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“…US needs to shift its economic policy from demand-side stimulus to supply-side reform…” says Dehn

Head of research at Ashmore Jan Dehn tells IFA Magazine that the US needs to shift its economic policy from demand-side stimulus to supply-side reform, or else face the same fate many EM countries have in the past.

He says the appropriate turning point for this policy is when the economy approaches full employment. He uses Argentina as an example of what could happen if the US doesn’t make the appropriate shift.

Recoveries from crises – a few lessons from EM countries

“The recoveries of Western economies from their severe banking and housing crises in 2008/2009 have so far relied almost exclusively on heavy demand side stimulus, including zero interest rate policies, massive fiscal support and Quantitative Easing (QE).

“The experience from Emerging Markets (EM) countries, however, shows that sustainable recoveries do not rely on stimulus alone. Rather, a critical turning point is reached in every recovery, when the focus of economic policy must shift from demand-side stimulus to supply-side reform. This important turning point is usually reached when the economy approaches full employment.

“Experience from EM also shows that failing to switch from stimulus to reform at the appropriate time undermines the recovery and might, in extreme cases, lead back to crisis as imbalances multiply over time and become ever more difficult to reverse. EM experience also shows that getting the timing right for changing the direction of policy can be difficult and that changing policy is very difficult politically.”

Argentina – a case in hand

“The recent history of Argentina illustrates these points quite clearly. In 2001, Argentina defaulted on USD 120bn of sovereign debt in what was then the world’s largest sovereign default. The economy fell into outright depression. Following a period of political chaos Nestor Kirchner, an authoritarian populist, secured the presidency. Nestor was quite clear about what needed to be done for the economy to recover. He turned on the fiscal and monetary spigots and before long aggregate demand began to respond. Argentina’s economic depression was so deep however that Nestor was able to stimulate the economy at full tilt right up to 2004/2005, before aggregate demand finally caught up with aggregate supply.

“At this critical point, however, Nestor made a major mistake. He ought to have recognised that once the economy had reached full employment further stimulus would become counter-productive. Rather than pushing up prices, widening the trade deficit and overvaluing the real exchange rate he should have been encouraging trend GDP growth. The correct policy at that point would have been to address the many constraints on the supply-side of the Argentinian economy and to allow aggregate demand to rise only in line with increments in aggregate supply, that is, the pace of productivity growth. Nestor’s policies began to push Argentina away from equilibrium.

“Obsessed with keeping the expansion going, Nestor continued to stimulate the demand side of the economy and his wife, Cristina Fernandez de Kirchner, continued along the same lines after Nestor passed away in 2010. The ramifications of this colossal mistake were serious and very sobering. Argentina soon began to experience the inevitable inflationary pressures. But instead of tightening monetary policy the Kirchners opted to manipulate the official inflation numbers in a bid to make the problem go away. This approach understandably freaked out the local pension funds, which began to sell their holdings of government bonds. The Kirchner responded by nationalising the private pension funds and forcing the state pension fund, ANSES, to buy government debt.

“This sent a clear message to savers: get your money out of the country. As capital flight became a major problem the government decided to apply capital controls. Almost immediately a parallel exchange rate system emerged, which soon precipitated massive over- and under-invoicing of trade flows. In a bid to stamp out such unpatriotic practices, the government orchestrated a clampdown on trade, led by the commerce ministry. Meanwhile, the exchange rate was becoming ever more overvalued, so exporters were increasingly being priced out of their markets. The government actually made the problem worse by directly intervening in trade via a plethora of trade taxes, tariffs and other instruments. The multitude of distortions resulting from all these policies eventually so undermined business conditions that honest hard work and above-the-board businesses became entirely unprofitable. Thus, in the final days of the Kirchner administration there were only two games left in town, namely rent-seeking and speculating against the currency in the parallel FX market.

“Argentina’s example is an extreme one, but it illustrates two key points about heterodox policies that are entirely universal, namely that (a) it is critically important to rotate from demand to supply-side policies when the economy reaches full employment in order to avoid macroeconomic imbalances; and (b) once macroeconomic imbalances have re-emerged due to protectionism and other heterodox policies the temptation to introduce yet more controls only increases. This dynamic is extremely dangerous; addressing the symptoms rather than the causes tends to set in motion dynamics that ultimately lead to economic ruin.”

A warning to DM investors

“Given EM experiences, alarm bells ought to be going off in the minds of investors with money invested in the US and the UK. Both economies are at or close to full employment and inflation is rising. Both countries have reached their respective turning points, where they ought to shift from demand stimulus to productivity enhancing structural reforms. The central banks in both countries are far behind the curve with real policy rates lingering deep within negative territory. Neither the US nor the UK appears inclined to engage in serious structural reforms. To the contrary, they both seem to be leaning towards yet more fiscal stimulus. Both countries are also dismantling rather than deepening important trade ties. US protectionism and UK’s withdrawal from the European Union’s single market will erode trend growth rates and appreciate real exchange rates. This is precisely the opposite of what the doctor ordered for this stage of the recovery from crisis.”