Counterintuitive economics can help politicians

December 6, 2012

Absurd wishful thinking. This is how most finance ministers describe criticism of their tough budget policies designed to control government debt and reduce borrowing. Britain, even more than Germany, has been in the vanguard of this austerity movement, as Chancellor of the Exchequer George Osborne demonstrated again in this week’s budget statement:

“Confronted with tough economic conditions, some say we should abandon our deficit plans, and try to borrow more – they think that by borrowing more, they can borrow less.”

For Osborne , this reductio ad absurdum seemed so conclusive that there was no need to justify his controversial economic beliefs.

To claim that a government should borrow more when its debts are already too high is ridiculous ‑ as ridiculous as suggesting in the 16th century that the earth moves around the sun or that humans evolved from monkeys.

While economics does not deserve to be called a science on par with physics or biology, it is supposed to be a systematic and objective analysis of empirical evidence about the way the world works. The goal of such rigorous analysis is to find insights that are not obvious, and may sometimes even seem ridiculous to casual observers.

Several counterintuitive insights are now nearly universally accepted among economists – for example, that a country can usually gain more wealth by reducing trade tariffs than by increasing them. Others are still very much in dispute. Perhaps the most important of these, especially in the present global context, concerns public borrowing. Should governments try to reduce borrowing during an economic slowdown, or should governments borrow more or less without limit until economic activity revives and full employment is restored?

This is a complex and subtle question on which opinions among serious economists can reasonably differ and change over time. What cannot be described as reasonable, much less as serious economics, is the claim routinely made by politicians, including finance ministers and central bankers who ought to know better, that this is a simple question to be answered with the commonsense aphorisms beloved by Osborne and his counterparts in the German government and the U.S. Tea Party: “You can’t cure debt with more debt.”

This may seem obvious. But isn’t it equally obvious from our perspective that the earth is flat? There is a parallel between the debt cliche and the flat-earth cliche. Both seem obvious at close quarters but break down when the world, whether economic or geographic, is viewed as a whole.

The world economy is very different from an individual company or a household. When individuals spend less than they earn, the savings they put aside give them a claim on the incomes of other people, allowing them to hire workers and make businesses grow, and this makes them richer. But this cannot be true of the world as a whole. The world cannot spend less than it earns, because one country’s spending is another country’s income. So if the whole world tries to spend less than it earns, the result is not an increase in savings but rather a reduction in total income. To make matters worse, the world as a whole cannot lay claim to anyone else’s income, unless extraterrestrial workers arrive from Mars. The only way to increase global prosperity is by investing in technology and management. But businesses are reluctant to make new investments when they see consumer spending in decline.

The upshot of these arguments and others like them is the central conclusion of Keynesian economics: If private businesses and households collectively are determined to spend less than they earn, then government must spend more than it collects from taxes to make up the difference. If government instead tries to do the opposite, reducing its debts at the same time as the private sector, incomes will collapse – and government borrowing will paradoxically go up.

There are, of course, many caveats. One country can spend less than it earns if others do the opposite and spend more than they earn, thereby increasing their trade deficits. Alternatively, government austerity can reduce interest rates and boost confidence, prompting more consumption and investment.

Such arguments justify genuine debate about how governments should respond to economic weakness – and serious economists reach different conclusions depending on the the conditions. In 2010, Britain’s incoming conservative government believed it could boost confidence by accelerating the budget consolidation that the previous Labour government had begun. Two years later it is clear that this bet did not pay off. Growth and deficit reduction have both been deeply disappointing, especially in comparison with the U.S., despite much bigger tax increases and spending cuts. In fact, there would be almost no reduction in Britain’s deficits over three years – last year (121 billion pounds), this year (120 billion pounds) and next year (112 billion pounds) — if it were not for the new gimmick of transferring Bank of England profits to the Treasury at exactly the rate required to keep apparent deficits on a downward path.

Can the additional austerity imposed by the Conservatives in 2010 be blamed for this grim performance? Maybe not. But in 2010 the economy hovered between recovery and relapse into recession. As with a finely balanced seesaw, where a small amount of pressure has a big effect, economics becomes a path-dependent process, with outcomes even harder than usual to predict.

In such circumstances, governments are bound to keep missing economic forecasts and targets. But they could try to limit the risks by basing policies on serious economic analysis, not oversimplified cliches and appeals to common sense that are just plain wrong.

