A New Perspective on the Global Economic Crisis V: The Near Future and the Distant Past

I. Introduction

In an incisive article, 'Is the Fiscal Stimulus Pointless?' (Project Syndicate, February 26, 2010), Professor Bradford DeLong shows surprising courage to take on the Chicago School of Economics on its home ground. As a result, the policy framework for discussing the fiscal stimulus is now rapidly shifting away from Keynesian concepts like spending multiplier, output gap, (counter-cyclical) deficit financing and demand management. The new language of the stimulus debate is the old-fashioned price theory of the Chicago School.

Consequently, it has now become possible to talk, in a precise manner, about the longer-term effects -- like burgeoning national debt, inter-generational transfers and destabilization of price expectations -- that result from massive stimulus efforts. Professor DeLong's article is, in its entirety, a rebuttal of Professor Robert Barro's article, 'The Stimulus Evidence One Year On' that appeared in the Wall Street Journal on February 23, 2010. The rebuttal does a thorough job, indeed, of picking apart Professor Barro's arguments.

Unfortunately, Professor DeLong's arguments lead him to suggest that the stimulus could be repeated a few more times with great advantage. There is now an urgent need to raise awareness of some of the other perspectives on the economic crisis, which the monetarists and the Keynesians are both missing, in their economic models. For, the global economy could not possibly afford another round of trillion-dollar goof-ups.

The one monetarist argument against massive stimulus efforts, that is widely accepted by the Keynesians, is the 'jump-discontinuity' argument that is provided by Professors Carmen Reinhart and Kenneth Rogoff in their recent book, 'This Time is Different'. They point out that increasing national debt appears to be a tame affair for a long time. So, one might think that the current situation of low interest rates could be exploited, in the short-term, for reducing output gap and unemployment. However, the book shows that the perils of mounting debt only become apparent all of a sudden (like a jump-discontinuity), when the public debt exceeds 90% of GDP or so.

Sadly, this useful cautionary tale, grounded in much empirical evidence, has not prevented the increasingly irrelevant Professor Niall Ferguson from conjuring a dooms-dayer's fantasy. Citing models of chaotic dynamics as evidence, he has written an article entitled, 'America, the fragile empire: Here today, gone tomorrow -- could the United States fall that fast?' (Los Angeles Times, February 28, 2010). Though the Reinhart-Rogoff argument is effective and reliable, it does not provide tools for analyzing the strengths of the stimulus effort.

The first article, to appear in the news media, that considered the strengths of the stimulus bill, using sophisticated tools from price theory was from Professor Edmund Phelps. In 'A Fruitless Clash of Economic Opposites' (Financial Times, November 2, 2009), he argued that "... companies appeared to underestimate cutbacks and price cuts of competitors on the way down. That excessive optimism signalled deficient demand for goods and labour. So any stimulus then may have had a Keynesian effect. By now such optimism has surely been wrung out of the system".

Professor Phelps' argument takes after the gainful correction a stimulus could make towards the mis-expectations of firms. In Section II, we provide an argument that considers the stimulus bill's effect on firms, as well as households and individual investors. Our approach is to focus on the fact that the price movements in free markets are completely random. Essentially, from our perspective, what both sides, the Keynesians and monetarists, are missing is the recognition that the stimulus served as a calming influence against the massive wealth destruction caused by the high volatility in the markets during 2008 and 2009.

That is, the greatest advantage of the $862-billion stimulus bill enacted last year was that it served as a bulwark of re-assurance at a time of widespread panic and fear. Viewed in this way, one would see that while the stimulus bill of 2009 was quite useful, it would be unwise to enact another stimulus bill, at least until the long-term prospects for growth in the American economy become clear. We analyze the shifting policy framework for the stimulus debate thoroughly in Section II.

One comment I should make here is that it is harmful for liberal economists to keep arguing that they knew all along that last year's stimulus bill was too small. One might argue that what was needed in 2009, was not a larger stimulus bill, but better stewardship and closer monitoring of the fiscal deficit. The public ought to have been immediately informed that the national debt was growing alarmingly, instead of pre-maturely bringing on the health care agenda.

