Stimulus or Reform?

Charting a Path Out of the Recession

Republican vice-presidential candidate Paul Ryan in Dover. (Brian Snyder / Courtesy Reuters)

Menzie D. Chinn

In "The True Lessons of the Recession" (May/June 2012), Raghuram Rajan sketches a structuralist interpretation of the Great Recession's causes and aftermath and draws out the resulting policy implications. Although he gets much right about the causes of the crisis, the reforms he recommends for ending it are misguided. In an environment of insufficient demand, a strategy that relies solely on getting rid of regulations, investing in human capital, and spurring entrepreneurship is doomed to end in sorrow. These types of policies are better thought of as complements to, rather than substitutes for, aggressive tactics aimed at boosting demand.

As Rajan admits, the crisis was caused by a confluence of forces, most important among them an ill-conceived frenzy of financial deregulation. This deregulation swept away existing checks on banks and gave rise to the weapons of mass financial destruction that proliferated in the early years of this century, such as credit default swaps and collateralized debt obligations. Rajan holds politicians primarily responsible for these problems, since they promoted a culture of homeownership, backed Fannie Mae and Freddie Mac, the government-sponsored mortgage agencies, and defended the interests of Wall Street.

Yet more blame should go to the financial sector, which deployed lobbyists to plead the case for deregulation. Had the George W. Bush administration pursued an aggressive regulatory stance, it could have avoided -- or at least reduced -- the devastating bubbles in the housing sector and in asset-backed financial products. In fact, even minimal regulation would have been helpful. Instead, just as the challenges of bank lending were rising, James Gilleran, the administration's first head of the Office of Thrift Supervision, which was supposed to watch over savings banks, proudly cut 20 percent of his agency's work force. Likewise, the Federal Reserve under Alan Greenspan failed to crack down on predatory lending practices through its authority over bank holding companies.

Rajan asserts that because resources were misallocated before the bubble burst -- in residential construction, finance, and elsewhere -- the cure must involve a drastic reallocation of resources to the right places. Although some sort of reallocation of labor to manufacturing and the production of other exportable goods and services is necessary, the current malaise is not due to a mismatch between workers' skills and employers' needs. If it were, then unemployment would not be distributed over many sectors, as is the case in the United States today. Moreover, formal statistical analyses have failed to find a substantial increase in the mismatch between workers' skills and jobs after the financial crisis. What the evidence does suggest is that low-skilled workers have had trouble integrating into the labor force over the past 30 years.

Rajan also points out that inequality has increased as a result of global competition and technological innovation. But although those factors have changed the income distribution, they have not, as he suggests, resulted in involuntary unemployment. Pressure from competition and technology does gradually depress wages over time, but it would certainly not lead to sudden jumps in unemployment, as have occurred since 2008. One could suggest, as Rajan does, that the housing boom temporarily masked workers' lagging incomes, until the bursting of the bubble revealed the truth. But the more plausible story is that since structural unemployment has always existed, the bulk of the jobs shed during the recession were lost due to depressed demand in the private sector.

The diagnosis matters. If the problem is demand, then encouraging entrepreneurship, for instance, will not be particularly useful when there is little appetite for the products entrepreneurs develop. In fact, such structural adjustments might be counterproductive in the short run if they drive prices down as workers and firms become more efficient. If deflation occurs, already-indebted households in the United States will have a harder time getting back on their feet, since they will owe more in real terms.

Austerity, Rajan claims, will hurt in the short run but yield benefits in the long run. There is a real chance, however, that spending cuts could instead end up prolonging the downward spiral. In the crisis countries of Europe, for example, lower government expenditures and higher taxes are pushing the entire eurozone into recession, just as textbook macroeconomics would predict. What Europe needs is the opposite: stimulus by those countries that can afford it, additional transfers from the creditor countries to the debtor countries, and a looser monetary policy. Moreover, austerity policies can ironically end up entrenching the structural problems they are intended to address, as unemployed workers drop out of the work force altogether and their skills degrade.

In the past, technological innovation and rapid productivity growth have not been enough to rescue the U.S. economy from the combined effects of a credit bubble, a systemic financial crisis, and a deep recession, and there is no reason to believe that supply-side solutions such as Rajan's will work any better today. As the economic historian Alexander Field has documented, during the Great Depression, productivity grew rapidly while overall GDP growth remained lackluster. Moreover, the economy relapsed after fiscal and monetary policy was tightened in 1937. What pulled the United States out of the Depression was the more expansionary demand-side policies in the period leading up to World War II. That crucial part of the history is missing from Rajan's narrative.

