Two fundamental beliefs have driven economic policy aroundthe world in recent years. The first is that the world suffers from a shortageof aggregate demand relative to supply; the second is that monetary and fiscalstimulus will close the gap.
Is it possible that the diagnosis is right, but that theremedy is wrong? That would explain why we have made little headway so far inrestoring growth to pre-crisis levels. And it would also indicate that we mustrethink our remedies.
High levels of involuntary unemployment throughout theadvanced economies suggest that demand lags behind potential supply. Whileunemployment is significantly higher in sectors that were booming before thecrisis, such as construction in the United States, it is more widespread,underpinning the view that greater demand is necessary to restore fullemployment.
Policymakers initially resorted to government spending andlow interest rates to boost demand. As government debt has ballooned and policyinterest rates have hit rock bottom, centralbanks have focused on increasingly innovative policy to boost demand. Yetgrowth continues to be painfully slow. Why?
What if the problem is the assumption that all demand iscreated equal? We know that pre-crisis demand was boosted by massive amounts ofborrowing. When borrowing becomes easier, it is not thewell-to-do, whose spending is not constrained by their incomes, whoincrease their consumption; rather, the increase comes from poorer and youngerfamilies whose needs and dreams far outpace their incomes. Their needs can bedifferent from those of the rich.
Moreover, the goods that are easiest to buy are those thatare easy to post as collateral – houses andcars, rather than perishables. And rising houseprices in some regions make it easier to borrow even more to spend on otherdaily needs such as diapers and baby food.
The point is that debt-fueled demand emanates from particular households in particularregions for particular goods. While it catalyzesa more generalized demand – the elderly plumber who works longer hours in theboom spends more on his stamp collection – it is not unreasonable to believethat much of debt-fueled demand is more focused. So, as lending dries up, borrowing households can no longer spend,and demand for certain goods changes disproportionately,especially in areas that boomed earlier.
Of course, the effects spread through the economy – asdemand for cars falls, demand for steel also falls, and steel workers are laidoff. But unemployment is most pronounced in the construction and automobilesectors, or in regions where house prices rose particularly rapidly.
It is easy to see why a general stimulus to demand, such asa cut in payroll taxes, may be ineffective in restoring the economy to fullemployment. The general stimulus goes to everyone, not just the formerborrowers. And everyone’s spending patterns differ – the older, wealthierhousehold buys jewelry from Tiffany, rather thana car from General Motors. And even the former borrowers are unlikely to usetheir stimulus money to pay for more housing – they have soured on the dreams that housing held out.
Indeed, because the pattern of demand that is expressible has shifted with the change in access toborrowing, the pace at which the economy can grow without inflation may alsofall. With too many construction workers and too few jewelers,greater demand may result in higher jewelry prices rather than more output.
Put differently, the bustthat follows years of a debt-fueled boom leaves behind an economy that suppliestoo much of the wrong kind of good relative to the changed demand. Unlike anormal cyclical recession, in which demand falls across the board and recoveryrequires merely rehiring laid-off workers to resume their old jobs, economicrecovery following a lending bust typicallyrequires workers to move across industries and to new locations.
There is thus a subtle but important difference between my debt-driven demand view and theneo-Keynesian explanation that deleveraging (saving by chastenedborrowers) or debt overhang (the inability ofdebt-laden borrowers to spend) is responsible for slow post-crisis growth. Bothviews accept that the central source of weak aggregatedemand is the disappearance of demandfrom former borrowers. But they differ on solutions.
The neo-Keynesian economist wants to boost demandgenerally. But if we believe that debt-driven demand is different, demandstimulus will at best be a palliative. Writing down former borrowers’ debt may be slightlymore effective in producing the old pattern of demand, but it will probably notrestore it to the pre-crisis level. In any case, do we really want the formerborrowers to borrow themselves into trouble again?
The only sustainable solution is to allow the supply sideto adjust to more normal and sustainable sources of demand – to ease the wayfor construction workers and autoworkers to retrainfor faster-growing industries. The worst thing that governments can do is to stand in the way by proppingup unviable firms or by sustaining demandin unviable industries through easy credit.
Supply-side adjustments take time, and, after five years ofrecession, economies have made some headway. Butcontinued misdiagnosis will have lasting effects. The advanced countries willspend decades working off high public-debt loads, while their central bankswill have to unwind bloatedbalance sheets and back off from promises ofsupport that markets have come to rely on.
Frighteningly, the new Japanese government is still tryingto deal with the aftermath of the country’s two-decade-old property bust. Onecan only hope that it will not indulge in moreof the kind of spending that already has proven so ineffective – and that hasleft Japan with the highest debt burden (around 230% of GDP) in the OECD.Unfortunately, history provides little cause for optimism.