One wonders if the lure, for the liberals, in a stimulus bill exceeding one trillion dollars was the expectation of grand self-affirmation. Was it the very same expectation as the one that drove the conservatives to gloat about the 'Shock and Awe' campaign in the Iraq war initially? It is useful to keep in mind that this is the age of uncertainty and decline. The best chance for the success of a stimulus effort would be to keep the general public well-informed and closely involved.

While Section II is concerned with the near future, in contrast, the short Section III considers the distant past. Please recall that in my recent article, 'A New Perspective on the Global Economic Crisis IV: It is NOT the economy, stupid!', I had argued that to understand the global crisis, it is necessary to super-impose the Efficient Market Hypothesis (EMH) upon the infrastructure of an empire. Section III gives a further application, in economics, for the concept of an empire.

Monotheism is widely considered to be one of the fundamental precepts of the Western liberal tradition. It was monotheism that enabled the separation of science and religion. This separation was crucial for the independent progress of science in the Western world. As a result, monotheism is of foundational importance for studying the Western world's economic progress as well. In Section III, we provide evidence that historically, the practice of monotheism could simply derive from the existence of an empire.

We argue further that it is not necessary to scrutinize strongly-held religious beliefs to analyze monotheism. Delving into religious literature to understand the roots of monotheism was something that was done for a long time in the Western liberal tradition, even as late as the 1930s. Our modern knowledge of the ancient world demonstrates that monotheism tended to arise wherever empires took hold for a prolonged period. The empire's people either worshiped the emperor, as they did in China, or they worshiped the same god that the emperor did.

Section III indicates that the concept of an empire is a gold mine for contemporary researchers in the social sciences. In particular, the concept of an empire is of direct relevance for re-formulating modern economic theories, in light of the current global economic crisis. I request the Professors to kindly provide me with post-doctoral employment for a period of 3 years, so that I could pursue the path-breaking ideas mentioned in Section III.

II. The Near Future: The Shifting Policy Framework for the Stimulus Debate

President George W. Bush signed a $168-billion stimulus bill in February 2008. Prior to this bill, there were two major spending programs under the George W. Bush administration that were aimed at directly stimulating the economy. These were the massive tax cuts of 2001 and 2003, which taken together, have cost the US Treasury more than $1.6 trillion, over ten years. Before President Bush left office on January 20, 2009, there would be one more major stimulus effort.

That stimulus effort would be the drastic increase in emergency discretionary spending amounting to $150 billion (excluding war expense) in the budget for the fiscal year 2007-08 (Source: http://www.heritage.org/research/budget/wm2127.cfm). Note that these stimulus figures do not include the spending under President Bush during the first 100 days of fiscal year 2008-09, nor do they include the substantial expansion of the federal government during the 8 years that Bush was in office.

With the benefit of hindsight, It is now accepted that President Bush's 2001 and 2003 tax cuts had been unwisely skewed to heavily favor the wealthy. Although Bush's tax-cut policies were later caricatured and vilified as lacking common sense, at the time that Bush first proposed them during his 2000 Presidential campaign, his proposals were the state-of-the-art of conservative policy making. Over the course of the second half of the 20-th century, the Chicago School of Economics had patiently built up an effective set of arguments with which public opinion could be persuaded to favor minimal government, price stability and permanent tax cuts.

With President Bush's political popularity having taken severe beatings by the beginning of 2008, his economic advisers took care to make out the stimulus checks only to low income earners (individuals earning up to $75 000 received $600, couples earning up to $150 000 received $1 200 plus an additional $300 per child. Senior citizens availing social security benefits and veteran's disabilities also received $300). The argument from the liberal economists had been that giving money to low income earners would ensure that they spend it right away for their day-to-day needs. Whereas rich people would simply save the money in the banks, and this would result in a time-lag before the banks could re-circulate these savings as business investments.

