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Building a Durable Recovery: Is the Answer in the Aggregates?

Author: Benn Steil, Senior Fellow and Director of International Economics
October 25, 2010
Financial News


The financial tsunami of 2007 and 2008 left a trail of economic wreckage in its wake with which the US and Europe will be reckoning for years. Cleaning up this wreckage has been the subject of the most consequential debate among economists we've seen in decades.

For the Keynesian hardcore of macroeconomists, the problem we face is simple. The US and other developed economies currently face a shortage of “aggregate demand”. We are therefore producing much less, in aggregate, than our capacity to produce, in aggregate. The composition of the aggregate doesn't matter. The economy is essentially one giant factory producing GDP widgets.

Businesses that anticipate an ongoing shortage of demand don't invest. Government must therefore, we are told, quickly fill the demand gap by spending vast sums that the central bank mints to buy its debt (so-called quantitative easing).

What exactly should the government spend the cash on? Here is where hardcore Keynesian macro actually gets fun.

“At this point, anything that boosts the government's deficit over the next two years passes the benefit-cost test,” Berkeley econoblogger Brad DeLong wrote last November 30, “anything at all.”

So it just doesn't matter. Demand is demand is demand.

Lest that sound like harmless left-coast hyperbole, note that far more influential voices began propounding this thinking years before the crisis hit. Let's see how it has worked out.

It is the summer of 2001. The Nasdaq bubble has burst. The US economy has slowed to a crawl. In an August 14 New York Times column, future Nobel prize winner Paul Krugman explains that “the driving force behind the current slowdown is a plunge in business investment”. But “to reflate the economy, the Fed doesn't have to restore business investment; any kind of increase in demand will do”.

Demand is demand is demand.

Krugman did not believe that the Fed could rectify the problem of plunging business investment. “{O}ver the last few years businesses spent too much on equipment and software, and... they will be cautious about further spending until their excess capacity has been worked off.” But the Fed could stimulate other forms of demand that would do just as well. In particular, he tells us, “Housing, which is highly sensitive to interest rates, could help lead a recovery.”

You read that right. The US government needed to stimulate more demand for housing.

But the Fed didn't move quickly or aggressively enough for Krugman. So a year later he made himself clearer. The Fed, he wrote on August 2, 2002, “needs to create a housing bubble to replace the Nasdaq bubble”.

Well now, quite a few smart people called the housing bubble. But Krugman was in rarefied company in calling for a housing bubble.

And we know how that worked out.

So maybe the composition of demand does matter after all. Maybe crude aggregates can mask meaningful tectonic shifts in economic activity that are problematic for policymakers to ignore. Maybe it is not, after all, a no-brainer for government to replace “a plunge in business investment” with “a housing bubble”, as Krugman seemed to think.

What are the implications for policy today?

There are real dangers lurking in the breakdown of a major part of the credit transmission mechanism. Large corporations, like IBM, that can bypass the busted banking sector and issue securitised debt are clearly benefiting from record-low borrowing costs. But small- and medium-sized companies have always been dependent on small- and medium-sized banks, whose balance sheets are still cluttered with the detritus of soured loans.

These banks will not lend, except on vastly greater collateral and at much higher real interest rates than before the bust. Little recognised is that the firms, for their part, have for years relied overwhelmingly on real estate for their collateral, the value of which has been badly impaired or obliterated. So a zero Fed funds rate is doing little for them.

You won't read about this problem in Paul Krugman's columns or blog posts, because it just doesn't matter when you see the economy wholly in terms of aggregates. A new bubble in one sector is just as good as a revival of investment in another. And indeed, the zero Fed funds rate is fuelling a renewed frenzy of yield-chasing that is germinating bubbles in markets from junk bonds to poor-country sovereign debt to metals ETFs. It is also fuelling incipient currency wars.

For the US economy, 2011 looks set to be one marked by severe imbalances, with continued high unemployment and low business investment persisting side by side with worrisome commodity inflation and wildly gyrating asset prices.

The American economy is endlessly innovative, and many of the new structural problems of business financing will resolve themselves in time. One interesting initiative I discovered recently, for example, aims to help firms auction off their accounts receivable directly to institutional investors, and thereby bypass their zombie banks. But I am not advocating laissez-faire.

In 2007 I suggested the creation of a new Resolution Trust Corporation to purchase impaired debt from banks, and I still believe it was a mistake that the US Troubled Asset Relief Program (TARP) did not ultimately feature such an element, particularly concentrated on the smaller institutions that are the backbone of non-securitised business lending. Government equity injections are not enough; banks consider them politically toxic, and therefore focus on disgorging them at the earliest opportunity.

Previous US administrations recognised the importance to economic recovery, at home and abroad, of moving aggressively to repair or resolve zombie banks. It would be a shame if the current administration were unable to do so and the country were instead to place its bets on blindly stoking future bubbles.

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