Ideas: Getting the economic policy right

This article first appeared in Forum, The Edge Malaysia Weekly, on September 30, 2019 - October 06, 2019.
Ideas: Getting the economic policy right
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When you feel sick, you usually go to see a doctor. Surely you do not expect the doctor to prescribe a cure or a treatment just by looking at you, do you? In general, he or she will first ask you to describe your symptoms and if the situation is still unclear, recommend a more thorough check-up until the disease is clearly identified. Only at this point will medicine and treatments be prescribed.

Such a process looks like common sense. Yet, when we shift from the medical metaphor to an analysis of the economic system, common sense gets lost in translation. In particular, I have in mind the ongoing discussion on the possibility that a recession may hit the Malaysian economy and how Budget 2020 should address it.

The debate can be summarised as follows: Is a recession on the horizon? If yes, how can we face it, given that budget constraints will make it difficult to implement expansionary fiscal policies? Will an eventual monetary easing be enough? The European case, for example, shows that easy credit was more a part of the problem than an actual solution.

I believe that the main problem of this way of thinking is the aggregative approach — to look at things only from a macroeconomic perspective. In this way, I think, we fail to capture the peculiarity of a downturn and, therefore, to address it in the right way and implement the right cure. In a nutshell, it is like visiting a doctor and expecting the same medicine for every kind of disease. It does not sound right, does it?

From a macroeconomic perspective, a recession is defined as a period of temporary economic decline during which trade and industrial activity are reduced, generally identified by a fall in gross domestic product (GDP) in two successive quarters. GDP is key here. Though a relatively young instrument, it has become crucial for judging the economic health of a country. But how is it measured?

GDP is the sum of consumption, private investment, government spending and the balance between exports and imports. Though an important indicator, GDP per se is not enough to judge the actual status of an economic system. A simple example: Let us imagine that, ceteris paribus, government spending increases. The GDP value will go up. But what about the qualitative nature of that spending increase? If that money were spent in unproductive investment by borrowing foreign funds, thus shifting the burden of that debt onto future generations, are we still convinced that the increase was a good thing for the economic system?

While GDP does say something, it does not say everything. To keep to our metaphor, it is like the description of an initial symptom but is unable to tell the real status of the patient. Our task as economists should be to further dig into the qualitative reality behind the quantitative measurement.

Therefore, if we see GDP showing a downward tendency, before asking for more government spending (the need for heavy counter-cyclical measures), we should look at what is actually going down in the GDP and we should ask why. The higher the level of disaggregation, the better.

What follows is that simply advocating expansionary fiscal measures (more government spending) or monetary measures (lowering the reference interest rate) is highly misleading. It is clear that, if the economic system is a complex — German economist Ludwig Lachmann calls it “kaleidic” — reality, to flood it with government money or easy credit can produce more harm than good.

Imagine that, as a result of fiscal stimuli, an industrial sector expands beyond its natural and organic size (which is, the dimension given by non-stimulated demand and supply). What will happen when the stimuli will have to reach an end? The risk is that the post-expansion situation will be worse than what it was before.

Not all recessions are alike and an increase or decrease in GDP does not capture the actual status of the economy. In order to properly address an economic situation, it is necessary to look at the micro-elements behind the macro-aggregates. Only in this way can the real nature of a downturn be appreciated and sound policies implemented, always keeping in mind that policymaking requires humility as the economic system is a dynamically ever-changing organism. The unintended consequences of over-ambitious policies can be dramatic and worse than the disease itself.

Carmelo Ferlito is senior fellow at the Institute for Democracy and Economic Affairs

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