The response from Professor Vernon Smith several months later in his article 'There's No Easy Way Out of the Bubble', that appeared in the Wall Street Journal on October 9, 2008 was: "Enter a bi-partisan Keynesian-inspired Congress and administration, who authorized Treasury to write large numbers of small checks as part of a "stimulus" package to many people who do not pay taxes. People spent money at Wal-Mart. Much of it went to China (which recycled it into U.S. bonds). And we saw a blip in retail sales that just delayed the inevitable".

When the Presidential race took off in earnest at the end of the summer of 2008, public attention began to focus on another stimulus package. It was becoming increasingly evident that the economy was in the worst downturn since the Great Depression. By the time President Obama was elected on November 4, 2008, the financial crisis of 2008 had hit home in full force. The widespread panic that led to massive destruction of wealth in the stock markets was still working its way through the global economic system. The threat of rising foreclosures due to falling house prices and widespread unemployment was getting worse and worse.

The political winds were now blowing in the opposite direction. It was clear that the liberals would be determining the economic policy completely, no matter what the conservatives had to say. However, even at this stage, the conservative economists were expecting that a new stimulus bill would not exceed $300 billion (see Dr. Brian Reidl's article 'Why Spending Stimulus Plans Fail', Wall Street Journal, November 14, 2008). Half a century of developments in modern economic theory had trained the conservatives to deny any advantage to stimulus efforts, unless they were made up exclusively of permanent tax-cuts.

The liberals, fresh from gaining historic majorities in the Congress and a landslide victory in the Presidential election, put all their faith in Keynesian policies instead. Liberal economists argued that the stimulus had to be in excess of one trillion dollars in order to make the recovery effective. It is here that Professor Lawrence Summers should be given a lot of credit for shepherding the stimulus bill with care and foresight. He recognized that the main weakness of the Bush tax cuts had been the misguided certainty that the solution to every economic problem was permanent tax cuts for the rich.

At a time when the markets were beset with debilitating uncertainty in late 2008, Professor Summers understood that there is no one single magic solution that would address all the problems in the economy. He also exhibited enough bravery to restrict the projected cost of the stimulus bill at $787 billion, in the wake of the liberals' clamoring for a 'Shock and Awe' stimulus exceeding one trillion dollars. This was a big service to the nation, considering how quickly the national debt had exploded by the end of 2009.

Thus, the stimulus effort was divided, roughly equally, between tax cuts, infrastructure development, and aid for the states and localities. The tax cuts and aid to states could begin to flow immediately. The infrastructure spending would be slower. Moreover, more than half of the stimulus would be spent after 2009. In this way, by choosing a broad set of tools and a longer time-frame, the stimulus bill was well-designed to reduce uncertainties in the economic environment. Finally, since the government's spending on the stimulus was specifically planned to be steady and predictable, this was expected to provide clarity to the private sector in its investment plans for pursuing business opportunities.

The second aspect of the post-election Keynesian policy tilt was that, to combat the global dimensions of the unfolding crisis, liberal economists advised governments around the world to resort to massive deficit spending. The liberals warned that the loss of trillions of dollars in the wealth of Americans would lead to a drastic reduction in their consumption. Hence, the governments around the world should spend vast sums through deficit financing. This spending would offset the decline in exports for foreign countries. For the US, it would offset the decline in domestic consumption, which accounted for nearly 70% of its GDP.

By the time of the Presidential election of 2008, the Federal Reserve had long tilted towards Keynesian policies substantially. Milton Friedman's prescription for avoiding a repeat of the Great Depression had been that the Fed provides ample liquidity in times of panic in the markets. The Fed and the Treasury decided that this would not be adequate. The government takeover of Fannie Mae and Freddie Mac, the direct intervention to prop up AIG that cost $180 billion and the $700-billion TARP program to bail out banks (apart from the shot-gun marriage of Bear Stearns with J P Morgan Chase earlier in March 2008) were all decisions that were taken under the Keynesian advocation for the government's strong interventionist role in the markets.

