highly regarded Professors Carmen M. Reinhart and Kenneth S. Rogoff confirm this prospect of slow or negative growth ahead in their seminal study, “Growth in a Time of Debt,” published January 2010. They found that when government debt/GDP ratios are, “… above 90 per cent, median growth rates fall by one per cent, and average growth falls considerably more.” BIS estimates put U.S. government debt exceeding this threshold: at 92 per cent for 2010 and 100 per cent in 2011.

Economists once again getting it wrong
Her Majesty, just like her subjects and the citizens of most developed countries, were all misled by their economists. The majority of economists today have not changed their ways, continuing to fall prey to all the concerns earlier mentioned, and again painting a rosy picture for the next few years. Quoting Christina Romer, Chair, U.S. government’s President’s Council of Economic Advisors, “the Administration forecasts [real, after inflation] growth of 3 per cent in 2010, followed by growth of 4.3 per cent in both 2011 and 2012. Our estimate of growth in 2010 is virtually identical to the consensus of private forecasters surveyed by Blue Chip Economic Indicators (Blue Chip) and is right in the middle of the central tendency of the Federal Reserve’s Federal Open Market Committee (FOMC) forecast released in November.”

Such consistent rapid growth has not been seen for many, many years—and never in periods of such overbearing private and public debt. My bet is these economists, like most of the others, get it wrong again!

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