A MANIFESTO FOR ECONOMIC SENSE

  More than four years after the financial crisis began, the world’s major advanced
economies remain deeply depressed, in a scene all too reminiscent of the 1930s. And the reason
is simple: we are relying on the same ideas that governed policy in the 1930s. These ideas, long
since disproved, involve profound errors both about the causes of the crisis, its nature, and the
appropriate response.


  These errors have taken deep root in public consciousness and provide the public support
for the excessive austerity of current fiscal policies in many countries. So the time is ripe for a
Manifesto in which mainstream economists offer the public a more evidence-based analysis of
our problems.


  The causes. Many policy makers insist that the crisis was caused by irresponsible
public borrowing. With very few exceptions – other than Greece – this is false. Instead, the
conditions for crisis were created by excessive private sector borrowing and lending, including
by over-leveraged banks. The collapse of this bubble led to massive falls in output and thus in
tax revenue. So the large government deficits we see today are a consequence of the crisis, not its
cause.


  The nature of the crisis. When real estate bubbles on both sides of the Atlantic burst,
many parts of the private sector slashed spending in an attempt to pay down past debts. This was
a rational response on the part of individuals, but – just like the similar response of debtors in the
1930s – it has proved collectively self-defeating, because one person’s spending is another
person’s income. The result of the spending collapse has been an economic depression that has
worsened the public debt.


  The appropriate response. At a time when the private sector is engaged in a
collective effort to spend less, public policy should act as a stabilizing force, attempting to
sustain spending. At the very least we should not be making things worse by big cuts in
government spending or big increases in tax rates on ordinary people. Unfortunately, that’s
exactly what many governments are now doing.


  The big mistake. After responding well in the first, acute phase of the economic crisis,
conventional policy wisdom took a wrong turn – focusing on government deficits, which are
mainly the result of a crisis-induced plunge in revenue, and arguing that the public sector should
attempt to reduce its debts in tandem with the private sector. As a result, instead of playing a
stabilizing role, fiscal policy has ended up reinforcing the dampening effects of private-sector
spending cuts.


  In the face of a less severe shock, monetary policy could take up the slack. But with
interest rates close to zero, monetary policy – while it should do all it can – cannot do the whole
job. There must of course be a medium-term plan for reducing the government deficit. But if this
is too front-loaded it can easily be self-defeating by aborting the recovery. A key priority now is

to reduce unemployment, before it becomes endemic, making recovery and future deficit
reduction even more difficult.


  How do those who support present policies answer the argument we have just made?
They use two quite different arguments in support of their case.


  The confidence argument. Their first argument is that government deficits will raise
interest rates and thus prevent recovery. By contrast, they argue, austerity will increase
confidence and thus encourage recovery.


  But there is no evidence at all in favour of this argument. First, despite exceptionally
high deficits, interest rates today are unprecedentedly low in all major countries where there is a
normally functioning central bank. This is true even in Japan where the government debt now
exceeds 200% of annual GDP; and past downgrades by the rating agencies here have had no
effect on Japanese interest rates. Interest rates are only high in some Euro countries, because the
ECB is not allowed to act as lender of last resort to the government. Elsewhere the central bank
can always, if needed, fund the deficit, leaving the bond market unaffected.


  Moreover past experience includes no relevant case where budget cuts have actually
generated increased economic activity. The IMF has studied 173 cases of budget cuts in
individual countries and found that the consistent result is economic contraction. In the handful
of cases in which fiscal consolidation was followed by growth, the main channels were a
currency depreciation against a strong world market, not a current possibility. The lesson of the
IMF’s study is clear – budget cuts retard recovery. And that is what is happening now – the
countries with the biggest budget cuts have experienced the biggest falls in output.


  For the truth is, as we can now see, that budget cuts do not inspire business
confidence. Companies will only invest when they can foresee enough customers with enough
income to spend. Austerity discourages investment.


  So there is massive evidence against the confidence argument; all the alleged evidence
in favor of the doctrine has evaporated on closer examination.


  The structural argument. A second argument against expanding demand is that
output is in fact constrained on the supply side – by structural imbalances. If this theory were
right, however, at least some parts of our economies ought to be at full stretch, and so should
some occupations. But in most countries that is just not the case. Every major sector of our
economies is struggling, and every occupation has higher unemployment than usual. So the
problem must be a general lack of spending and demand.







  In the 1930s the same structural argument was used against proactive spending
policies in the U.S. But as spending rose between 1940 and 1942, output rose by 20%. So the
problem in the 1930s, as now, was a shortage of demand not of supply.

                             ___________________



  As a result of their mistaken ideas, many Western policy-makers are inflicting massive
suffering on their peoples. But the ideas they espouse about how to handle recessions were
rejected by nearly all economists after the disasters of the 1930s, and for the following forty
years or so the West enjoyed an unparalleled period of economic stability and low
unemployment. It is tragic that in recent years the old ideas have again taken root. But we can no
longer accept a situation where mistaken fears of higher interest rates weigh more highly with
policy-makers than the horrors of mass unemployment.


  Better policies will differ between countries and need detailed debate. But they must
be based on a correct analysis of the problem. We therefore urge all economists and others who
agree with the broad thrust of this Manifesto to register their agreement at
www.manifestoforeconomicsense.org, and to publically argue the case for a sounder approach.
The whole world suffers when men and women are silent about what they know is wrong