To be fair, the leading macro-economist from the Chicago School, Professor Robert Lucas had come to believe that in contemporary times, a depression-like situation would not occur; that the economy was firmly set on a long-term growth trajectory with only mild, periodic fluctuations caused by the business cycle; and that the economy could recover from downturns simply through the Fed's monetary policy. So, by the time of Lehman Brothers' bankruptcy in mid-September 2008, it was widely acknowledged that the economy was in un-chartered territory.

There was a third aspect in which the policy framework had turned decidedly Keynesian. This was the liberal economists rooting for a temporary nationalization of the Wall Street banks. Whereas the jury was still out on the deficit financing and the demand management initiatives of the liberals, it was quite clear even in November 2008 that nationalizing the banks would be a big mistake. This was because there is no institution, nor any body of intellectuals that could claim to have the expertise to deal with the financial crisis right away.

The financial crisis was an inter-temporal problem that would only unfold fully over the course of the next two or three decades. For this reason, it was necessary for the government to provide a direct channel of communication between the home owners and the security owners (See Q5 in my FAQ on the current financial crisis, dated October 8, 2008). This direct channel would have provided a robust price-adjustment mechanism for dealing with the financial crisis.

In any case, due to mounting public backlash against pouring public money into the Wall Street banks, the liberals quickly abandoned the idea of dealing with the financial crisis through bank nationalization. In fact, by the time the new Treasury Secretary Timothy Geithner proposed his Public Private Investment Partnership (PPIP) in March 2009, there was equally strong opposition from economists of all political persuasions. We also note here that helping the homeowners to avert foreclosures never really took off even after a Democrat became the President.

Thus the twin Keynesian concepts of deficit financing and demand management came to be the main avenues by which the Obama administration deals with the crisis. The $862-billion stimulus bill enacted about one year ago was the first milestone of this Keynesian landscape. The second milestone was the decision to increase total expenditures in the federal budget by about 20% (from $2.9 trillion in 2007-08 to $3.5 trillion in 2008-09) in spite of drastic falls in tax revenue. The budget deficit for the fiscal year 2008-09 finally ended up at $1.41 trillion and it is projected to be $1.56 trillion for 2009-10 (these figures include the spending from the $862-billion stimulus bill).

Now, the trouble is to figure out how to measure the effectiveness of these spending programs towards stimulating the economy. The multiplier effects of consumer spending and government spending on GDP growth were old concepts for which current data is not available. This was why Professor Barro had to use data from World War II and the Korean War in his WSJ article quoted above. Also, Professor Barro acknowledges, in his article, that Professors Christina Romer and David Romer have been major contributors to research on tax multipliers. But he says serious scientific research on the spending multipliers has not been made available by them.

Moreover, it is an open question, how many of the jobs created by the stimulus spending comes at the expense of jobs that the private sector would have itself created? Has the government created significant uncertainties for business investment through its direct spending programs and the Fed's 'quantitative easing', resulting in the crowding out of private capital? By taking large scale measures to prevent lay-offs, has the government damaged the ability of the economy to evolve and create new type of jobs and new economic sectors?

Further, could it be that spending massively to sustain current demand has only led to pre-ponement of consumption that would have happened any way in due course of time? Moreover, what are the chances that an arbitrary adjustment of consumption, in the name of stimulus spending, would destabilize price expectations through out the economy so badly that it would set off a destructive spiral of deflation for years to come (a question that Professor DeLong also raises in his article)? Apart from these questions, there are also concerns about the national debt and the threat of rising interest rates and inflation. But, these concerns have been given sufficient attention in the Reinhart-Rogoff work.

Already under President Bush's 8-year term, it was becoming unclear as to how to evaluate a stimulus effort. This was because the American government had simultaneously gotten involved in two wars (Iraq and Afghanistan) during this time. The war expenditure, which would cost 3 trillion dollars in the long term, is independent of the stimulus. But this war expense would interfere with the cost of funding the economic stimulus. Moreover, the negative effects of the war on foreign relations could also impact the economy.

