The hysterical economy

Laurence J. Kotlikoff, 16 December 2012

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Imagine that you are an employer. Every day you hear, “the economy’s going over a fiscal cliff. Tax hikes and spending cuts totalling $600 billion will kill the economy”. Everyone is saying it - the politicians, the media, the economists, the Fed, the CBO, the IMF. So it must be true. Sure, the Republicans and Democrats may make a deal and save the day. But these guys never agree and, meanwhile, economic doomsday - January 1st - is just weeks away.

What do you do? Do you wait for your customers to disappear, as they surely will, or do get a head start and start firing now - or at least stop hiring? You get a head start And in so doing, you make the prophecy come true. Other firms see less demand from your erstwhile and prospective workers. But the other firms - there are 30 million of them - all do the same thing. So, voilà, you see fewer customers and weren’t all the pundits right. And weren’t you smart to get a leg up?

Self-fulfilling recessions

Economists use different words to describe the economy’s ability to freak out and spontaneously contract based on nothing more than hearsay. ‘Sunspot equilibria’, ‘multiple equilibria’, ‘coordination failure’, and ‘animal spirits’ (coined by Keynes) (cf. Shell 2008, Diamond 1982, Chamley 2003, Keynes 1936) are all used to reference what Franklin D Roosevelt told us we had most to fear - fear itself.

Personally, I think the term 'The Hysterical Economy' best describes this problem. It suggests that:

  • The economy goes nuts.
  • The economy does not need a good reason to go nuts.
  • A state of confidence is a precious public good.

The economy certainly went nuts in 2008. Around the developed world, 27 major financial companies had near-death experiences. Yet only one -Lehman Brothers - actually closed down. True, there was no loss of life or physical property, but Lehman’s collapse struck panic into the hearts of many, particularly leaders in Washington.

President Bush once said of the economy, “this sucker is gonna blow”. Sure enough, it blew as employers got a head start by firing 8.5 million people over the next 19 months. Had they fired all 8.5 million the day after Lehman went under, everyone would have realised this was coordinated panic. But the panic built over time as more and more ‘experts’ and ‘leaders’ continued to talk about the ‘Great Depression’ -- two words that were searched extensively on Google in the days and months after Lehman died.

And now, fiscal cliff hysteria

Today we’re Googling ‘fiscal cliff’ -- two words strung together by Fed Chairman Ben Bernanke. ‘Fiscal cliff’ is panicking the public and justifying yet further delay in dealing with our country’s enormous fiscal problems.

Let us be clear; absent collective panic, our economy will not implode if we move from running a 7% of GDP deficit to a 3% of GDP deficit. The Federal Government ran deficits of 3% or less during most of the post-war era and the economic sky did not fall in.

Running a 3% of GDP deficit is no reason to go nuts. Indeed, the real reason to go nuts is that we should be running a 5% of GDP surplus to deal with the enormous Social Security, Medicare, and Medicaid bills looming over the horizon.

Ten thousand baby boomers are retiring each day. Within two decades all 78 million will be retired and collecting $40,000 per person (in today’s dollars), on average, from these three programs. These and other projected expenditures combined with our low average tax rates - historically speaking - have produced not a fiscal cliff but a fiscal abyss. The fiscal gap separating the present values of all future expenditures and all future revenues is now $222 trillion.

As we justify doing far too little far too late, the fiscal gap, the only economically appropriate measure of our government’s true indebtedness, is growing at a colossal pace - by $11 trillion over the past year alone. To put $11 trillion in perspective, it’s as large as the entire stock of official debt in the hands of the public. So if we want to panic, there is something real to panic about. It’s the fiscal abyss, not the fiscal cliff.

America needs leadership

But, of course, what is needed is not panic, but leadership. The President and other politicians need to stop scaring the nation. In so doing they are coordinating everyone’s expectations on recession and, thereby, assuring it will come. Two thirds of the public are now convinced the economy will face major problems come January 1st (Cowan 2012), whilst corporate America is already cutting back on investing and hiring (Son 2012).

If Congress remains deadlocked - which seems likely - and recession ensues, both parties will say “I told you so”. What they will miss is that their telling us so, not making minor fiscal adjustments relative to what’s needed, will likely be the true source of the recession. Our economy is crazy enough. We don’t need hysterical leaders to make it more so.

References

Chamley, Christophe (2003), Rational Herds: Economic Models of Social Learning. New York, Cambridge University Press.
Cowan, Richard (2012), “With U.S. 'fiscal cliff' deadline nearing, parties still at odds”, Reuters, 27 November.
Diamond, Peter A (1982), “Aggregate Demand Management in Search Equilibrium”, Journal of Political Economy, 90(5), 881-894.
Keynes, John Maynard (1936). The General Theory of Employment, Interest, and Money. Houghton, Miffland, Harcourt.
Shell, Karl (2008), "Sunspot Equilibrium" in L Blume and S Durlauf (eds.) The New Palgrave: A Dictionary of Economics, 2nd Edition, New York: Palgrave Macmillan.
Son, Hugh (2012), “BofA Chief Moynihan Says Fiscal Cliff Already Hurts Economy”, Bloomberg, 13 November.

Topics: Global crisis, Macroeconomic policy
Tags: global crisis, recession, USA

William Fairfield Warren Professor and Professor of Economics, Boston University

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