PHOTO: Britain’s Chancellor of the Exchequer George Osborne delivers his autumn budget in parliament in London December 5, 2012.  REUTERS/UK Parliament


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From a global perspective, surely the surplus countries (eg China and Germany should spend more and deficit countries, like the UK, should spend less.

Posted by John_Andrews | Report as abusive

Wonderful article. Economics should be an empirical science, but hasn’t yet made itself into one. Unfortunately things may be going the wrong way in recent years. The right wing in particular has funded numerous “think tanks” to generate numerous fake papers to support their predetermined conclusions. Lots of easy money is put on the table for academic economists to get funding if they put out fake papers to support right wing talking points. Lots more money is being pumped into the Tea Party, Fox News, and right wing radio shows to repeat “oversimplified cliches and appeals to common sense that are just plain wrong.”

Am I am biased blaming the right wing more than the left? Well, I went empirical and looked at the numbers from scratch for myself and reached my own conclusions. However, you should not take my numbers or Fox News or MSNBC. With a some effort and the internet you can do it yourself. I think you should. Pick your own independent and dependent variables. Especially the dependent variables that you care most about. If you find yourself tweaking time periods or data choices, you may be too emotionally committed to a position to be honestly empirical. I hope not.

Posted by QuietThinker | Report as abusive

Economics as a profession suffers from confirmation bias, and so cannot be a science. “researchers” look backward at the data, and see the explanations they are inclined to already possess. Set out with a goal in mind, and you probably will not be disappointed.

Posted by Benny27 | Report as abusive

Another excellent article. I’ve been trying to work this out for some time, because I’ve been reading news about economics for some years, and I’ve noticed in practice the counter-intuitive operation of global economics; where national/currency-area level policies sometimes seem to have the exact opposite effect to family & local budgetary policies (contrary to what I previously thought, I have been partly persuaded by the evidences I have seen, just by reading the news over the years). I think I’m finally beginning to understand global economics.

> “From a global perspective, surely the surplus countries (eg China and Germany should spend more and deficit countries, like the UK, should spend less.”
— Otherwise, perhaps some countries are being robbed by the economic fraud of others. It’s simply not right for my neighbour to subvert the system so that he spends, year after year, a significant part of the earnings from my labour.

One of the biggest paradoxes is how the USA can continue spending itself into oblivion (or, what would be oblivion for any other country in terms of the ratio between external debt and GDP, or the difference between budget deficit and GDP-growth); yet nothing bad has happened YET. Will the system collapse all of a sudden, in a catastrophic structural failure? Or can this continue indefinitely?

I think a part of the reason why the US economy hasn’t collapsed already is:
• Lack of alternative growth markets with sufficient legal & regulatory & cultural protection for foreign investors (many African countries have tremendous growth potential but such stifling corruption that foreign investors will never make a cent without bribing local officials big-time).
• The USA is trading internally & externally in their sovereign currency, which is also the standard currency of world trade — which foreign governments and companies are therefore obliged to hold in reserve (whether or not the “Federal Reserve” chooses to follow modest inflationary/confiscatory policies. It might take a big economic shock or a loss of the military-backed “pax Americana” to bring serious consideration of an alternative medium of international trade).
• Comparative political culture between the USA and China (and their respective allies/ effective partners in world trade). China’s political need to continue forcing economic “growth” to happen, irrespective of what is happening in the rest of the world. On the other hand, America renews political good-will every few years with an election (and as a democracy with better standards of individual freedom, finds a “strong dollar” to be politically expedient, to some extent).

I’d like to read more from Mr. Kaletsky…

Posted by matthewslyman | Report as abusive

Thanks Anatole for more stimulating reminders on the discrete charm of counterintuivity, not to mention the value of more attention to the empirical foundations of common sense. For something that also gives a “second opinion” among international organisations on many of the same issues that your article treats, please check out this UNCTAD Policy Brief No.26 just issued:  /presspb2012d2_en.pdf

We say: “Such measures are often associated with
attempts to improve the “international
competitiveness” of countries. However,
competitiveness is a concept to be
applied at the level of companies, and
even more importantly, it is a relative
concept. While all countries can
improve their productivity performance
and increase the incomes of their
population, the attempt by everyone
to improve competitiveness by cutting
wages in relation to national productivity
can only end in general impoverishment
– a true race to the bottom.”

