Instrument instability & the global economic crisis

Robert Holbrook in 1972 drew attention to the issue of policy instrument instability.  Essentially an economic policy can become infeasible if policy needs to adjust more intensively to offset past effects of policy - the policy itself becomes an unstable process.  This type of instability is particularly likely if we try to pursue stabilisation of the economy too completely. An example arose when money supplies needed to grow at ever faster rates to try to keep unemployment down. As Jeff Sachs suggests (HT Greg Mankiw) in relation to the current batch of US economic policies:

"Massive deficits and zero interest rates might temporarily perk up spending but at the risk of a collapsing currency, loss of confidence in the government and growing anxieties about the government’s ability to pay its debts. That outcome could frustrate rather than speed the recovery of private consumption and investment. Deficit spending in a recession makes sense, but the deficits should remain limited (less than 5% of GNP) and our interest rates should be kept far enough above zero to avoid wild future swings.


We should also avoid further gutting the government’s revenues with more rounds of tax cuts. Tax revenues are already too low to cover the government’s bills, especially when we take into account the unmet and growing needs for outlays on health, education, state and local government, clean energy and infrastructure. We will in fact need a trajectory of rising tax revenues to balance the budget within a few years".

The source of the current crisis is that US citizens have borrowed too much and saved too little over the past decade partly because interest rates and taxes have been excessively low.  Private citizens have not produced enough goods and services to achieve the lifestyle (and to fund their wars and tax cuts) they wanted, they have not exported enough and instead have financed their consumption binge mainly by borrowing against the value of their real estate whose prices were inflated by a debt-funded real estate bubble.  Equilibrium will be established once debts have been reduced and savings rates increased and once the value of real estate falls back into line with consumer incomes*.  Adding extra government debt (and equivalently, cutting taxes) as well as setting close to zero interest rates might provide a short-term palliative but - whatever else it might do - does not at all resolve the underlying problems.  The danger is apocalyptic - continued borrowing can lead to a US public sector bankruptcy, a consequent (or precedent) collapse of the US dollar that would then destroy large segments of the world economy and a global depression that will make current events look seem like a Sunday school picnic.

A number of policy theorists have described current policy as a 'paradox' - incurring a bit more debt to resolve America's debt-induced problems.  I think it is just dangerous policy and a potential instance of instrument instability. Barack Obama must see something of the same difficulty - he is committed to reducing the US fiscal deficit by half during his first term.  I think he is an able man but this is a very tough objective. 

We are due for a recession and a severe economic downturn. This is inevitable and the attempt to eliominate its consequences too completetely can be futile and induce worse future economic problems.
* The same is true to a less extent for Australia.  Eventually house prices must fall very substantially.  Australian real estate remains some of the most expensive on earth even though we have a small population and abundant land.  That is true even if we live in a 'highly urbanised' country (one of the standard reasons advanced for our high prices). .