Debt-to-GDP & Misdiagnosing A Bubble Economy’s Ills

By Tim Iacono * GoldSeek.com

A few economists seem to be catching on, but not nearly enough…

About a year ago, St. Louis Fed President James Bullard wondered whether too much faith was being placed in what models say economic growth should be but, as detailed in When Models Trump Common Sense, he was rebuffed by nearly the entire establishment (or at least “a small army of bloggers with PhDs in economics”).

Now, in a story at Project Syndicate, Raghuram Rajan, Professor of Finance at the University of Chicago Booth School of Business and the IMF’s youngest-ever chief economist tries to explain Why Stimulus Has Failed and, in doing so, questions whether the root cause of our current economic troubles is simply a lack of demand, casting himself as an Austrian sympathizer in the process:

What if the problem is the assumption that all demand is created equal? We know that pre-crisis demand was boosted by massive amounts of borrowing.
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Put differently, the bust that follows years of a debt-fueled boom leaves behind an economy that supplies too much of the wrong kind of good relative to the changed demand.
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The only sustainable solution is to allow the supply side to adjust to more normal and sustainable sources of demand … The worst thing that governments can do is to stand in the way by propping up unviable firms or by sustaining demand in unviable industries through easy credit.

Not surprisingly, it didn’t take long for one commenter to call Rajan out:

Raghuram Rajan’s article sounds awfully close to me to a defense of Austrian Economics, a la Ludwig von Mises. Even though Mr. Rajan might not want to portray it that way. [Austrian Econ is not all too popular these days in the venerable halls of the top departments of Economics, where Mr. Rajan circulates.]

For reasons that make no sense to anyone who isn’t an economist, it has long been accepted as conventional wisdom amongst the dismal set that demand is demand – it doesn’t matter where it comes from – and, once it appears, it forms the basis of an economy’s “potential” output or “potential” GDP.

Once an economy’s actual output dips below its “potential” output (as extrapolated from past activity, regardless of what drove that past activity), then you have what’s called an “output gap” as shown below, and this is what leads to the massive amounts of money printing and borrowing seen today.

What Rajan is suggesting above is that policymakers may have misdiagnosed the problem – that the mid-2000′s demand wasn’t really sustainable demand – and, as a result, they are now applying the wrong solution by trying to close this “output gap” via more money printing and more government debt.

In effect – Gasp! – the Austrians could be right about this – there is no easy solution to a debt-driven boom.

You either take your medicine or you take steps that could end up destroying your currency (in our developing global currency war, perhaps all the worlds currencies).

Clearly, the world’s economists are opting for the latter.

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