Raghuram Rajan, U. Chicago finance professor, has a big piece in Foreign Affairs arguing that we can’t borrow and spend our way out of recession. Why?

In fact, today’s economic troubles are not simply the result of inadequate demand but the result, equally, of a distorted supply side. For decades before the financial crisis in 2008, advanced economies were losing their ability to grow by making useful things. But they needed to somehow replace the jobs that had been lost to technology and foreign competition and to pay for the pensions and health care of their aging populations. So in an effort to pump up growth, governments spent more than they could afford and promoted easy credit to get households to do the same. The growth that these countries engineered, with its dependence on borrowing, proved unsustainable.

Rather than attempting to return to their artificially inflated GDP numbers from before the crisis, governments need to address the underlying flaws in their economies. In the United States, that means educating or retraining the workers who are falling behind, encouraging entrepreneurship and innovation, and harnessing the power of the financial sector to do good while preventing it from going off track. In southern Europe, by contrast, it means removing the regulations that protect firms and workers from competition and shrinking the government’s presence in a number of areas, in the process eliminating unnecessary, unproductive jobs.

To which Karl Smith understandably rages in response:

Rajan says, “the best short term policy response is to focus on long-term sustainable growth.” Again, I hate to be rude but I have to be direct.

Is this some kind of sick joke?

Is there an area in which our policy initiatives have more consistently failed than in producing long term sustainable growth? Do we even have a consensus on how long term growth got started in the first place? Do we have a solid story to explain growth differentials today?

Is there a policy explanation for why the GDP of Northern California is booming out of control while Maine dies a slow death? Lets not even get started with cross-country comparisons where we can gesture in the vague direction of institutions but still know little-to-nothing about how to produce sustainable ones.

Perhaps, Rajan thinks the milder goal of human and physical capital accumulation is what is needed? Yet, this entire piece is arguing against the massive borrowing that is at the heart of such accumulation. Indeed, the largest single type of capital is housing, which Rajan has dismissed. Over half of the production activity of the government sector is education, which Rajan has said is bloated.

If you don’t want more borrowing or more teachers, what do you want? Perhaps efforts to increase TFP or educational effectiveness.

Welcome to the world!

This is what folks have been desperate for my entire life. If we knew how to get it, we would.

This is a good example of a “he’s right and he’s right? they can’t both be right” situation, in which, in fact, they are both right. The increasing financialization of the American economy is something that got papered over in the 2000s with the housing boom. The collapse of that boom revealed that American consumption growth was not supported by productivity growth, and hence by growth in real wealth. Americans realized they weren’t as rich as they thought they were. So they cut back sharply on consumption. Hence a recession, which in turn is the primary cause of ballooning government debt. But just because what we need is to counter that financialization and engineer rising productivity doesn’t mean we have any idea how to do that. Who said managing the economy was easy?

Smith goes on to make the correct point that, if the problem is we have accumulated too much debt, what should be happening is the dollar should be collapsing versus the currencies of countries that are financing that debt. This would sharply raise American interest rates, which would perforce scale back our borrowing, and would sharply raise the prices of foreign imports (of which the most important is oil). On the other hand, America’s real assets would be much cheaper, as would American exports. Americans would all be poorer, but more competitive internationally.

But this isn’t happening. My own suspicion is that it isn’t happening because nobody thinks a catastrophic collapse of the dollar against the Yuan would be a good thing. America wants the dollar to remain the primary global reserve currency (because it makes borrowing cheaper than fundamentals would dictate – basically, everybody who uses the dollar as a reserve currency is paying a fee for the privilege to the United States); China wants to continue the path of export-led development (because the regime is tied – by blood in many cases – to major exporters, and because its own financial system would suffer severe strain if it were suddenly required to deliver a reasonable return on savings); and instability in the currency markets makes business harder for everybody (except FX traders). Moreover, a collapse of the dollar would cause a real crisis in confidence, both domestically and internationally, in the future of the American economy. We’d go from getting the benefit of being the world’s reserve currency to paying a penalty for having burned the entire investing world.

What we want is a gradual decline in the dollar, which is what we’re getting (against the Yuan; Europe, obviously, has its own problems that are depressing its own currency).

And so we’re stuck with a very gradual decline in unemployment.

What about simply increasing inflation? There is a very credible critique of our current approach that argues that what we need is higher nominal growth, and that it’s really a secondary concern whether that growth is real. The problem I have with this approach is the preponderance of “all else being equals” in the argument. All else being equal, yes, higher nominal growth is what we want. But all else may not be equal. How will our trading partners react? If they react by taking action to prevent their currencies from rising, our inflation will “leak” out to them. That’s fine for Europe. It’s not so fine for China – and so we’re back to the question of what happens to the dollar-Yuan relationship. More centrally, the Taylor rule is predicated on the notion that real growth is maximized when inflation is low and stable – achieving that expectation has real value. So if we deliberately abandon this rule in favor of aiming for higher inflation, we should – by the same logic – reduce real growth. Depending on how big the tradeoff is, it’s not obvious to me we’re better off on net.