None of these arguments for stimulus policies implies that countries can merely spend their way to prosperity. Budget constraints exist, and some governments will have to cut their budgets and raise taxes, particularly in the indebted eurozone countries (although they will have to do more than just that). But the United States should not embark on the path of unbridled austerity. The federal government enjoys rock-bottom borrowing costs, the U.S. dollar remains the world's reserve currency, and the Internal Revenue Service knows how to collect taxes. In short, the United States is no Greece. Washington has the room to stimulate the economy now while reducing its long-term debt and building much-needed infrastructure. Doing that would spare millions of workers the pain of additional years of unemployment and also invest in the country's future.

MENZIE D. CHINN is Professor of Public Affairs and Economics at the University of Wisconsin and a co-author, with Jeffry A. Frieden, of Lost Decades: The Making of America's Debt Crisis and the Long Recovery.

Karl Smith

Raghuram Rajan argues that rather than rely on fiscal and monetary stimulus to restore growth, Western governments should address the roots of the economic crisis they now face. But in implying that countries must choose between immediate efforts to reduce unemployment and lasting plans to improve productivity, Rajan presents a false dichotomy. In fact, governments do not face a tradeoff between short-term relief and long-term prosperity, since the goods and services that businesses buy as investments contribute just as much to aggregate demand as do the goods and services that households buy for consumption. Stimulus spending can reduce unemployment now while also promoting productivity in the long run.

Indeed, encouraging long-term investments is exactly the right response to the crisis, since consumption is already back on track. In the United States, expenditures for personal consumption had recovered from the downturn by the middle of 2010, and they are now hitting all-time highs with each new quarter. But expenditures for private investment, as of the first quarter of 2012, have gained back only half the ground lost during the Great Recession. Expenditures in the public sector are still falling, with local governments shedding thousands of workers each month, many of them teachers.

Housing is another area in which the government can both create jobs and make provisions for the future. According to Rajan, the residential construction sector is "bloated" and "need[s] to shrink" and the crisis was a painful but inevitable correction to the unsustainable housing boom. But the numbers tell a different story. Although the construction of single-family homes built for sale did increase during the boom, the construction of rentals units actually fell. The net result was that at the peak of the housing boom, fewer housing units were being completed each month than during the construction boom of the early 1970s. Moreover, in every single month since 2009, fewer housing units have been completed than in any month on record before the Great Recession.

As a result, the United States now faces a housing shortage, with more than two million fewer households than would be expected given the size of the population. The squeeze is largely a consequence of young adults, including married couples, moving back in with their parents because they cannot afford to live on their own. Nonetheless, landlords are reporting fewer apartment vacancies than they have had in decades, and rents are steadily rising.

And so at a time when construction workers remain unemployed and teachers are getting laid off in droves, the United States is refusing to invest in housing for its young families and in education for their children. Far from being a distraction from long-term investment, the U.S. unemployment crisis is itself the result of a failure to invest in future generations.

A deeper problem with Rajan's essay is that it presumes that governments and central banks can easily plan for future productivity. It is worth remembering that the crisis was caused in part by policies intended to ensure long-term growth: in particular, financial deregulation, the creation of the eurozone, and central banks' decisions to target low inflation. These policies created an environment in which a massive international financial sector could grow unchecked and in which governments possessed limited tools to manage its collapse.

Before the crisis, central banks committed themselves to keeping inflation low in an effort to promote growth. They succeeded in that goal, but in so doing, they rendered useless their most important tool: the power to set the rates at which banks loan money to one another. That is because once central banks had shoved inflation down as far as it could go, they ran out of room to lower the real interest rate -- that is, the market interest rate minus inflation -- and thus stimulate investment. In the United States, because the Federal Reserve has already lowered interest rates to near zero and inflation hovers around two percent, there is nothing central bankers can do to push real interest rates further down below negative two percent.

Things are even worse in Europe. Operating under a mandate to focus on inflation and ignore unemployment, the European Central Bank refuses to lower market interest rates. When inflation in Europe began to rise and provide the lower real interest rates that would stimulate investment, the European Central Bank upped rates and snuffed out any incipient recovery. The problem has been exacerbated by the euro, which prevents weaker countries from devaluing their currencies relative to stronger ones. That limitation, in turn, means that struggling states are not able to enjoy the boost in production, and the accompanying bump in employment, that occurs when a country's exports become relatively cheap on the international market.

