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November 14, 2008
We can see one of the reasons why NSW is in the doldrums. Michael Costa, the former Treasurer, doesn't like Keynes. He says in The Australian that traditional Keynesian macro-economics is the theoretical refuge of economists who continue to believe economic magic can occur by the government waving its fiscal wand. The reality is that the market is best left to do its adjustment thing. Costa says that we need to put Keynes aside for a while and pick up Joseph Schumpeter and read about creative destruction.
Costa mentions Paul Krugman, as an example, and questions Krugman's argument that monetary policy by itself won't solve the financial and economic crisis and that a fiscal stimulus for the US economy is also needed.
What is wrong with this Keynesian argument? According to Costa:
How Krugman can equate this situation with the circumstances of the '30s described by John Maynard Keynes in his General Theory is difficult to understand.Even if you accept Keynes's analysis that lack of effective demand was responsible for the mass unemployment of the '30s, you would be hard pressed to credibly argue, coming off the recent speculative asset bubble, that lack of effective demand has caused the present problems....what is absolutely clear is that attempting to maintain aggregate demand at the levels seen during the asset bubble is a recipe for further financial dislocation.
Krugman is not saying that we need to return to the levels of demand of the asset bubble. What Krugman says is that:
what the economy needs now is something to take the place of retrenching consumers. That means a major fiscal stimulus. And this time the stimulus should take the form of actual government spending rather than rebate checks that consumers probably wouldn’t spend.
As Martin Wolfe asks on Lateline: what are the engines of demand to pull the world out of this? He adds that historically the final engine of demand for the last 10-15 years has been the US consumer; and to a lesser extent the consumer in the United Kingdom, Australia, Spain etc. However, the big spending consumer is no more. So, where is the demand going to come from that will really pull the world out of this tailspin?
Costa opposes this form of fiscal intervention in favour of letting the market do its automatic adjustment thing coupled with a bit of welfare for the deserving poor:
As the recession bites, households' ability to consume at the levels of the recent past will certainly be curtailed. But remember, this household expenditure was based on excessive leverage and clearly unsustainable. A period of economic contraction and financial deleveraging is the natural, albeit unpleasant, antidote to the excesses of the period. Certainly the Government should provide support to those caught up in the inevitable adjustment process. In many ways the automatic stabilisers built into the system already provide that support through the social security system.
On Costa's account the present financial crisis is caused by the failure of government institutions, principally central banks, that were reluctant to burst the asset price bubble and are unwilling to accept the inevitable readjustment by the market. The inference is that government intervention should be minimal, because the market will inevitably produce the most efficient outcomes. So we should work to restore faith in markets.
His free market ideology Tiss that free markets are always best. This belief holds that that markets ultimately work themselves out, and therefore only need small nudges in the right direction by governments. If free markets are always the solution, then there is little need to flex the muscles of government when markets fail.
That still leaves us with the problem of where the demand going to come from that will really pull the world out of the recession tailspin? Costa's argument is that there are plenty of investment opportunities in the global economy that would return more than the risk-adjusted cost of capital. Markets are sufficient to generate investment, and people aren't hoarding scarce capital because of lack of profitable opportunities; rather, they are confused.
The immediate objection is that this overlooks the fact that without effective demand there is no point in firms investing in capital equipment. Costa's response, however, would be that investment drives growth not consumption---investment creates jobs that create the demand they keep the rest of the economy going.
However, if consumption is falling, and private investment is unable to compensate, then the federal and state governments should--have to---fill the gap. Secondly, Costa's defence of the free market is strange given that the market has failed, free market financial capitalism is broken, and the core of the lending system has been nationalized. This happened because something had gone terribly wrong, the financial world has been mismanaged, and people are now living in a world of hurt.
Where Costa is right is that we are entering a period of structural adjustment, and it will be painful for many.
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The idea that the until-recently NSW Treasurer deserves serious attention on any economic issue is laughable. Like all good political thugs he chooses to assert that something is 'absolutely clear' in lieu of developing a coherent argument, which might require inconvenient stuff like evidence and logic.
Of course the current downturn wasn't caused by insufficient demand, but a drastic drop in consumer demand will be one of the consequences. Government deficit spending to help sustain levels of economic activity is therefore highly desirable.
Reading Costa's ill-informed economic 'analysis' helps us understand why NSW is such a basket case. His columns serve no other useful purpose apart from illustrating the urgent need to get rid of the Labor government in this state.