We are at zero interest bound and the economy is in the liquidity trap. The greatest problem facing the world is a severe lack of final demand. There is a wall of overcapacity (the output gap between trend and actual growth of about 8%). The grim employment picture is the worst in the last six decades and will surely last for years to come given that fewer jobs are generated than population growth, which also pose long term risk to the country by making a large percentage of population permanently lose their productive skills. Central bankers are still burnishing their inflation fighting credentials while the median core inflation is showing a stubborn trend of heading south short of a future catastrophic shock. Meanwhile, bond vigilantes seem to live in a world in where up is down and down is up (or maybe they keep making the rudimentary mistake of confusing bond yields and prices). They tirelessly exert gravity on long-term government bond yield to the extent that the real cost of stimulating the economy is trivial if we could actually jump-start the economy to a sustainable level. With these facts in mind, the argument for “austerity now” in countries such as the U.S. is intellectually naked. Irish experience is a recent example of “austerity now” gone poorly. We shall take care of the austerity issue when the economy is on a sound footing.
Even with the intellectual nakedness of the “austerity now” emperors, this debate is far from a forgone event. It is important to keep pointing out their nakedness, because they are emperors and thus are in power to make life and death decisions for all of us and because they often think their power means that they have wisdom . It is important to educate the population to be imaginative enough to get accustomed to seemingly big numbers in the short term (say, e.g., expanding Fed balance sheet to US$10 trillions and another couple of trillions of fiscal stimulus) and to organize pushes for more stimulus from grassroots level. It is important because the consequence is dire without drastic actions. Without doing much, we are lucky to be bouncing around in the disinflation or mild deflation environment for a long time with no end in sight (think Japan, the most likely scenario). If we are really unlucky, we could have severe deflation. It is also important because once people start to get used to this new normal, it will require even bolder actions to eradicate the deflationary expectation.
At the same time, however, those of us who agree with substantially more stimulus need to ponder the unthinkable, “If we could obtain enough fire power to attempt jumping start the economy, can we surely generate sustainable growth within foreseeable future and how long that would take?” The answer may be just as long as it takes. After all, the greatest problem facing the world now is a severe lack of final demand. Also, in the aftermath of the current balance sheet recession, households are bound to struggle to save and pay off debt, and the approach of whole-sale bail-outs for most stakeholders guarantees that we are not in a 1930’s world in which households have escaped debt prison through defaults by this time of economic cycle. In addition, we should not expect another World War to wipe out and suck up all the overcapacity. Further, short of a trade war, the beggar-thy-neighbor tendency of global governments also makes the coordinated global rebalancing, which should be part of the plan for sustainable future growth, nearly impossible.
We have to identify the linchpin for sustainable long-term demand growth and plan for its attainment. I certainly hope it is not another bubble as in the last two decades. It seems that we need something else in addition to the stimulus (which likely will involve reducing the massive unemployment) and figuring out that something else probably lies in the core of the future intellectuality of the stimulus debate (Forget about China rebalancing its economy soon. Though it should be an important part of the solution, it will probably be too little and too late). I understand that many times we may have no choice but to improvise as events unfold, and we can attempt navigating the uncharted water with measures such as persistent pursuit of an inflation target. However, it helps to at least identify and think about the issue. At this point, figuring “it” out seems to be at the center of the intellectuality of any future stimulus debate. This shift from the debate with “austerity now” emperors will become much more evidence in the next few months, when the Fed, and maybe even the Congress, starts to injecting stimulus again in the face of certain faltering of economic growth.
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