For those looking for the assumptions underlying the current big economic debate the Institute for New Economic Thinking (Inet) website is a good starting point.
Its home page features a debate on whether public deficit reduction is necessary to encourage private sector growth or whether it will undermine recovery.
Richard Koo, the chief economist of the Normura Research Institute, provides the opening remarks for those who argue continuing stimulus is necessary. He argues that the western world is suffering from a “balance sheet recession” similar to Japan over the past 15 years and America’s Great Depression of the 1930s.
In a balance sheet recession the goal of companies is to minimise debt rather than to maximise profits even though interest rates are close to zero. Firms have even more debt than they can show on their balance sheets. In effect they are bankrupt despite having cash flow. Under such circumstances the right thing for companies to do, from their perspective, is to pay down debt.
The problem comes on a macro level where there is little demand in the economy. Under such circumstances the government has to do the opposite of the private sector by spending to keep the economy going. “It’s not a common cold anymore, this is pneumonia,” says Koo. (article continues below)
In contrast, Ken Rogoff, a professor of economics at Harvard and former chief economist at the International Monetary Fund, argues that deficits must be cut and debt reduced to inspire confidence in the financial markets. In his view there is a need for discipline in the management of resources.
He also disputes Koo’s description of events in Japan. For Rogoff the Japanese failed to anchor inflation expectations through targeting while the rise of China was a big shock to Japan’s economy.
Other economists, including Robert Skidelsky who attended the Inet conference and Paul Krugman who did not, side with Koo on the need to maintain a fiscal stimulus.
As I have previously argued (see blog post of 21 July) this debate is much narrower than it seems. However, it is important to critically examine the underlying assumptions held by each side.