Most Stimulus Packages Have Been Far Too Small: Tim Harford

Tim Harford is a senior columnist for the Financial Times. His long-running column, ‘The Undercover Economist’, reveals the economic ideas behind everyday experiences. Harford’s first book, The Undercover Economist, has sold one million copies worldwide in almost 30 languages. He is also the author of The Logic of Life, Dear Undercover Economist, Adapt and most recently, The Undercover Economist Strikes Back. In this free-wheeling interview with Forbes India, Harford discusses the ideas he explores in his latest book The Undercover Economist Strikes Back, from why he feels that stimulus packages in the Western world have been far too small to why money does buy happiness to why Henry Ford was the man who invented unemployment.

Q. One of the most interesting parts of your book is where you talk about the babysitting recession. What is that all about?
The babysitting recession was first discussed in an article published by Joan and Richard Sweeney in the 1970s, but it has been made famous by Paul Krugman. There was a babysitting co-op in Capitol Hill, Washington DC, which suffered a severe and lasting depression. Couples would keep track of who was babysitting for whom by exchanging babysitting tokens; however, there weren’t enough tokens in the economy. Almost everybody wanted to babysit for other people, accumulating a few more tokens as a reserve, before they spent any tokens themselves. But of course the arithmetic does not work: Somebody has to go out or there is no economy at all.

Q. What drew you to this example?
A number of things are interesting about this example—notably that a total economic breakdown could be fixed by a simple policy tweak: Printing more tokens. [Paul Krugman has more recently tended not to mention the end of the story: The co-op printed too many tokens and ended up suffering from a serious inflation problem. But that is more of an interesting sting in the tale than a refutation of the entire example.] In The Undercover Economist Strikes Back, I use the babysitting recession as a nice simple example of a Keynesian recession in which there is some dysfunction in the way the economy works—a dysfunction that can be fixed by governments printing money or perhaps borrowing and spending money. Some commentators believe Keynesian recessions are logically impossible; this is nonsense and it is nice to have a simple counter-example.

Q. Another interesting part is about the prison camp recession. What is that all about?
The prison camp I talk about was in Germany during the Second World War. The economic activity in the camp—a bit of production, but mostly trading items sent to prisoners by the Red Cross—was analysed in quite a brilliant article by one of the prisoners, Robert Radford, who published his findings a few months after the war ended.

The prison camp is almost the perfect counter-weight to the babysitting co-op. Trade in the prison camp worked amazingly well. There were well-understood prices and middlemen ensuring that prices in different parts of the camp tended to converge to similar levels. At one stage, coffee was worth more outside the camp in the cafes of Munich than it was inside the camp. That meant gains from trade, and coffee began to go “over the wall”—the prison camp had an export trade! Despite various attempts from senior officers to regulate trade and, particularly, fix prices at levels they regarded as fair, they were flexible and refused to respect any social or ethical conceptions of the “just price”. This was close to a perfect market. And yet… and yet the prisoners nearly starved to death.

Why they starved is not hard to understand. The parcels from the Red Cross began to dry up as the war progressed. Food and cigarettes both became scarce. In the last desperate days, there were few goods and prices fluctuated wildly. Finally, the US Army arrived and liberated the prisoners.

Q. But what does all this have to do with a modern economy?
The point is that there are two conceptions of what a recession really is. One conception is Keynesian, like the babysitting co-op: Some internal malfunction that needs fixing. But another conception is Classical: That economies fluctuate not because of anything wrong within the economic system itself, but because of policy errors or external shocks. Of course, the prison camp is an extreme example of a recession caused by an external shock, but modern economies are subject to technological changes, fluctuations in the price of basic commodities, and, of course, financial shocks from a banking crisis.

Q. Where do the babysitting recession and the prison camp recession meet? What are the policy lessons one can draw from them?
A Keynesian, babysitting co-op recession invites a role for government intervention—most famously through fiscal policy [cutting taxes or boosting spending] but also through monetary policy [cutting interest rates or even printing new money]. A Classical, prison camp recession invites a more fatalistic response: There’s nothing the government can do to make things better, and plenty of things it can do to make things worse. The huge argument that has raged in many economies about fiscal stimulus versus austerity is really a debate about whether recent recessions have been mostly Keynesian, or mostly Classical. If Classical, then austerity is the right response: We’re poorer and we need to get used to it. If Keynesian, then fiscal stimulus is the right response: We’re only poorer if the government gives up and allows us to be.

Q. So are the recent recessions Keynesian or Classical?
In a book, you can give black-and-white examples and, in life, nothing is black and white. But in my view, the recent recessions have been at least partially Keynesian and governments—especially in the UK and US, where they had a choice—should have postponed austerity measures.

Q. The Western world has been running stimulus programmes. Do they really work?
It’s interesting that this is your perception. I think most stimulus packages have been far too small—although the US has at least tried. The evidence on such things is always tricky because macroeconomists [unlike microeconomists] cannot run controlled trials. But we can try our best.

