The Way Forward

Policy Paper
Oct. 10, 2011

Notwithstanding repeated attempts at monetary and fiscal stimulus since 2009, the United States remains mired in what is by far its worst economic slump since that of the 1930s.1  More than 25 million working-age Americans remain unemployed or underemployed, the employment-to-population ratio lingers at an historic low of 58.3 percent,2 business investment continues at historically weak levels, and consumption expenditure remains weighed down by massive private sector debt overhang left by the bursting of the housing and credit bubble a bit over three years ago.  Recovery from what already has been dubbed the “Great Recession” has been so weak thus far that real GDP has yet to surpass its previous peak. And yet, already there are signs of renewed recession

It is not only the U.S. economy that is in peril right now. At this writing, Europe is struggling to prevent the sovereign debt problems of its peripheral Euro-zone economies from spiraling into a full-fledged banking crisis – an ominous development that would present an already weakening economy with yet another demand shock.  Meanwhile, China and other large emerging economies--those best positioned to take up worsening slack in the global economy--are beginning to experience slowdowns of their own as earlier measures to contain domestic inflation and credit-creation kick in, and as weak growth in Europe and the United States dampen demand for their exports.  

Nor is renewed recession the only threat we now face.  Even if a return to negative growth rates is somehow avoided, there will remain a real and present danger that Europe and the United States alike fall into an indefinitely lengthy period of negligible growth, high unemployment and deflation, much as Japan has experienced over the past 20 years following its own stock-and-real estate bubble and burst of the early 1990s.3  Protracted stagnation on this order of magnitude would undermine the living standards of an entire generation of Americans and Europeans, and would of course jeopardize America’s position in the world. 

Our economic straits are rendered all the more dire, and the just mentioned scenario accordingly all the more likely, by political dysfunction and attendant paralysis in both the United States and Europe.  The political stalemate is in part structural, but also is attributable in significant large measure to the nature of the present economic crisis itself, which has stood much familiar economic orthodoxy of the past 30 years on its head.  For despite the standoff over raising the U.S. debt ceiling this past August, the principal problem in the United States has not been government inaction.  It has been inadequate action, proceeding on inadequate understanding of what ails us. 

Since the onset of recession in December 2007, the federal government, including the Federal Reserve, has undertaken a broad array of both conventional and unconventional policy measures. The most noteworthy of these include: slashing interest rates effectively to zero; two rounds of quantitative easing involving the purchase of Treasuries and other assets, followed by Operation Twist to flatten the yield curve yet further; and three fiscal stimulus programs (including the 2008 Economic Stimulus Act, the 2009 American Recovery and Reinvestment Act, and the 2010 Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act) and the 2008 Troubled Asset Relief Program to recapitalize the banks.

These actions have undeniably helped stabilize the economy—temporarily. But as evidenced by continuing high unemployment and the weak and now worsening economic outlook, they have not produced a sustainable recovery.  And there is no reason to believe that further such measures now being proposed, including the additional tax relief and modest spending found in the administration’s proposed American Jobs Act – which  look all too much like previous measures – will be any more successful.  Indeed, there is good reason to worry that most of the measures tried thus far, particularly those involving monetary reflation, have reached the limits of their effectiveness.  

The questions now urgently before us, then, are these:  First, why have the policies attempted thus far fallen so far short?  And second, what should we be doing instead?

Answering these questions correctly, we believe, requires a more thorough understanding of the present crisis itself – its causes, its character, and its full consequences.  Regrettably, in our view, there seems to be a pronounced tendency on the part of most policymakers worldwide to view the current situation as, substantially, no more than an extreme business cyclical decline. From such declines, of course, robust cyclical recoveries can reasonably be anticipated to follow in relatively short order, as previous excesses are worked off and supply and demand find their way back into balance. And such expectations, in turn, tend to be viewed as justifying merely modest policy measures.

Yet as we shall show in what follows, this is not an ordinary business cycle downturn.  Two features render the present slump much more formidable than that – and much more recalcitrant in the face of traditional policy measures.

First, the present slump is a balance-sheet Lesser Depression or Great Recession of nearly unprecedented magnitude, occasioned by our worst credit-fueled asset-price bubble and burst since the late 1920s.4  Hence, like the crisis that unfolded throughout the 1930s, the one we are now living through wreaks all the destruction typically wrought by a Fisher-style debt-deflation.  In this case, that means that millions of Americans who took out mortgages over the past 10 to 15 years, or who borrowed against the inflated values of their homes, are now left with a massive debt overhang that will weigh down on consumption for many years to come.  And this in turn means that the banks and financial institutions that hold this debt are exposed to indefinitely protracted concerns about capitalization in the face of rising default rates and falling asset values.

But there is more.  Our present crisis is more formidable even than would be a debt-deflation alone, hard as the latter would be.  For the second key characteristic of our present plight is that it is the culmination of troubling trends that have been in the making for more than two decades.  In effect, it is the upshot of two profoundly important but seemingly unnoticed structural developments in the world economy.  