The situation for the Obama stimulus bill is even more complicated because of the Federal Reserve's ramped-up involvement in the economy ever since the crisis intensified in the fall of 2008. The Fed had then increased its balance sheet quickly from $900 billion to $2.2 trillion. Since then, its balance sheet has held steady between $2 trillion and $2.3 trillion. Initially, the increases in the Fed's balance sheet were mainly due to the Fed's direct lending programs (term auction credit, commercial paper purchase) to the private sector.

Over time, these were replaced with purchases of mortgage and treasury securities. As of February 25, 2010, the Fed held $776.5 billion in US treasury securities and $1.032 trillion in mortgage securities. (Source: http://www.federalreserve.gov/releases/). These security holdings constitute the most significant concern about the Federal Reserve's functioning. The global economy is yet to feel the distortions, by way of moral hazard, that the Fed's holding of a total of $1.8085 trillion of treasury and mortgage securities imply.

Recall that mortgage securities were considered so toxic as recently as the fall of 2008, that they caused the financial system to collapse. At present, the overall losses on these mortgage securities, for government organizations taken as a whole, are being absorbed on the balance sheets of Fannie and Freddie (about $120 billion so far). There is vast uncertainty associated with the question of how the Fed is going to realize the full value of the mortgage securities that it has on its balance sheet. The maturity of nearly all of the mortgage securities is over 10 years.

On the positive side, the Fed has also made significant profits on its currency swap agreements with foreign central banks, because of the depreciation in the dollar. These swap agreements were entered into during the 'flight to safety' phase of the financial crisis of 2008. The peak value of the Fed's dollar deposits with foreign banks was $667 billion on October 29, 2008. The swap agreements program has now been retired completely.

Having discussed the various factors involved in the stimulus efforts for the economy, we now provide an argument that shows the effect of the stimulus on households, firms and individual investors. An unpolished form of this argument had first appeared in my article, 'Some Perspectives on the relevance of John Maynard Kenyes to the modern economy', dated December 24, 2008:

"The free market knows no yesterdays, nor any tomorrows. It is relentlessly focused on the present. Of course, one may purchase insurance and future contracts to safeguard oneself against the vagaries of the future behavior of the market. But one would be doing that based on information that one has from outside the market framework. The market mechanism itself does not guarantee anything other than a random walk of price movements.

While there are many advantages to this quality of the market, the single major disadvantage is that it does not reflect normal economic activity accurately. Sure enough, changes in economic activity can be sudden and random, but usually a nation's economy has some continuity to its functioning, and based on this assumption, economic decisions are often made looking into the future.

Investments on raw materials, inventory management, extension of credit to consumers, time value of money, experimenting with new technology, R & D, hiring new employees are some examples where the trust in our ability to gauge the future is crucial. Thus there is some role for another institution like a central bank or the state to step in to ensure that the market mechanism, in its pre-occupation with the present, does not get too much out-of-touch with reality."

In other words, in the immediate aftermath of a panic, the high volatility in the markets makes the random fluctuations of prices especially palpable. This high randomness upsets people's expectations of continuity in the functioning of the economy. If this mismatch between the high randomness of the markets and the people's expectations of continuity is allowed to persist, panic attacks would recur.

Hence, there is a role for the state to step-in to assuage people's fears and restore their expectations of continuity, thus avoiding panic. Examples of the government's role in maintaining continuity are (i) to provide unemployment insurance and assist people with updating their skill sets, (ii) to fill in temporarily through deficit spending, for the fall in consumer spending, (iii) tax cuts to compensate mildly for increased relative cost of labor, (iv) aid to states and localities to avoid drastic increases in their deficits.

Thus the combined stimulus efforts of 2008/09 had the great advantage that they played an important role in preventing the recurrence of panic attacks in the markets. The feeling of panic and fear has vastly receded now. As an aside, we mention here that the stimulus efforts of a newly elected, highly popular President also promised to reduce uncertainties about the future in early 2009. However, when the health care agenda was prematurely brought up for legislation, it led to a complete paralysis of the political system by the end of 2009. As a result, uncertainty about the future is once again heavily afflicting the investment decisions of businesses.

