The Fear Factor

LOS ANGELES – The debate over fiscal expansion versus consolidation continues to divide the developed world. In response to the global recession of 2008, the United Kingdom embarked on an austerity program while the United States enacted an $800 billion fiscal stimulus. Despite a softening economy, British Prime Minister David Cameron is promising to stay the austerity course. Obama, too, is sticking to his guns with his recent proposal for an additional $450 billion of government expenditure and tax cuts to help boost employment. Unemployment in the US has remained above 9% for 22 of the last 24 months. While some are supporting additional stimulus, others are calling for UK-style austerity. But would either of these approaches reduce unemployment most effectively, or would a new round of “quantitative easing” (an unconventional form of economic stimulus by which the central bank purchases financial assets) work better? With Nobel prize-winning economists on both sides of the current debate about how to solve the unemployment problem, the public is rightly confused. Paul Krugman and Joseph Stiglitz are calling for an even larger fiscal stimulus to target government spending on education and infrastructure investment. On the other side, Robert Mundell, Myron Scholes, and Reinhard Selten have called for “draconian measures” to tame debt levels. The American Recovery and Reinvestment Act (ARRA) that Obama passed barely three weeks after his inauguration was disappointing. An $800 billion stimulus did not have the effect for which its proponents hoped, largely because it was accompanied by a big increase in private savings. Backers of the stimulus plan now claim that things would have been much worse without ARRA. I am skeptical. A better approach to reducing unemployment would be a new and expanded round of quantitative easing. I am heartened by calls for this in the UK, and that the talk is now turning to the purchase of risky assets, such as corporate bonds or bundles of loans to the private sector, as opposed to long-term government securities. This is a step in the right direction that I have been advocating for the past three years. But I would go even further. My work provides a new and coherent approach to macroeconomics that explains how a lack of confidence can lead to persistent unemployment. It supports the purchase of equities by central banks to reduce asset-price volatility, restore the value of wealth, and prevent a future market crash. When businessmen and women are afraid, they stop investing in real assets. Lack of confidence is reflected in low and volatile asset values. The environment of fear that arises has little to do with bad government policies, although bad policy may exacerbate the situation. Businessmen and women become afraid that stocks, and the values of the machines and factories that back those stocks, may fall further. Fear feeds on itself, and the prediction that stocks will lose value becomes self-fulfilling. The 2008 recession was triggered by the collapse of a real-estate bubble. Housing wealth in the US has fallen by 34% since its peak in 2006, and is still declining. The stock market fell by almost 50% from its 2007 peak and remains down by nearly a third. This enormous loss of wealth caused a large and persistent drop in consumption demand, which has led to an increase in unemployment. Until we are willing to explore new solutions, the misery experienced by millions of unemployed workers will continue. A quantitative-easing policy in which a central bank buys risky assets can prevent price fluctuations and restore the value of financial wealth. These purchases would need Treasury support, since this tactic is in effect a fiscal policy, not a monetary policy. And, by involving the Treasury, the purchase of risky assets could be financed by issuing debt, rather than by printing more money, thereby attenuating inflationary fears. The Great Recession did not turn into Great Depression II because of coordinated action by governments around the world. Although fiscal expansion may have played a role in this success, central bank intervention was the most important component by far. Quantitative easing works by increasing the value of wealth. In both the US and the UK, it reduced the real expected return on long-term government bonds, which in turn nurtured a recovery in the stock market. We need not tolerate 9% unemployment as the new normal. Confidence is a self-fulfilling prophecy, and we can, and should, manage it by direct intervention in asset markets. The way ahead leads through science, not ideology, dogma, or failed theories. Roger E. A. Farmer is Distinguished Professor of Economics and Department Chair at UCLA. He is the author of two books on the current global economic crisis: How the Economy Works: Confidence, Crashes, and Self-Fulfilling Prophecies and Expectations, Employment, and Prices. Copyright: Project Syndicate, 2011.