Yet Rajan seems to have missed the chief lesson of these failures: that policies aimed at long-term growth can end up backfiring. Instead, he calls for more long-term reforms. Such efforts may already be doing more harm than good. Tighter financial regulation in the United States is constricting lending and may be exacerbating the housing shortage. Efforts to encourage education in the United States have led to a proliferation of diploma mills, which deliver second-rate schooling to increasingly desperate students.

More troubling is Rajan's recommendation that governments cut back on borrowing, a move that could end up creating dangerous investment bubbles. The process begins as governments trim their welfare states as a way to prevent aging populations from straining the public pension and health-care systems. Those cuts force the elderly to increase their savings as they lose government benefits. Someone has to borrow those savings, but since the government will not be doing so, younger people will have to.

They, in turn, will have to put that money somewhere, contributing to the very investment flows that have led to bubble after bubble. When the money was invested in emerging economies, it led to the Asian financial crisis of 1997-98. When it was invested in new technology, it led to the dot-com bubble, which burst in 2000. When it was invested in real estate, it led to the housing bubble. In each case, investors flooded a new asset class and then began to sour on it.

As these examples demonstrate, reforms rarely work out exactly as intended. No one can predict all the side effects of a new round of structural reforms, such as those Rajan proposes. So the best course for governments today would be to treat the victims of the last round and to think twice before embarking on any new attempts to remake the economic landscape.

KARL SMITH is Assistant Professor of Public Economics and Government at the University of North Carolina at Chapel Hill.


In criticizing work, it is often easier to caricature it, because caricatures are easier to attack. Both Menzie Chinn and Karl Smith have yielded somewhat to this temptation. The main point of my essay was that demand was bloated in the years before the Great Recession, thanks to unsustainable borrowing by governments, households, and the financial sector, with the importance of each varying by country. Bloated demand also distorted the supply side, which fed back into demand. In the United States, as more people bought houses financed with easy credit, home prices increased, and people borrowed against their homes to buy washing machines and cars.

After the collapse in housing construction and housing finance, not only did construction jobs evaporate, but demand for goods from now-overindebted households fell, too. This is why, in my essay, I called for making demand more sustainable, primarily by improving workers' incomes. This means creating better, more productive jobs in the industrial world and training workers to fill them: structural reforms. In short, industrial countries have to overcome weak growth and an unequal distribution of that growth, problems accentuated by aging populations and unsustainable entitlement spending. The standard remedies for business-cycle downturns that both Chinn and Smith propose simply will not be as effective.

My essay did not detail the process of adjustment industrial countries will have to undergo as they refocus on sustainable growth. But as I made clear, and contrary to what Chinn and Smith imply, I do not support cutting back sharply on government spending in all cases. It may make more sense, politically and economically, to reduce government spending, where excessive, at a measured pace.

That said, government spending is far from the cure-all its advocates describe. First, few governments like to cut spending, so promises to cut in the future are rarely credible. Governments that splurged in the past may not have the fiscal room to slow spending cuts, a constraint that may not be entirely bad if it refocuses them on doing what is essential. Second, although cutting government spending quickly does hurt short-term growth, increasing spending does not necessarily generate sustainable growth.

Governments that overspent before the crisis may face no choice other than to cut spending today. As Joseph of the Old Testament understood, countries should save up in the fat years to prepare for the inevitable lean years. Yet as studies that control for the business cycle show, eurozone countries, with a few exceptions, such as Germany, overspent in the years leading up to the crisis; it was not just Greece. More generally, government debt has steadily increased in industrial countries since the mid-1970s. The crisis was building for a long time.

In the European periphery, governments therefore cannot credibly promise to tighten their belts in the future in return for financing today. The German government, pointing to the last decade, says that it cannot trust countries to reform once they have access to money. With no sugar daddy willing to lend money to countries that have lost the market's faith, there may be no alternative to austerity. If confidence in Italy or Spain deteriorates again, the eurozone may have to resort to the traditional way of bridging the gap between credibility and financing: a temporary monitored reform program akin to those of the International Monetary Fund.

Some states in the United States have also been guilty of treating revenues in good times as permanent. Many of them made promises about pensions and health care to public-sector workers, politically easy guarantees that did not show up clearly on budgets or in current taxes. Only now are the magnitude and unsustainability of these agreements coming to light. Moreover, not all state spending is efficient. Although the United States clearly needs good, dedicated teachers, not all the administrators and support staffers added to education payrolls over the years are equally important. A crisis may impose useful discipline on government spending.

