Monday, February 23, 2009

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). .


Anonymous said...

It was interesting to see the comments of Hilary Clinton yesterday -- it was amusing to see the US give up on talking to the Chinese about human rights completely, as well as tell them that they needed to keep buying US bonds! Obviously they must be getting worried that people won't care about their funny money printing scheme anymore.

Anonymous said...


I don’t buy this line that Australia’s housing prices are going to fall to any great degree – certainly nothing like the US/UK etc.

Sure our house prices are expensive, but they are justified and likely to hold up based on for example;

1. Our economy is not completely tanking (unlike US, UK, Japan etc).
2. We are probably one of the best countries in the world to live.
3. Good/reasonable social services.
4. Good/reasonable urban infrastructure.
5. High level of immigration.
6. More stringent lending practices and regulation of financial sector than US/UK etc.
7. More appropriate interest rate settings during this decade than US which has had lots of credit.


hc said...


Our house prices are out of wack with earnings - about 6.3* annual earnings when 3X is high.

As a modestly paid university professor I wonder why the house I live in is worth more than 10X my gross income.

Part of the Aussie obsession is doubless due to negative gearing of investment properties and the ability to take capital gains on owner occupied housing tax free.

Anonymous said...


I dont think tax deductability for negative gearing is going anywhere and neither is the capital gains concession on owner occupied housing.


Anonymous said...

"I wonder why the house I live in is worth more than 10X my gross income."

Because that's what people are prepared to pay for it.

People are prepared to pay 10X because many people want to live in the desirable parts of Melbourne and there aren't many alternatives.

"Deficit spending in a recession makes sense, but the deficits should remain limited (less than 5% of GNP)"

So the Australian deficit should be no more than $50 billion per year. Seems reasonable.

Anonymous said...

Fiddlesticks Spiros because it took us eleven and a half years to pay off that $96bill black hole last time and accrue that surplus with the Great Moderation and now you want to load up the kids when the Great Geriatrification has begun with a bang rather than an anticipated whimper. I'd remind you the youngest BBer is now 47 and the oldest 64. Who the hell is going to pay this debt? Keyne's great grankids?

Anonymous said...

Observa, on your logic, if debt is so terrible, no one should ever take out of a mortgage to buy a house, even a moderately priced house.

It's just a nonsense to say we are burdening our children. Every generation is richer than the previous one, and by quite a big margin. The kids will be fine.

Anonymous said...


The Rudd stimulus is less than that of Fraser in 1982 ( who was the Treasurer?) and net debt did not rise.

If things get better you problems of debt will be shown to be overblown. If things get hairy then more money will be needed but it will still be paid back.
Even if ALL of the $220b of the proposed bonds were actually used it still means Government debt of 5% of GDP , easily the lowest amongst Western Countries

Unknown said...

Our economies based on making money on money instead of making things are burning out.

The real tangible value of workers and labor have been deflated to a point where it impacts the paper money. Paper printed with images on it and then called money requires a vast amount of manipulations of transactions to add value to it. The whole of what a society or nation contains ends up as the money standard. What Globalist Free Traders forgot about was that the value of workers and labor act as a money standard and play a giant role in the money standard that is behind the printer paper money.
The deflation of the value of workers and labor is now impacting all money products.

The only thing that will work is local added value economies that add values from raw product up through to the retail and end user level. Then it has to recyle again and again. If the pieces of the local economies are spread across the world, the added values are too. Water always seeks its own level and when Globalization and Free Trade have workers compete with one another for the same jobs down to the lowest levels of wage slave and even child labor there are very few ways any economy can recyle real values.

For more, see

Anonymous said...

'Observa, on your logic, if debt is so terrible, no one should ever take out of a mortgage to buy a house, even a moderately priced house.'
There is a fallacy of composition in macroeconomics and in your case its corollary decomposition. Just as it makes perfect sense for 25-30yr olds to take on a mortgage as all those Reaganite/Thatcherite young things did starting in the 80s, it makes little sense for them to do so at 50-55. If the demographic composition is changing, therein lies the problem in a macro sense as distinct from an individual sense. Public debt is macro debt remember. Also each generation does not necessarily get richer if the preceding one has failed to reproduce itself.

Anonymous said...

Some observations in this forum on the future price of housing in Australia, place to much stock in what occured in the past.

While it's certainly true that the best predictor of the future is the past, it's not always true.

The times it becomes unreliable are when new factors enter a market. That new factor is long term affordability. The only way forward is low cost quality housing and low cost land/services acquisition.

Wages will never again be able to keep pace with mortgages ( low interest, falling price markets aside )