El Pelado de Calvo

I found this Guillermo Calvo article over at VoxEU interesting.  His basic point is that spending more on stuff we don't need is a bad idea.  I think that part is completely correct, and I agree with the idea that you can't just pump more money into the economy and expect it to instantaneously go back to its pre-crisis trend.

Proponents of expansionary fiscal policy claim that the government should increase expenditure – spending what B can't and Lwon't – by issuing the Treasury bills that L wants. This closes the circle, the additional fiscal deficit is financed by L and the economy goes back to full employment.

But, unfortunately, economies in crisis are not that simple. The argument assumes that the government channels additional spending towards the very same goods that B cannot afford. This is not true in general. In the US, for instance, small firms lost access to working capital that the government spends on solar energy. Hence, sectoral "lack of demand" is unlikely to vanish. The sun will set on B goods and shine on government goods.

Fiscal expansion could thus have little impact on unemployment, because the unemployed in the sector that caters to B's tastes are unlikely to find new jobs in those sectors that benefit from the government's largesse. One important reason for sluggish employment creation is that stimulus packages are transitory and hiring-and-firing is costly. Sectors producing government goods will go on overdrive, but will be reluctant to hire new workers. Equally important, labour reallocation is costly and cannot take place in the spur of the moment: a bricklayer does not become a computer technician overnight. 

This is what I take to be the part of Austrian theory that is useful.  There really is a hangover because there really is a process by which our economic system discovers what people want and gears up to make it; equilibrium, if such a thing exists at all, is not instantaneous.  The more radically people's wants change, the bigger the hangover.

However, I'm less sure I buy the pot shots he throws at the Keynesians.

The subprime crisis is a financial crisis that threw a dark cloud of mistrust on financial intermediation; lender L stopped lending to borrower B, not because B became a rogue, but because L hears that people like her are worried about the health of the financial sector. That's the central reason why a small financial problem catapulted into the present global crisis. Many professional economists agree with that.

Once this is acknowledged, "lack of demand" is almost a corollary. If L does not lend to B, B's demand will have to fall. L is a lender and, therefore, now she has to find a place to park her money. The easiest alternatives are cash or Treasury bills. Therefore, B's forced austerity is not offset by L's overindulgence, and "lack of demand" springs to life. B's sudden austerity – it is worth stressing – is due to a credit crunch. He didn't become anorexic or lose his self-esteem as some Keynesians want you to believe. These psychological diseases may happen to him as crisis evolves, but the roots of his austerity are in a suddenly malfunctioning credit market.

At this point I'm pretty sure that the party line the banks use in front of congress -- don't regulate us because it will restrict credit which will kill the recovery -- is mostly full of shit.  The credit crunch was a trigger, I agree, but not a cause, as he seems to claim.  But that doesn't make the psychological malady produced by the trauma less real.  The problem really is that there really isn't any demand -- for loans or much else.  This isn't because B became a rogue or because L is too nervous to lend.  It's simply because B is already in way over his head, and no matter how cheap you make his loans, he's done.  Do I need to cite mortgage rates and current housing market stats to convince you of this?  Go read Richard Koo again.  And again.  Till the logic of the zombie holding pattern sinks in.  So I don't think that the fundamental problem is a credit crunch any more than I think the fundamental cause of WWI was the shooting of Fritz.  The problem was fundamentally an unbalanced economy that can't get back into balance quickly because the debt used to drive it away from equilibrium governs the speed with which it can return.  I wish that economists could wrap their noodles around the idea that money is real.  

But there's no point in getting academic over this.  Hayek and Keynes can rap about it till they're blue in the face, and the question will still be what do we do.  In the end I am tempted to side with the suggestion he makes here of cutting back on general fiscal spending but expanding policies that put money in the hands of people without jobs.  In an ideal world I might be inclined to argue that this is a perfect time for the government to spend on things like infrastructure that we have neglected for a long time.  But in the real political world we live in, I think this is a lost cause.  The spending we have engaged in so far, and the spending we are likely to continue to engage in may keep us out of a depression, but it will be aimless and useless in the long term, just as Japan's has been.  The government is an incredibly lousy allocator of capital.  That's the sort of system you get when the whole thing can be held hostage by some nitwit from Nebraska.  And there's always the looming threat that the best jobs program it can come up with is a war.

The next best option then is just letting the economy adapt on its own -- to let people go bankrupt, to let mortgages get written off, to let wages and house prices and equity prices decline till we get back to some semblance of equilibrium where we are actually able to start making the things people now want again -- and in the meantime to make sure no one starves.  This is pretty close to what Calvo is arguing.  And it seems to me the most politically plausible path closest to the very best solution, which is to get everyone in a room and have a fast track national bankruptcy procedure.  Writing off the pipe dream promises made to creditors wouldn't in itself right the system, but coupled with some changes in finance to prevent a recurrence, it seems to me that it would get things going faster than any other method.