Q. Can you elaborate on that?
The International Monetary Fund at first estimated a modest effect from fiscal stimulus—that is, government spending does make the economy larger in the short run, but only a bit. But the Fund later recanted and argued that in the recent recession, fiscal stimulus was far more effective than they’d believed at first.

Let’s assume this is correct—I think it is. How did the Fund make their original mistake? The problem was that they were looking at historical evidence on stimulus spending, and the historical evidence incorporated much milder recessions in which monetary policy was a good alternative to fiscal stimulus. Those mild recessions weren’t a good guide to recent experience, alas.

Q. What is the best way to make a stimulus work?
I argue in my book that the best bet is advanced planning: Governments should have a list of well-planned infrastructure projects, and should accelerate those plans in case of a downturn. That way, we carry out the investment we were intending to anyway, but at a time when it will have nice macroeconomic side-effects.

Q. Economists have been criticised for having too much faith in GDP growth. Even Simon Kuznets, the man who invented GDP, never saw it as a measure of welfare. You write that “they rely on the popular misconception that much of what is wrong with the way the economy is organised is wrong because we collect GDP statistics, and that the way to fix our economic problems is to measure something else. I think that is a mistake”. Why is that a mistake?
Because it isn’t the measuring of GDP that has caused the problems. We had economic growth—and inequality, environmental degradation and other problems—long before we could measure it. Of course, there are thoughtful critics of GDP who suggest additional things we could measure, or ways to make GDP a better measure of economic activity. But the more radical critics seem to assume that our economy is organised the way it is because some sinister force is trying to maximise GDP. And that’s just crazy.

Q. A lot of recent thinking talks about happy economics (or what you call happynomics). Does money buy happiness?
Money does buy happiness, it seems—or at least having more money, within a particular society, is correlated with being happier—or rather, with telling surveyors that you are more satisfied with your life. The big contested question in happynomics is whether that’s also true across countries: So, is a richer country such as the US happier than a poorer country such as India?

Early research from Richard Easterlin suggested that richer countries aren’t happier—hence the phrase ‘the Easterlin Paradox’. If money buys happiness for individuals but not for countries which are collections of individuals, what’s going on? Two possible explanations: One is that what really counts is relative income. Indians compare themselves to other Indians; Americans compare themselves to other Americans. If Americans compared themselves to Indians they’d feel rich and would be happier. But they don’t, so they don’t. An alternative explanation—favoured by economists Justin Wolfers and Betsey Stevenson—is that Easterlin is just wrong: At the time of his research, the data were of poor quality. Now we have better quality data and we see that money is correlated with happiness both across and within countries. It will be interesting to see this debate play out.

Q. Can economic growth carry on forever?
In principle, yes. Quite a few environmentalists and physicists have pointed out that the planet simply cannot support exponential growth. Sooner or later—and, with exponential growth, sooner than we think—we will reach environmental limits.

Q. You don’t buy that?
I regard myself as an environmentalist but I think this is just a simple conceptual error. Of course, we cannot continue to use more resources or energy at an exponential rate. But economic growth is just growth in the market value of output. So it can continue forever—at least in principle. There are already signs that energy growth is being decoupled from economic growth. In countries such as the UK, the US, Germany and Japan, energy consumption per capita has been falling for a long time now. Population growth is also low or negative in many rich countries. I believe that we need to focus on practical environmental questions—for instance, how to reduce carbon dioxide emissions now—rather than these very abstract concerns about exponentiation.

Q. One of the things that you write about India is that “there simply isn’t enough money in India yet for it to be unequal”. What do you mean by that? Do you see it changing in the years to come?
The World Bank economist Branko Milanović has this idea of the “inequality possibility frontier”. Imagine an extremely poor subsistence society. Then imagine some class of plutocrats, who somehow confiscate wealth and spend it themselves. How much can they take? The answer is: Not much if the society is to survive, because the poor cannot dip below the average income since the average income is barely enough to keep you alive. Now imagine a much richer society. This, in principle, could be far more unequal because the poor could still survive on a tiny fraction of the average income. Milanović and his co-authors were interested not only in how unequal a society is, but how unequal it is relative to how unequal it could possibly be. My point was that despite important gains over the past 20 years, India is still a very poor society. There’s a limit to how unequal it can get until it gets richer—which should make us worry about the inequality we do see.

Q. Why was Henry Ford the man who invented unemployment?
Ah yes, this is one of my claims—and I should say that it’s an exaggeration, of course. But here’s the puzzle: Henry Ford of the Ford Motor Company raised wages at his factory to such a level that men were queuing round the block for jobs, being hosed down by police in a sub-zero Chicago January. Why have such high wages? Why not cut them and save money, given how much demand there was for jobs?

The idea here is “efficiency wages”—that it can be efficient for an employer to pay well above the market rate because it gives him the pick of applicants, and a fiercely loyal group of workers who will do almost anything to keep their jobs. And, of course, that describes many—perhaps most—jobs in the formal sector today. That means, in turn, that we’ll always have unemployment, not because of some macroeconomic slump, but because individual profit-maximising companies prefer efficiency wages.