The first of those developments has been the steady entry into the world economy of successive waves of new export-oriented economies, beginning with Japan and the Asian tigers in the 1980s and peaking with China in the early 2000s, with more than two billion newly employable workers.  The integration of these high-savings, lower wage economies into the global economy, occurring as it did against the backdrop of dramatic productivity gains rooted in new information technologies and the globalization of corporate supply chains, decisively shifted the balance of global supply and demand.  In consequence, the world economy now is beset by excess supplies of labor, capital, and productive capacity relative to global demand.  This not only profoundly dims the prospects for business investment and greater net exports in the developed world — the only other two drivers of recovery when debt-deflation slackens domestic consumer demand.  It also puts the entire global economy at risk, owing to the central role that the U.S. economy still is relied on to play as the world’s consumer and borrower of last resort.  

The second long term development that renders the current debt-deflation, already worse than a mere cyclical downturn, worse even than other debt-deflations is this: The same integration of new rising economies with ever more competitive workforces into the world economy also further shifted the balance of power between labor and capital in the developed world.  That has resulted not only in stagnant wages in the United States, but also in levels of income and wealth inequality not seen since the immediate pre-Great-Depression1920s.  

For much of the past several decades, easy access to consumer credit and credit-fueled rises in home values – themselves facilitated by recycled savings from emerging economies’ savings – worked to mask this widening inequality and support heightening personal consumption.  But the inevitable collapse of the consumer credit and housing price bubbles of course brought an end to this pattern of economic growth and left us with the massive debt overhang cited above.  Government transfer payments and tax cuts since the crash have made up some of the difference over the past two years; but these cannot continue indefinitely and in any event, as we argue below, in times like the present they tend to be saved rather than devoted to employment-inducing consumer expenditure.  Even current levels of consumption, therefore, will henceforth depend on improvements in wages and incomes.  Yet these have little potential to grow in a world economy beset by a glut of both labor and capital.

Only the policymakers of the 1930s, then, faced a challenge as complex and daunting as that we now face. Notwithstanding the magnitude of the challenge, however, this paper argues that there is a way forward.  We can get past the present impasse, provided that we start with a better diagnosis of the crisis itself, then craft cures that are informed by that diagnosis.5  That is what we aim here to do.  The paper proceeds in five parts: 

Part I provides a brief explanatory history of the credit bubble and bust of the past decade, and explains why this bubble and bust have proved more dangerous than previous ones of the past 70 years.

Part II offers a more detailed diagnosis of our present predicament in the wake of the bubble and bust, and defines the core challenge as of the product of necessary de-levering in a time of excess capacity.  

Part III explains why the conventional policy tools thus far employed have proved inadequate – in essence, precisely because they are predicated on an incomplete diagnosis. It also briefly addresses other recently proposed solutions and explains why they too are likely to be ineffective and in some cases outright counterproductive.

Part IV outlines the criteria that any post-bubble, post-bust recovery program must satisfy in order to meet today’s debt-deflationary challenge under conditions of oversupply.

Part V then lays out a three-pillared recovery plan that we have designed with those criteria in mind.  It is accordingly the most detailed part of the paper.  The principal features of the recovery plan are as follows:

First, as Pillar 1, a substantial five-to-seven year public investment program that repairs the nation’s crumbling public infrastructure and, in so doing, (a) puts people back to work and (b) lays the foundation for a more efficient and cost-effective national economy.  We also emphasize the substantial element of “self-financing” that such a program would enjoy, by virtue of (a) massive currently idle and hence low-priced capacity, (b) significant multiplier effects and (c) historically low government-borrowing costs.

Second, as Pillar 2, a debt restructuring program that is truly national in scope, addressing the (intimately related) banking and real estate sectors in particular – by far the most hard-hit by the recent bubble and bust and hence by far the heaviest drags on recovery now.  We note that the worst debt-overhangs and attendant debt-deflations in history6 always have followed on combined real estate and financial asset price bubbles like that we have just experienced.   Accordingly, we put forward comprehensive debt-restructuring proposals that we believe will unclog the real estate and financial arteries and restore healthy circulation – with neither overly high nor overly low blood pressure – to our financial and real estate markets as well as to the economy at large.

Third, as Pillar 3, global reforms that can begin the process of restoring balance to the world economy and can facilitate the process of debt de-levering in Europe and the United States.  Key over the next five to seven years will be growth of domestic demand in China and other emerging market economies to (a) offset diminished demand in the developed world as it retrenches and trims back its debt overhang, and (b) correct the current imbalance in global supply relative to global demand.  Also key will be the establishment of an emergency global demand-stabilization fund to recycle foreign exchange reserves, now held by surplus nations, in a manner that boosts employment in deficit nations.  Over the longer term, we note, reforms to the IMF, World Bank Group, and other institutions are apt to prove necessary in order to lend a degree of automaticity to currency adjustments, surplus-recycling, and global liquidity-provision.7

To read the full paper, click here.