March 24, 2010

There is no ‘right’ answer. There never has been and there never will be.

Economics, much like politics, is filled with dichotomy and ambivalence. Since the beginning of time people have argued over the ‘right’ thing to do. The problem is that there is no ‘right’ answer. There is no black or white – only shades of gray.

This means that policies pursued today may turn out well or may turn out badly. We simply don’t know. There are too many unpredictable variables to honestly forecast any further than a week into the future. What this also means is that the ‘right’ answer at one point in time – due to a prevailing set of circumstances – may not be the ‘right’ answer at another point in time. Much of our success has as much to do with the direction of the wind as it does our economic and political policies.

Yes, we can and do impact our future. But we often stop short of our goals despite our strategies for reaching them. We want freedom, a thriving middle class, poverty-reduction, peace, incentives to innovate and a generalized improvement in living standards. Have our policies helped us get there? Or have they simply been attributed as cause to the effect when they are simply coincidences? We don’t know.
For all the policies created during the 1980s and 1990s, do we really know if they were the cause of the economic boom that occurred during that period? For all we know, the stagnation and high interest rates of the 1970s created a combination of pent-up demand and a platform for long-term disinflation that sent an economic tailwind in our direction. We were swept up by the wave during the 1980s and 1990s, all the while attributing our success to how hard we were paddling.

So are there times when paddling is simply a waste of time? In other words, can there be circumstances where there is no answer? A situation where no matter what we do we simply slide into economic despair? I refer you to the stagflation of the 1970s in the US and the deflation of the 1990s/2000s in Japan. Perhaps policies prevented things from being worse – but they sure didn’t make things any better. Circumstances leading up to these economic events (e.g. in the case of Japan, the Plaza Accord and a domestic asset bubble) may have made these events unstoppable. The best we could do as a society was cope.
I bring this topic up because of the scenario we find ourselves in today. The Keynesians, monetarists and Austrians are at each-others’ throats with economic prescriptions ranging from fiscal and monetary expansion to fiscal and monetary contraction. Many intelligent people are presenting arguments that cover the full, and contradictory, spectrum of economic policies. Unfortunately, they’re all correct and all wrong at the same time.

We (the world) are in an economic predicament that calls for both fiscal/monetary expansion and contraction at the same time. Real time events are showing that these two conflicting policies are needed concurrently – we are in an engulfing quagmire.

Here’s why I say this. Leading indicators show that the economic recovery is already sputtering, Treasury yields remain low and prices are falling – this calls for the expansion of the government balance sheet to provide economic life-support. On the other hand, government debts, budget deficits and central bank balance sheets around the world are extremely bloated – as bond vigilantes pick off the weakest debtor nations the cries for fiscal restraint grow louder. One only has to look at today’s G20 to witness the current conflict in economic prescriptions. Unfortunately, fiscal consolidation – especially a globally-coordinated fiscal consolidation – will simply cause slower growth and more reason for fiscal and monetary expansion.
For the sake of my children, tell me, how do we navigate such a dichotomy?

The answer: there is no answer. Regardless of which path we choose we will face life-altering challenges. In order not to gloss over what ‘challenges’ means to me, I will list them out: more poverty, political unrest, lower standard of medical care, general reduction in living standards, widening income disparity, high structural unemployment, and more. Unlike credit contractions of the past, as far as I can see, there is no simple way to devalue and export out of this one (as has been a successful prescription for over-extended countries in the past) – not given the global nature of the credit contraction. So can we change our fate – after-all, this is not the future we are choosing today. But that is precisely the problem. This is the future that we chose over 25 years of credit expansion.

We face a situation where our fate may already be decided. At this point it is ‘written’, and what will be will be.