There is much hand-wringing about the impossible situation of the global economy: there is insufficient aggregate demand to sustain growth in Europe and America, and high debt levels seem to rule out fiscal policies.
Misguided monetary policies, combined with inadequate regulation, may have helped get the world into its current mess. But seemingly aggressive monetary policies are incapable of getting us out. Some argue that there is a liquidity trap – so pumping more money into the system, while it may pose a risk of inflation down the line, is not going to get the economy’s engines revving again.
Only part of this is true: the economy is in fact seriously weak, and at most, monetary policy can only do a little. But monetary policy in conjunction with appropriately designed fiscal policy could do a lot more—even within today’s fiscal constraints.
First, a diagnosis: this crisis is more than just a financial sector crisis. The series of bubbles served to paper over the more fundamental weaknesses – structural transformation that is the result of the successes in increasing manufacturing productivity at a pace exceeding demand, so compelling labour to move elsewhere. The financial crisis compounded these existing problems, leaving a legacy of overleveraged households, deeply indebted governments, falling real estate prices, and excess real estate capacity.
Moreover, for most countries, including the US, the weak economy is the most looming problem, not the debt and deficits. Eliminating the deficit will not restore growth, and more than likely would push the US into a serious double dip. Even back-loaded deficit reductions could be problematic: if average citizens are told their taxes are going up next year, it’s likely to dampen spending.
Further, with interest rates at historic lows, standard models would suggest a flood of investment. The lack of one suggests something else is going on: what matters is the availability of credit, and the unprecedented levels of macroeconomic risk.
Monetary policy hasn’t worked, and isn’t likely to, for a couple of simple reasons. It does a far better job of restraining an overheated economy than reigniting a stalled one. With globalization, matters are worse: money goes to where the returns are highest. Right now, that means emerging markets, where money isn’t needed – not the US, where it is.
Traditionally, monetary policy is supposed to affect lending, but lending is still circumscribed, especially to small and medium-sized enterprises. The reason is simple: for all the fanfare of the Troubled Asset Relief Program (TARP) and the bank bailouts, a disproportionate share of the money went to the big banks – which are more focused on making money from speculation, trading, and M&As – than on the smaller regional and community banks, many of which are very weak. If the Obama and Bush Administrations had done more to fix the banks and the real estate market, monetary policy might have been more effective, but, alas, this was not the case.
Fiscal policy can still do the trick: if financial markets weren’t so shortsighted, they would realize that if, say, the US borrows at 3% for a long-lived project yielding 20%, in the medium term the national debt – and even more, the debt/GDP ratio – will be down.
Opponents of this approach argue, for one, that that public investment will crowd out private investment, because interest rates will supposedly rise. But in the current context, with the Fed committed to low interest rates for years, that argument seems absurd. Secondly, they argue that individuals, worried about future tax liabilities, will save more. Evidence for this, especially in the US, is almost nil: the Bush tax cuts, which set the country into its deficit, were followed by a dramatic fall in the savings rate. America’s savings rate has recently gone up not because of a far simpler reason than concern about future tax liabilities: the bottom 80% had been spending 110% of their income, and that was simply not sustainable. They have been forced to live within their means; but they are not saving for their future.
If financial markets demand more immediate gratification, the balanced budget multiplier says that if the government increases taxes and spending by an equal amount, GDP increases. If taxes on upper income Americans are increased by just 1% of GDP, rough calculations suggest that GDP could be increased by as much as 2% to 3%. Using Okun’s law, which relates changes in output and unemployment rates, the unemployment rate could fall by 1 to 3 percentage points. This approach would, in the medium term, markedly decrease the debt and debt/GDP ratio.
The fact is, we can reduce the long-term deficit and stimulate growth, but it won’t happen on its own. It won’t happen if we rely on monetary policy, and it won’t happen if we stick with what is on the table in today’s political discourse.
Joseph Stiglitz is Professor of Economics at Columbia University and a Nobel Laureate