Posted by RajaKhalidi | Report as abusive

I’d like to propose another counterintuitive thought. Printing money does not necessarily result in inflation. It only results in inflation if the economy is nearing capacity, which the world economy is nowhere near. I am proposing that the US government print money to stimulate the economy because it is clear that the velocity of money M2 is collapsing. Borrowed money does not stimulate as well as printed money because it requires that the loaned money be taken out of circulation. An increase in savings, which is deflationary, counters the increase in spending. This can also be accomplished by devaluing the currency. Either way, this action is necessary because wealth has become extremely concentrated among a small percentage of the population. The easiest way to rectify this is to devalue that wealth and hand the money to people whose incomes have not kept up with inflation. Before calling me a communist, please note that economists have cheered such actions by other countries such as Argentina and Iceland. They are noted as having taken decisive action required to rectify economic imbalances. Now, I know so many people think that printing money would be madness because it might cause world players to stop using the dollar as a reserve currency. To that I propose another counterintuitive idea: who cares. Having a reserve currency is nothing more than a burden for the reserve country because it requires that our incomes fall via trade deficit when other countries purposefully hold our currency while running trade surplus. So in the end, we need to print money and let the world find another reserve currency.

Posted by sophia.leghorn | Report as abusive

Are the terms “spending” and “earning” used in this article congruently with “consuming” and “producing”?

Posted by dbjones | Report as abusive

Poorly reasoned and poorly written article.
Saying that an economic theory is stupid because it reminds the author of the claim that the earth is flat doesn’t necessarily add weight to the their arguments against that theory.
Many governments borrowed and spent too much, and by doing so they managed to turn bad economic situations into full fledged catastrophes.

Posted by reality-again | Report as abusive

Governments don’t need to issue debt in a recession/depression. They can simply print new fiat currency AND spend it directly into the economy.

And before you all start responding like Pavlov’s’ puppies, it is not inflationary in the current circumstances.

Posted by Sustento | Report as abusive

Typical mind set of game theory economist.

Major misunderstanding at several levels.
1. The current prosperity of the system based much on production efficiency, you redistribute the resources more evenly will push the system away from efficiency and to a slippery downward slope.

2. Money printing will lead to inflation in basic food and fuel, especially in poor country (hello Egypt). It is ALREADY inflationary in the current situation. Just because people in rich countries can’t feel it, doesn’t mean it is not there.

3. Very DANGEROUS mind set of game theorist: You lose so I win. This is the fundamental driving force in Keynesian game theorist economists’ way of thinking. If the savers lose money (in real purchasing power term), because of the finite zero sum game principle, the wealth doesn’t not disappear. The wealth will thus be transferred to everybody else.

Game theorists thus set forth the idea of life is about redistributing wealth to allow a growing population. It’s ok to steal if you steal from the wealthy. Thus the society breeds an entire industry of people whose job is to prey on someone else with money and saving. If these savers lose money (to them), then they can redistribute the money to the poor and the ones that they consider deserving. They play the role of the benevolent agent of God. They stand between man and God. They become the richest in the society at the same time together with their acolytes screaming for more equality.

Hurt most in the end are those who actually put in real work, real productive work (from constructor, plumber, bakers, farmers, etc…).

It’s never a zero sum game, very simple example. If you steal from a productive person, you might make him very sad, depressed, his dopamine and serotonin levels go down. He will be a lot less productive, he loses and EVERYBODY loses as well. It is not a lose-win situation. It can be a LOSE-LOSE situation. It is wrong to think that when you destroy real wealth of the rich, wealth will magically appear in the hands of the poor somehow because of zero sum game principle.

Who actually win? The crooks who play God, the crooks who steal in the name of “equality”.

In my life, I have met a lot of game theory people. They appear nice, they look nice, they talk nice, BUT they are NOT nice. They are only nice with the things that doesn’t cost them anything, the words, the writing, the other b.s. Talks are cheap, and they are only nice in cheap things. When the niceness requires them to lose something, even if it is just a little bit of convenience, they will bail out (or say that they will be nice if others are nice too). Remember in game theory, the best strategy is not actually to exploit, play dirty and cheat you, the best strategy is behave nice to you at the same time taking advantage of you. PLAY DIRTY but TALK NICE.

Look around and be very careful when you see a game theorist.

Posted by trevorh | Report as abusive

I want to add a few more observations.

4. Certain individuals will be smart enough to see how the system is operating, they will try to take advantage of it. At the very least, they will try to play defensive to protect their wealth (remember the rush to buy gold just last year).

