There is an excellent exchange between prominent experts (Bill Bradley, Niall Ferguson, Paul Krugman, Nouriel Roubini, George Soros, Robin Wells) about the causes and prospects of the current economic crisis. It is titled “The Crisis and How to Deal with It” and appears online at the NY Review of Books.
Reading it made me think about an analogy between the progression of the world economy and the movements of a bicycle. Think of a well functioning economy like a bicycle moving rapidly along a road. The rider represents the government whose modest adjustments, left and right, keep the bicycle on a steady path. However an even greater force keeping the bicycle upright is the torque created by the spinning wheels. The torque is analogous to the forces exerted by the private market in an economy. As long as the bicycle (economy) moves sufficiently fast (grows), the rider (government) needs only exert a small level of checks and balances to keep it moving steadily forward: mostly though it is the torque (private market activities) that keep the bicycle upright and moving.
The current economic crisis is like the bicycle hitting a big bump in the road. No one knows precisely how or why we hit the bump, but hit it we did, and the bicycle (our economy) has slowed down and is beginning to tumble over. But as we all know, a slow moving bicycle requires many more adjustments by its rider; and the slower the movement, the more aggressive must be the rider’s reactions to keep the bike from falling over.
In the dialogue described above, Krugman’s argument is like saying that the bicycle is moving so slow right now that we need dramatic rider reactions (government intervention) to correct for the lack of bicycle momentum due to the slower speed. (i.e., the private sector has chosen to save much more, or demand much less, and the government must substitute by spending instead – in other words, the government must pedal for awhile. Government borrowing is not a problem, he says because the private sector is unwilling to do it itself.)
Ferguson’s argument (and others) however is a concern about another point in time during the adjustment process. He is worried about what happens later because of the massive fiscal deficits and the borrowing demands they will require. This concern arises once the bicycle has begun to gain more momentum again. Note, this is China’s major concern right now too.
So suppose Krugman is indeed right, that we need a major government corrective effort to right the bicycle. Well, what happens if, after the bicycle is about to fall over to the right, the adjustment by the rider is so strong to the left that although the bike will indeed become vertical again, it will also eventually begin to topple over leftward. If the rider cannot correct the movement fast enough a near collapse to one side will be righted only temporarily as the bicycle begins to topple over to the other side.
More specifically, a government intervention that gets the economy humming along again quickly, may also stimulate consumption (thereby reducing savings demand) and leave the government still with a huge fiscal deficit and no way to finance it without printing money. This is when the bicycle may begin to topple over in the other direction.
Krugman’s analysis would be more credible if it were apparent that the fiscal stimulus would be spent mostly in the next year and if thereafter government spending would revert to its previous levels. In other words, if the projected deficit this year were 12% but next year it goes back to 3% of GDP, then one could support the idea that the correction
is not excessive.
Finally, as with a wobbly bicycle, although reactions are necessary to keep the bicycle from falling over (Krugman is right), overreactions are almost the norm (Ferguson is probably right too), perhaps several times, before the bicycle can get back to its normal progression. If the analogy is accurate then, any improvement in the economy now, is likely to be followed by another collapse, perhaps next time with higher inflation and another economic slowdown even after markets seem to be rebounding.
With this said, hopefully the analogy is wrong.