And will inflation even achieve the goal of increasing demand (as opposed to increasing demand eventually causing inflation)? I’m not so sure. There’s a prevailing assumption that rising inflation will reduce savings and increase consumption (which is the Keynesian prescription for recovery). But what if savings actually increases because people are trying to “stay ahead” of inflation? We’ve talked in this space before about whether higher taxes make you work harder (to maintain your consumption level) or work less (because work is less remunerative). The same is true on the savings and investment side: there’s empirical evidence (from China, most recently, which is interesting) that lower returns on savings (which is what inflation would cause) can increase the savings rate. And what if it’s not that consumption patterns increase (or that they only increase), but that consumption patterns change, favoring goods with short shelf lives and reducing demand for capital goods that require confidence in long-term economic stability? Such a consumption shift should lower long-term growth prospects, and again, I’d argue we’re in a worse position.

The main empirical evidence for the inflationary position comes from two places. One is from small countries (e.g., Sweden, Israel) who let their currencies drop when the recession hit, and who therefore were able to reap the benefits of a more favorable trade balance. This is the “let the market clear” approach that Karl Smith advocates, and I don’t dispute its validity as an approach. But it’s not obvious that a major economy like the United States can play this game, and I think I’ve laid out some arguments why we’ve been specifically reluctant to take that path with respect to China.

The other is FDR’s revaluation of the dollar versus gold. This unquestionably made a huge dent in the Great Depression. But FDR’s action didn’t take America from a low-inflation environment to a higher-inflation environment. It broke the back of outright deflation. After the revaluation, inflation was low and stable – until we tipped back into recession, when deflation kicked in again. World War II is another example – the greatest Keynesian stimulus of all time – but it is, again, a questionable example, because World War II didn’t just involve government spending; it involved the physical destruction of a huge amount of “excess” industrial capacity (and human capital) outside the United States. That’s not a trivial fact!

So what do we do?

I said Rajan is more right than wrong, and that’s because I think the focus on real growth rather than simply nominal growth is more right than wrong. We may need to tolerate a modest uptick in inflation, but we’re not trying to engineer higher inflation expectations – we’re trying to engineer higher real growth expectations. Rajan is not exactly right because the issue isn’t actually engineering long-term growth, but of changing expectations. Changing expectations doesn’t require the government to get the policy mix exactly right – it doesn’t require that we “know” how to generate sustainable growth. It requires getting people – employers, savers – to believe that the policy mix has shifted in a pro-growth direction – that the odds have shifted in their favor.

I’m arguing, in a nutshell, that people can tell the difference more than you realize between real and nominal problems. Trying to manipulate them into thinking their prospects have improved when, in real terms, they haven’t makes less sense than trying to do things that they believe will actually improve their prospects. Building a high-speed rail system, to my mind, makes sense. Undertaking reforms that would dramatically reduce the cost of building a high-speed rail system makes much more sense, not only because it would “save money” but because the concern for efficiency gives the public a reason to believe that this project will be worth the money, and that therefore on-net they’ll be better off.  Giving money to the states to keep them from laying people off in a recession is a good policy. Giving money while extracting commitments to reform (or pensions, work rules, etc) in exchange is a much better policy – because, again, the expected return on that spending just went up, and hence so did expectations of long-term growth. Borrowing when rates are low is a sensible strategy for the government to follow. But borrowing and spending without regard for the projected return on spending is a bad strategy – because it reduces expectations for real growth. We should be running a deficit now, not engaging in austerity. But we should also be realigning our spending (and our tax system, and our regulatory infrastructure) to make them more efficient.

We don’t need to get it all right. We need to demonstrably be moving in the right direction – to change expectations for future real growth. If the expectations change, investors and employers will change their behavior, and we’ll move into an accelerating recovery.

Again, I want to be clear what I’m arguing:

  • The trigger for the recession was a financial crisis, which in turn was the fruit of a decade of bad economic policy that ignored structural problems and papered over them with a housing bubble. We shouldn’t use the peak of the bubble as a reference point for anything we want to get “back” to.
  • When the economy fell off a cliff, the Fed acted boldly and swiftly – but not adequately, because its conventional tools were no longer workable and it was understandably slow to use unconventional tools with similar boldness. Perhaps if we had a cashless economy the Fed could have been more effective than it was in the most dangerous phase of the crisis. But we didn’t, it didn’t, and we wound up in a deep hole. The question now isn’t how to avoid falling into such a hole but how to get out of it.
  • Devaluing a currency in response to a recession is a plausible route to prosperity for a small economy (though it has its own risks if it becomes a habit – see Italy, Argentina, etc.) but is a much less-plausible strategy for a large economy to pursue.
  • Historically, “catch-up” growth has not been driven by rising positive inflation, but by rising real growth. Inflation has picked up only when a recovery has accelerated. There are real reasons to worry that trying “make up” for past deflation with accelerating inflation will not achieve the same effects as preventing the deflation in the first place, and that trying to “lead” with inflation may be counter-productive.
  • Therefore, what we need to do is change expectations for real growth. This requires both realigning our spending away from less-productive activities towards more-productive activities, and undertaking reforms to make our spending (and our tax and regulatory system) more efficient. Not all of these changes need to work; they just need to be credible enough to change expectations.