Even Buffet pointed out, he doesn’t see how people can “invest” in gold (well, they don’t invest in gold to win, they invest in gold to not lose). When you invest in gold, the only kind of jobs you create is perhaps for the miners in South Africa.

That is a prime example of incorrect allocation of financial resources.

5. The writer wrote “Businesses are reluctant to make new investments when they see consumer spending in decline.”
I absolutely disagree, business have so much money, they don’t invest because they run out of value-generating new ideas. If they invest with old ideas, then they can only go investing in developing poor countries where even old ideas have not been implemented (thus investing in poor countries right now generates real value and thus legitimate, real profit).

Having said that, I don’t see any other option. The governments in rich countries are gonna have to spur demand for certain type of labor somehow. Or else you end up seeing riots on the street. In the US, (except the career welfare ones) most people are not as spoiled as those in other more liberal countries like Europe, so some spending might not be that bad.

Anyway, imagine a balance society, but then all of a sudden, one type of people, say the lawn mowers (or accountants), decide to have lot of kids causing imbalance in society. What you end up with is high unemployment because there are only so many lawns (accounts) out there. You have imbalance.

Yes you can stimulate demand for lawn mowing by legislating people to have bigger lawns, or even spend money to create gigantic public lawns (hello pyramids in Egypt) to spur lawn mowing demand. But then this kind of solution is.. I don’t even bother comment more

The more I read expert analysis, the more I can see how the world elites misunderstand how the world operates (or they know it, but they want to milk it, or they afraid people call them Nazi, or they afraid to lose their ‘nice’, ‘benevolent’ mask, or combination of all).

I like truly benevolent people, and I dislike “go eat cake” Nazi kind of people too, but the current thoughtless way simply can’t continue.

I will discontinue my internet at the end of this month, the more I read, the more news I follow, the more things I realize, the more headache my brain has to go through…

Posted by trevorh | Report as abusive

Counter intuitive economics, or better yet an understanding of comparative economics, are the only solutions that make sense in this liquidity trap environment. Anatole you should profile Warren Mosler and the Modern Money Theory movement which has provided the necessary framework to view policy options in a private debt deflationary environment. How & Why do central banks afford to pay 100% for useless assets, ie QE’s? Because it doesn’t matter! They only want to get money back into the economy and maintain the low price,rates with the hope and prayer that it will lead to employment and demand when people refinance and lower debt burdens.

The GD proved that fiscal policy and direct investment is public goods is the only way to sustain consistent long term growth. We can’t afford not to pick up this argument and declare it with the realistic, moral authority it deserves.

Posted by BVN1 | Report as abusive

Even if you think in term of liquidity trap, you have to fully understand what is trapping liquidity (ie money).
The conventional Keynesian answer is “saving”.

Data I know seems to show that personal and household savings are not increasing (if not decreasing), so people are NOT trapping liquidity (ie saving money). Personal saving is NOT the issue.

What else can possibly trap liquidity?
I can see 2 possibilities:
– Corporations sitting on pile of cash
– Exporting countries like China.

– Corporations won’t release the liquidity for investment (in rich countries, where unemployment is high) because they run out of ideas to invest in rich countries.
– China won’t reduce reliance on export probably because they want employment for the mass to keep them busy and not wage uprising.

So government debt is not going to sustain long term growth and prevent liquidity to be trapped AGAIN! So you have to deal with the things that always end up trapping liquidity anyway. You can’t do anything to China, so the least you can do is to touch corporation.

Think about it as “capitals” trapping liquidity. If you ensure that there is a more equal distribution of capital, then liquidity will be distributed more evenly as well. This requires either people being self-employed or owning shares/stocks in profitable companies that are sitting on cash and trapping liquidity right now. The pile of cash distributed as dividends in profit sharing will definitely reduce liquidity trap problem.

But it is risky to keep capitals (as in companies go bankrupt, stocks/shares/assets go to zero). Not to mention the fraudulent activities involving equity market right now (especially common shares), so people only want to keep safe assets (cash, liquidity), then liquidity is trapped again.

As liquidity can’t trap liquidity, only capitals (of profitable companies) can trap liquidity. You can sing government debt all you want, but then the liquidity trap will come back again.

That’s how I see it, I don’t know what the world elites are seeing.

Posted by trevorh | Report as abusive