For those countries that do have the credibility and fiscal capacity to moderate the pace of adjustment, more untargeted spending will not necessarily create lasting jobs. A distant and general increase in spending would do little to help areas of the United States where a boom and bust in housing prices has left an overhang of household debt and depressed local demand. Greater demand in New York is not going to create restaurant jobs in Las Vegas. Targeted household debt write-offs in Las Vegas could be a better use of stimulus dollars. However, the past buildup of debt in now-depressed areas suggests that demand was too high relative to incomes. If so, demand, without the dangerous stimulant of borrowing, will stay weak. Government policies should instead focus on helping workers move to where there are suitable jobs, for instance, by helping them offload their current homes and the associated debt without the stigma of default.

Unemployment is also higher in those U.S. states that experienced a house-building bust, and especially in the real estate and construction sectors. Chinn and Smith suggest that big infrastructure projects, modeled on those in the 1930s, could reemploy the laid-off workers. But those might not work, since the United States today has less need for infrastructure on that scale. Moreover, even if policymakers decided that the government should provide high-speed trains or high-speed Internet access in rural areas, workers used to installing dry wall might not easily switch to laying railroad tracks or fiber-optic cables.

In any debate about the effectiveness of stimulus in a deep crisis, Keynesians will sooner or later refer to the Great Depression. But that experience does not really prove that Keynesian policies work. Chinn overstates the evidence when he writes, "What pulled the United States out of the Depression was the more expansionary demand-side policies in the period leading up to World War II." Although government spending expanded substantially in the 1930s, the number of hours worked per adult was still 22 percent below its 1929 level when the war began, in 1939, and unemployment was still 17 percent. Only World War II pulled the United States out of the Depression, and the war changed so many things other than government spending.

Japan's massive real estate boom and bust in the 1980s is the more relevant example today, and the case serves as a warning of the difficulties of stimulating the economy through massive infrastructure spending. Even though Japan covered much of the country with concrete, it never really emerged from the crisis. Those making the case for immediate stimulus policies to revive demand often cite John Maynard Keynes' dictum, "In the long run we are all dead." For the Japanese, the long run has arrived, and they are older, their population is declining, and their government has the highest debt-to-GDP ratio among the G-7 countries.

What Japan did much too late was shut down failed firms, write down private debts, and recapitalize its banking system. And it still has not undertaken the structural reforms needed to bring competition and efficiency into many of its domestic markets. Keynesian stimulus may or may not have staved off worse outcomes in Japan, but it has saddled the country with enormous amounts of debt without kick-starting steady growth. And the government's constant focus on spending, which politicians loved, arguably deflected attention from the need for structural reforms.

In sum, additional government spending is particularly useful in a panic, when targeted, timely, and temporary aid can avert a downward spiral of expectations. It is less useful when the underlying problems are structural, when temporary public spending can do little to revive the private sector and create a bridge to sustainable growth.

I disagree with Chinn and Smith on several other issues. Chinn grossly misinterprets my argument when he writes that I claim that globalization and technological innovation "resulted in involuntary unemployment." In fact, my main point was that the lost middle-class jobs were replaced by low-end jobs, including in construction, before the crisis. Unemployment increased after the crisis, but disproportionately at the lower end. The scenario he sketches of advances in innovation and productivity being "counterproductive in the short run if they drive prices down" may be theoretically possible, but it is extremely unlikely. More innovation and productivity will raise workers wages in real terms and expand investment, contributing to sustainable growth in demand. To argue that these changes will lead to spiraling debt deflation in today's world strains credulity.

Smith may be right when he writes that a number of Americans still desire housing, but if those people do not have the ability to pay for it or finance it, most economists would not say that the United States now suffers from a "housing shortage" -- at least not in the conventional use of the term. I agree, however, that construction has adjusted considerably since the crisis. Smith wants the government to do a lot more, including building infrastructure and expanding education. These are both laudable objectives if done well, but then he undercuts his argument by criticizing me for "presum[ing] that governments and central banks can easily plan for future productivity." I sympathize with his wariness about grand government plans, but he is in fact proposing a greater expansion of the state than I am.

Smith also presents a strained chain of logic in arguing that a cutback in government entitlement spending will lead to investment bubbles. If Western governments do not curtail the unaffordable promises they have made, they will surely have to default. Moreover, since today's middle-aged cohorts have little expectation that they will receive the benefits they have been promised, entitlement cuts (which typically do not affect today's elderly) will just bring promises in line with expectations -- and have little effect on savings behavior. Even if older cohorts do increase their savings, that money need not end up with the young, as Smith suggests; instead, it would more likely go to young industries or emerging economies that still need to invest a lot. There is no reason this process will inevitably lead to asset bubbles. A tenuous argument about increased risk is no reason to accept the certain disaster that will occur if governments do not cut back on their promised entitlements.

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