Geithner's Gamble

The recent G-20 summit in Toronto has provoked a contentious debate over world economic policy. The US economic troika of Treasury Secretary Geithner, NEC director Summers, and Fed Chairman Bernanke are pushing a reluctant European Union to accelerate fiscal stimulus and rescue the debt-laden economies of its weakest members. In their eyes, the singular objective is strong, balanced, and sustainable growth as they conjure up fear of another Great Depression. The Europeans counter that such advice is economically unreasonable and politically inappropriate. Furthermore, it demonstrates a profound lack of understanding of European realities. Faced with the unsustainable public spending of Greece, Spain, Portugal and Italy, they argue that sustainable growth cannot be not based on governments injecting cash they don't have, with mere hopes of fiscal restraint. Probably thinking more of the Weimar Republic than the Great Depression, their voting publics seem to agree.

Thus, the debate appears to have reached an impasse. But the Europeans are likely to blink first when confronted with the pain of near-term deflation and deleveraging. Unfortunately, the Geithner plan (or GSB for short; for conspiracy theorists, the acronym's resemblance to "Goldman Sachs bank" is purely coincidental) looks more and more like a Hail Mary pass in a game of fantasy policymaking. It embraces a stark contradiction between unrestrained fiscal stimulus in a political environment that is panicking over excessive debt. So GSB asks for credible plans to stabilize debt-to-GDP levels, while warning against withdrawing fiscal stimulus. It reminds one of St. Augustine's lament to God: "Give me chastity and continence, but not just yet."

Regrettably, these macroeconomic debates are distracting us from some stubborn economic truths that become more apparent at the micro level. In other words, what people are doing at the individual and firm level in their daily lives. I will argue that the GSB plan is unlikely to succeed because it fails to directly address the gross incentive distortions of these underlying behavioral functions that underpin all macroeconomic models.

We know for economies to grow, people need to work, save, invest, and consume, no matter what national flag they fly. However, we hear that the citizens of developed countries save too little and consume too much while those in emerging nations do the opposite. Macroeconomics assures us these will balance out in the long run – reality tells us in the long run we are all dead, maybe sooner. Look closely: GSB warns how imbalances must be corrected, but then advocates policies that reinforce the wrong behaviors. For example, US consumers need to pay down excessive debt by saving more and consuming less. But that has negative consequences for GDP and job growth. So US economic policy subsidizes low interest rates, punishing savers and rewarding profligate debtors. At the same time our leadership has recklessly increasing fiscal spending and borrowing, incurring new liabilities for taxpayers with bailouts that prevent prices from reaching an equilibrium. Without accurate prices, people who need to decide the proper mix between consuming, saving, and investing are flying blind. The result is that any surplus funds sit idly in the piggy bank rather than being invested.

One doesn’t need an economics degree to figure out the consequences of distorting incentives to such a degree: less saving, more consumption, and excessive liquidity that doesn't find its way into new production. This yields few new jobs and anemic GDP growth that more reflects trading in asset bubbles rather than the production of new goods and services. On an international basis, this only encourages export-led countries like China, India, and Germany to continue providing credit in order to buy their export goods. The game goes on until the next collapse. With each failure, politicians demand more power and control to do the wrong things. Yes, uncertainty and loss of confidence bedevil the best intentions.

Is this really the best course we can follow? Hardly.

First, the Geithner spin on the current financial environment is probably overly optimistic. Low interest rates and low Treasury rates are less a sign of confidence than a costly premium on liquidity in an environment that is deleveraging in the private sector and exploding with new debt in the public sector. GSB cannot speak to these truths until it becomes politically expedient, but if the stock market recovery is real, we should expect a broadening of support across all sectors and firm sizes. If it reverses or narrows with mergers and acquisitions, the booming market is more likely a sign of excess liquidity.

Second, yes, we run a real risk of a sustained deflationary environment, but the fears of deflation and deleveraging causing the next Great Depression are overblown. Most scholars conclude that the Depression was not caused by lack of spending, but overly restrictive monetary policy and that the fiscal stimulus of the New Deal most likely prolonged the downturn. Bernanke insures us under his command there is little chance of overly restrictive monetary policy. His hand will only be forced by the bond market and Treasury yields.

More important, the policies of the last twenty plus years have rewarded debtors and asset holders to the detriment of savers and workers. It's time to redress this imbalance if we wish to return to a sustainable path. We may need controlled deflation rather than controlled inflation. While certain financial interests (i.e., debtors and debt leveraging) will strongly object to changing the rules of the game, financial prudence has been on the short end of national economic policy for far too long.

Lastly, the most challenging political task is to advocate for an international economic model that recognizes and reinforces the basic formula for wealth creation: hard work, restrained consumption, and prudent saving and investing. National success is less about maximizing GDP growth than it is about the distribution of resources across time and across populations to insure sustainability and stability over the long run. A sustainable market system must be able to manage demographic and technological cycles, but our abilities are only hampered by credit-debt cycles that are engineered purely through bad policy.

This goes for emerging economies like China and India as well. A society that does not consume, has little reason to save and invest, and a society that does not save and invest has little to consume. This probably means slower but more stable growth with fewer reversals. It probably means more equity investment than debt. But we have seen the alternative and it is a casino. A return to fundamentals is the only way we can fulfill our commitment to raise living standards across all countries far into the future.