As Hurricane Irene barrels up the coast and the weather service warns about hurricane conditions in New York, at Via Meadia this morning we are more concerned with short term weather forecasts than with medium term economic predictions. Nevertheless I see from the Twitter feed that Nouriel Rubini (@Nouriel) is predicting a double dip recession after Goldman Sachs, which had been expecting 4 percent growth by the end of 2011 back at the start of the year, revised its growth prediction for the second half of this year down to 1.0 percent.
Nouriel is scarcely a voice crying in the wilderness; much of the talk among economics writers these days seems to be an argument over whose fault it is rather than over what comes next. Paul Krugman and Dean Baker are making the left/liberal case that there hasn’t been enough fiscal and monetary stimulus yet; almost everyone is pointing at Japan and warning that the US risks a prolonged slump on the Japanese model.
We’ll see; economic storms are like hurricanes. No matter how much you study them they retain a capacity to surprise. They jiggle and swerve; they blow up into Cat 5s without warning and then suddenly diminish. There’s almost certain to be ugly weather in Queens this weekend; we won’t know quite how ugly until its here.
The economic questions facing us seem unusually large. Unlike other economic crises in recent decades, this one seems to involve the foundational institutions and assumptions of the modern economic system. We’ve had Latin American debt crises; we had the Asian financial crisis; we had a dotcom bubble.
What we have now is something more pervasive: this crisis touches on the credibility and solvency of the national governments that have backstopped the financial system and moderated the effects of the business cycle since World War Two. It is not clear today that even the US, the EU and Japan have the financial resources, the technical skill or the political judgment required to play that role in the 21st century.
Several factors have brought us to this pass. Financial markets are deeper, more complex and more global than ever before, and the explosion of IT and communications technology has transformed the world of finance beyond recognition. These markets move faster than ever before, the mass of money involved makes intervention more difficult, and the dance of complex securities with unpredictable effects, market psychology, different national economies and the real economy is harder to understand than ever before. It is much harder to be a good central banker today than it was in 1958.
At the same time, the dynamics of the global economy are different from those of relatively closed national economies or of the old Atlantic world. The interplay between mercantilist Asia, spendthrift America, shell shocked Japan and social market Europe — to say nothing of the rest of the world — is different from anything we have experienced before and economists, investors and policy makers are frequently surprised by the dynamics of the emerging new system.
Meanwhile the real economy is changing in unprecedented ways. The manufacturing economy has become much more productive and globalized; there is a huge overhang of excess capacity globally and the returns to manufacturing are likely to be severely squeezed going forward. The high value service sector is also changing rapidly as IT capacity grows. The terms of trade between producers of commodities and manufacturers — favoring manufacturers most of the time for the last 100 years — seem to have changed, though it is hard to say how permanent this is. These interlocking sets of changes in the real economy interact with the global economy and financial markets in ways that make the picture that much harder to interpret — and add to the volatility of the economy overall.
Meanwhile governments in the advanced economies, though very large and powerful by historic measures, have less economic discretionary power than before. The rise of entitlements and transfer payments in advanced countries tends to turn national governments into passive economic spectators. The demographic decline and structural economic changes make those welfare states unsustainable and saddle advanced countries with almost incalculably large unfunded liabilities looking ahead. This means that governments have much less fiscal running room than they did twenty or even ten years ago, and the need to get the long term debt picture under control leaves less and less fiscal flexibility for short and medium term stimulus.
At the same time, we are paying an unexpected price for decades of controlled and managed economic performance in the proliferation of moral hazard at all levels of the economy. People have come to believe that governments can and will backstop the economy. This leads them to underestimate and underprice risk, and it has contributed to the series of expensive asset price bubbles of the last twenty years. People have lived in a bubble of artificial safety based on the belief that technocratic Keynesian management of a fiat money system can deliver semi-permanent prosperity without the disorienting booms and busts that made our great-grandparents so cautious and crabbed in their thinking.
The current period of economic trouble is so unsettling because it is a test of whether the post World War Two method of economic management still works. Can our current system of Keynesian macroeconomic management policed by independent central banks operating fiat currencies really work? In different ways, the fundamental assumptions of modern economic policy are being tested in Japan, the EU and the US and in none of these places can we assert with confidence that the test has been passed.
That is what is different about this crisis: other crises since World War Two have tested the institutions and arrangements of the global economy. This one is testing the foundational assumptions and policies of the modern economic order. The stakes are much higher and the way forward is less clear.
Lucky us; we are living in interesting times.