However, the prevention of panic attacks in the markets seems to be holding firm. The financial crisis was a long time in the making. So, the restoration of calm has come at a considerable cost of (i) the dollar's depreciation; today, the dollar is worth about two-thirds of its peak value in February 2002 (Source: http://www.federalreserve.gov/releases/h10/summary/indexn_m.txt), and (ii) projected increase in the net public debt, from $3.3 trillion in 2001 to $16.6 trillion in 2020 (Sources: http://www.gpoaccess.gov/usbudget/ and Wikipedia.org). Since there is no longer any sense of widespread fear and panic in the markets, the cost of funding a stimulus does not justify another round of stimulus spending.

III. The Distant Past: Empire and Monotheism

As late as the 1930s, no less an authority than Will Durant claimed in the first volume of his 'The Story of Civilization' that monotheism is the heritage of the Judeo-Christian religions. With great finesse, Durant employed techniques from cultural anthropology, which was then a newly developing field, to place religious texts of the ancient world in their social contexts. For example, he identified that the process of urbanization in the first millennium B.C., in the regions of Canaan and Mesopotamia, to be the underlying social force behind the writings in the books of the Prophets.

But in the end, studying ancient religious texts requires such keen awareness of nuances that even Will Durant could not avoid inevitable prejudices in favor of his own religious background. Sigmund Freud argued in his 'Moses and Monotheism' (1939) that monotheism was introduced to Judaism by Moses. Freud believed that Moses got the idea for monotheism from the sun-worshiping Egyptian Pharaoh Akhenaten (who died in 1336 B.C. or 1334 B.C. after a 17-year rule). Moses' improvisation was in the conception of the one omnipotent god as an abstract entity, and in the condemnation of idolatry.

In this book, Freud brings his formidable analytical power to bear on his deep knowledge of his own religious background in Judaism. Moreover, he provides methods of reasoning for understanding how taboos, myths and irrational beliefs are perpetrated over the course of human history. For a modern researcher, Freud's power of penetrating the human mind is frightening indeed. Could such profound insights even be possible?

But again, one sees that Freud's strength lies on three factors: the age of reason, biology as an empirical science, and the theory of cause and effect. In particular, Freud does not impose any abstract structure on social organizations. There are the individuals, the families and the tribes. In the Freudian worldview, all human history must follow in a linear fashion from psychological expressions within and among these entities. This severe restriction misleads Freud to over-reach himself, time and again. One could not help but notice that introducing a conceptual structure like 'empire' could take Freud's analyses further.

Our modern knowledge on the ancient Persians suggests that Zarathustra, who preached the exclusive worship of Ahuramazda, could have been the first monotheist, in the same sense that Moses was a monotheist. Until the late 1600s, the date of Zarathustra's life was believed to be about the 6th century B.C. However, after analyzing Avesta, the religious text of the Zoroastrians, from various modern perspectives, scholars now agree on a much earlier date. For one, the religious hymns, called Gathas, that are attributed to Zarathustra, are in the old Avestan language. Currently, the dating of the old Avestan language's period of use varies widely between the 10-th and the 18-th century B.C. (Source: Wikipedia.org).

More generally, it seems quite plausible that monotheism is the legacy of empires -- that the people either worshiped the emperor as in China, or they worshiped the same god that the emperor did. The ancient Middle East, comprising of the eastern Mediterranean region, the Arabian peninsula and the Iranian plateau, has been home to empires even earlier than 1700 B.C., the Babylonian empire of Hammurabi being an example.

Section I explains the importance of monotheism for the development of science in the Western world. The historical references provided in this section indicate that the practice of monotheism could simply derive from the existence of a stable empire. In summary, the concept of an empire appears to be a gold mine for contemporary researchers in the social sciences. I request the Professors to kindly provide me with post-doctoral employment for a period of 3 years, so that I could pursue the path-breaking ideas mentioned in this section.