Tuesday, November 25, 2008

Can budget deficits cure the debt problem?

When I first met Jim (that is not his real name) a few days ago he seemed like a fairly harmless businessman. But when he heard that I was an economist, he said that there was something he wanted to ask me.

I had the feeling that I would not like Jim’s question, so I mentioned that I had retired. Jim pretended not to hear. He said: “The current financial crisis was caused by too much debt wasn’t it? Before I could respond, he had added: “So, tell me how the world’s governments are going to solve the problem by having bigger budget deficits and more debt?”

I tried to get out of answering by saying that I didn’t know much about short-term macro-economic management. That response didn’t satisfy Jim. He said: “Come on, you must have some idea about what governments are trying to achieve.”

I started my explanation by going back to the cause of the problem. Making my explanation as simple as possible, I said that the problem had arisen basically because lending institutions in the U.S. thought that it was safe to lend a high proportion of the value of houses because they felt that house prices would continue to rise. This meant that when the bubble burst and house prices fell, a lot of borrowers had debts that were greater than the value of their houses. So defaults started to increase and that created big problems for banks.

At that point Jim interrupted. “I know all that”, he said, “what I don’t understand is why the governments didn’t just let the rotten banks fail”. I explained that the financial system had become like a house of cards, built on the expectation that some financial institutions were too big to fail. When the U.S. government let one bank collapse, this led to a crisis of confidence in the whole financial system.

Jim looked skeptical. “You still haven’t answered my question”, he said. “How can governments solve the problem by creating budget deficits? Doesn’t this just make the problem worse for countries that have been living beyond their means. Shouldn’t they be living within their means rather than going further into debt?”

I told Jim that I thought that was a good point, but the problem was how to get from where we are now to where we want to be. I suggested that the idea behind what governments were attempting to do was not stupid because they were trying to restore confidence and to avoid increased unemployment. I said that if you look at an economy and see a lot of people becoming unemployed and a lot of spare capacity emerging, this suggests that consumer demand is too low, not too high. I also explained that governments don’t actually have to go into debt to fund their deficits. They have the power to create the additional money that they spend.

Jim then looked alarmed. “Do you mean that they might use the printing presses like Robert Mugabe does? So we could end up with hyperinflation like in Zimbabwe?”

I tried to calm Jim down by telling him that at the moment a lot of economists – those who know about these things - seem to be more worried about deflation than inflation. They are worried that we might get stuck in a situation like that in Japan in the 1990s, with falling prices and economic stagnation. I said that the policy aim was to give economies just enough of a boost to restore economic growth without inflation.

Jim seemed to understand. He said: “So what these economists are trying to do is a bit like getting a satellite into the right orbit – they just want to give the economy the right amount of thrust?” I acknowledged that the policy problem could be a bit like that.

Jim smiled before he added: “Yeah, well I reckon that’s the problem with you economists. You think you are f***ing rocket scientists!”

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